Although many people classify all investments as either “safe” or “risky,” experienced investors understand that there are several levels and types of risk. Some risks can be mitigated with diversification, while others cannot. Investors who seek high returns must be prepared to absorb the high risks that come with them, which may include the loss of their principal. Ten of the riskiest types of investments available include:
- Options: The prices of listed market options change quickly and often unpredictably, and those who sell uncovered positions or buy contracts to open their positions can win or lose huge sums of money in very short periods of time. This type of trading is best left to experienced professionals.
- Futures: Like options, futures contracts can be high-risk vehicles for the inexperienced and uneducated. Those who speculate in this market are typically pitting themselves against institutional investors who hold underlying positions on the contracts that they purchase. Many financial advisors will tell you that both options and futures contracts can best be viewed as gambling instruments (although there are some safe and conservative strategies that employ them as well).
- Oil and gas exploratory drilling: There’s nothing better than striking it rich by drilling a hole that produces fossil fuels. There’s also nothing worse than spending thousands of dollars drilling a dry hole that produces nothing. Even though these expenses are usually deductible, the chances of substantial or total loss in an exploratory drilling venture are typically quite large.
- Limited partnerships: Although partnerships that are publicly traded tend to be relatively stable, small private partnerships should be viewed with caution and skepticism in most cases. Each partner is liable for all of the actions of every other partner, so you’d better be confident that everyone involved will be willing and able to do their part before you sign on the dotted line.
- Penny stocks: Stocks that trade for less than a dollar a share can provide enormous profits if you find the right company. The vast majority of them will instead provide you with substantial volatility, unpredictability (as they seldom move in tandem with the mainstream indices), and big losses if you are not careful. Stocks that trade on OTC Pink typically have little working capital and often provide bogus information to investors and regulators regarding their financial condition. A large percentage of the fraud that occurs in the financial industry happens in this arena.
- Alternative investments: Hedge funds, artwork, collectibles, precious metals, and royalty interests in oil and gas leases can provide sound returns for those who carefully research each possibility and do their homework. They can also drop drastically in value or become virtually worthless in some cases, and their prices may be determined by a very fickle market. Many investments in this category can also generate substantial tax bills, and alternative investments that are designed to function as tax shelters may post very weak returns. Private offerings that have not been filed with the SEC also do not have to adhere to the same regulatory criteria as publicly traded securities, and those who are approached with these investments should employ substantial due diligence on them.
- Junk bonds: Companies that have been either initially rated or downgraded to below investment grade must pay higher rates of interest than their more stable cousins in order to attract investors. However, their relative instability also means that there is a greater chance that they may default on their obligations, which can translate into a temporary cessation of income in less severe cases and a partial or total loss of principal in the event of total insolvency.
- Leveraged ETFs: Exchange-traded funds that employ leverage are among the most volatile instruments in the markets today. These funds are usually linked to an underlying index or other benchmark and will move either tangentially or conversely with it in some multiple. For example, an inverse ETF that is linked to the S&P 500 will drop twice as much in value as the index rises and vice-versa. Some ETFs are designed to trade in multiples of three, four, five, or even more against their benchmarks.
- Emerging and Frontier Markets: Although many companies that begin in underdeveloped regions of the world can show explosive growth in their early years, they are also vulnerable to many types of risks, such as political and military risk, as well as currency risk from exchange rates. Investors who look overseas may also have to pony up for foreign taxes and tariffs. It can also be difficult or impossible to obtain reliable information on the financial condition of some of these companies.
- IPOs: Although many initial public offerings can seem promising, they often fail to deliver what they promise. The riskiest type of IPO is that of a new company that has no current outstanding shares. Investors here have no historical data to analyze and must base their decision solely on the company’s projected business model and estimated probability of success. Statistically speaking, four out of five IPOs trade below their initial price within the first five years.
The Bottom Line
All investments are subject to at least one type of risk, but some investments carry a much higher degree of risk than others. The investments listed here can provide substantial returns in some cases. The money that is put into them can also disappear quickly and permanently in others. Consult your broker or financial advisor for more information on this topic.