Although many people will classify investments as either "risky" or "safe," experienced investors understand there are different levels and types of risk. Some risks can be mitigated with diversification, while others cannot. Investors who seek high returns must be prepared to accept high risks, such as the loss of principal. Below, we review ten risky investments and explain the pitfalls an investor can expect to face.
1. Options
An option allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Typically, traders hope to profit from a short-term move, either by buying a call or put. To the novice, prices in the options market can seem to change unpredictably, though knowledgeable traders improve their edge by learning technical analysis. Because investors can quickly lose all of their principal, options trading is best left to experienced traders.
2. 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 they purchase. Many financial advisors will tell you that both options and futures can best be viewed as gambling instruments (although there are hedging strategies that employ them as well).
3. 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.
4. Limited Partnerships
Although limited partnerships that are publicly traded tend to be relatively stable, many limited partnerships are not publicly-traded. Small, private partnerships—at one point referred to as "Master Limited Partnerships"—should be viewed with caution and skepticism in most cases. Limited partners are not liable for all of the actions of every other partner—managing partners assume that position; however, limited partners often have limited liability for precisely that reason.
Still, you'd better be confident that managing partners are doing their part, and their due diligence, before you sign on the dotted line.
5. Penny Stocks
Penny stocks can provide enormous profits if you find the right company. The vast majority of penny stocks will instead provide you with substantial volatility, unpredictability, and big losses if you are not careful. Stocks that trade on OTC Pink market typically have little working capital and often provide scant information to investors about their financial condition.
6. Alternative Investments
Hedge funds, artwork, collectibles, and royalty interests in oil and gas leases can provide sound returns for those who carefully research each possibility. They can also drop drastically in value or become virtually worthless in some cases.
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. Investors considering these investments should employ substantial due diligence.
7. High-Yield 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, the relative instability of high-yield bonds, aka junk bonds, also means there is a greater chance a company may default on its 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 insolvency.
8. 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 will move opposite the index. Some ETFs are designed to trade in multiples of two or three times against their benchmarks.
9. Emerging and Frontier Markets
Although many companies that begin in emerging and frontier markets 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.
10. IPOs
Although many initial public offerings can seem promising, they sometimes 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.
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.
