All investing bears some amount of risk. We are taught this from the first day we begin investing, and constantly reminded that this will never change. 2008 was an unpleasant reminder to stock investors that companies & markets that were thought to be only "somewhat risky" can indeed be extremely risky.
It's often said that "risk is commensurate with returns," meaning that the more risk we take, the more we stand to gain – or lose. On the bottom of the risk totem pole are investments like certificates of deposit (CDs), money market funds, and U.S. Treasury Bills. These are deemed to have a 100% chance of repayment, which is why investors can only hope to get a few percentage points per year of return from holding them.
But what about the top of the totem pole? In this rarefied air we can find investments that may bring us a windfall, or bleed us dry just as quickly. Today we look at some of the riskiest investments in the world. These investments should be viewed like a trip to the blackjack tables in Vegas – you only bring what you expect to lose. (Learn to trade smart instead of gambling with your money, in Tips For Avoiding Excessive Trading.)
Extreme Risk Investment #1 – Death Knell Stocks
Many stock investors who thought they were in pretty safe situation found themselves unwittingly in extreme risk investment #1 during 2008. Death knell stocks are companies staring into the abyss of bankruptcy or insolvency. Lehman Brothers went from a stable company to dead broke, and it literally happened over the course of a weekend.
On a longer timeline, the same fate befell AIG, Fannie Mae, and Freddie Mac, but these three companies can still be purchased on stock exchanges thanks to massive bailouts from the U.S. government. They may end up surviving, but big doubts remain as to whether current equity (stock) investors will ever have a claim to future profits.
When the stock of a company drops 90% or more, typically falling below $1 per share, you've got a death knell stock on your hands. It means most investors have long since fled, and the only people remaining are extreme investors hoping for outsized percentage moves. And they can certainly occur. In mid-March, for instance, AIG shares rose over 400% in one week. But investors here were also aware that they were just as likely to see shares drop 90% in one day as rise 90%.
Extreme Risk Investment #2 – Penny Stocks
Penny stocks may sound just like death knell stocks, but they are in fact quite different. While the latter are previously large companies facing bankruptcy, penny stocks are tiny companies that often trade over-the-counter (OTC) rather than on major stock exchanges. While not every penny stock actually trades for pennies, most of these micro-cap companies have stock prices below $5 per share. They are also defined by having very small trading volumes, meaning that the entrance or exit of one big investor can move the stock in a big way.
Many penny stocks have little revenue and zero profits, and many will end up going the way of the dodo bird at some point if they run out of cash before proving that the business model can actually work. And because of the low volumes, there is the risk that some days may see no shares traded at all. This means if you want to get in or out, your modest trade alone could move the stock 20% in the opposite direction than you want. (To protect yourself from an attack, don't swim in this ocean. Spot Sharks Among Penny Stocks.)
Extreme Risk Investment #3 – Stock Options
Listed stock options, which typically represent the rights to 100 share blocks of stock, are one of the most basic types of what are known as derivatives, meaning that they derive their value based on the price of something else.
Stock options are a big and legitimate market, with hundreds of thousands of these contracts being traded daily. But the vast majority of stock options are used by large institutions to hedge other risks in their portfolios. In this regard, most options end up being like insurance contracts – they pay the fees, and don't expect to get any return. Swimming against this crowd are the speculators, people who buy stock options outright in the hopes of making outsized profits.
An option investor who is betting on the price of stock XYZ to rise can seriously juice up their potential returns by purchasing call options. So for example, if XYZ shares rise 4% on a particular trading session, short-term stock options on XYZ could easily rise by 100% or more in the same day.
The options arena is not to be treaded lightly, and not by novices. A clear reason why is the fact that roughly 90% of all stock options expire worthless!
Extreme Risk Investment #4 – Commodities
Investors today have several ways to access commodities like crude oil, gold, global currencies, and sugar. Methods like recently-introduced ETFs are certainly volatile – and therefore risky – but not so much that they can't be considered in a well-diversified portfolio. The extreme risk investment is in buying & selling individual commodity futures contracts. It's here that leverage can easily go to 100-1 and beyond, and where you can not only lose your entire investment, but lose more than your entire investment.
Like with stock options, the commodity futures market is dominated by big players looking to hedge specific risks. Speculators have to prove they are sophisticated enough to even step up to the plate here. Another risky part of commodity investing is that should you hold a contract for too long, someone will assume you want delivery of the underlying product. So unless you want 30 barrels of crude oil delivered to your doorstep one day, commodity positions are meant to be entered and exited quickly.
All risk warnings aside, for those who are willing to lose everything, returns can be huge in the commodities space. One well-timed trade can net a return of 1,000% or more in just a few days. On the flip side, one poorly-timed trade can not only wipe you out, but put a bill in the mail for even more money. (Find out which funds make investing in gold, oil or grain an easier prospect in Commodity Funds 101.)
Risk is everywhere. Certain investments may seem safe and stable for years on end, then suddenly blow up in an instant. But remember that even the most extreme risk investors know enough to have a base of safe investments and a big cushion for losses. Just like you wouldn't take your rent money to Vegas, you don't expose yourself to losses you just can't stomach. But for the brave of heart and quick of hand, these extreme investments can boost your trading account - as well as your blood pressure.
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