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Guide to high-risk investments

Risk can be viewed as a necessary evil when it comes to investing. Without taking some risk, investors would find it difficult to stay ahead of inflation and grow their savings for retirement. By definition though, risk can have consequences so it is very important to understand the risks you are taking - especially when you venture into high risk investments.

What is a high risk investment?

There are many forms of risk, but this discussion will focus on the risk of losing the principal value of your investment. In that context, high-risk can be described as representing a strong possibility of losing some or even all of the value of your investment.

Obviously, people take on high risk because of the chance of earning a high reward, but risk and reward are not always in proportion. The following are some examples of investments with relatively high levels of risk.

Stocks

A stock is a share in a company which can be traded in a public market. This makes stocks exposed to risk in two ways: long-term, its value depends on the soundness of the underlying company, and short-term its price is subject to the often-fickle perceptions of investors.

Price fluctuations mean that a stock may lose a substantial amount of its value after you purchase it, and under extreme conditions, your entire investment might be wiped out if the company goes out of business. Diversification can help cushion you against the risk of extreme loss, and recent years discount brokers and online stock trading have made it cost-effective for even relatively small investors to diversify across a wide range of stocks. Investing in well-established companies can also help mitigate risk.

However, diversification and investing in large companies can only reduce risk so much. Historically, the S&P 500, an index of 500 large stocks, has lost more than 43 percent in a single calendar year. Furthermore, as recently as 2008, it had a loss in excess of 36 percent.

Penny stocks

Some favor of investing in very low-priced stocks, in hopes a small investment can produce a huge gain. However, low-priced stocks often move even lower.

The term "penny stocks" now applies to stocks trading under $5 a share. These penny stocks often trade over-the-counter and are subject to looser regulation than those trading on major exchanges. Their thin volume means they tend to trade very inefficiently. That looser regulation and thin volume also makes them especially prone to scams and manipulation, making them much riskier than larger stocks. In particular, be wary of stocks with a Q at the end of their stock symbol -- this means it has filed for bankruptcy.

Emerging market stocks

International diversification can be a sound risk management strategy - rather than have all your financial health depend on conditions in one country, it can be a good idea to spread some investments around to other economies.

However, it is important to make a distinction between established economies and emerging ones. Investing internationally adds the risk of currency fluctuations to the other risks inherent in investing in stocks, and with countries whose economies are still maturing, those fluctuations can be especially acute.

Add to that the political risk, under-developed regulatory environment and often limited liquidity involved in such markets, and emerging market stocks are certainly at a different risk level than international stocks in general. They have their place, but only as a very limited portion of a diversified portfolio.

Junk bonds

It's a question of perspective. Some people refer to bonds with a questionable ability to make their interest and principal payments as junk bonds, while others refer to them as high-yield bonds because they pay higher interest rates than most bonds.

The two definitions go hand in hand. The high yields are the price investors demand for the questionable quality of these bonds. Those yields may make them attractive investments, and junk bonds can also achieve substantial price gains if they are upgraded to investment quality.

Two things to remember about these bonds. First, as attractive as the yield may be, you cannot view it with the same certainty as the yield on a Treasury bond or even a top-rated corporate bond. Second, the junk bonds pay high yields because investors figure some of them will default. Therefore, if you want to own junk bonds, you can manage the risk by diversifying. This way, the yield on the bonds that actually fulfill their obligations can compensate for the lost interest and principal from the ones that default.

Bitcoin and other fads

Bitcoin, an electronic currency, has become extremely popular with speculators and the attraction is understandable. In the past seven years, the price of a bitcoin has soared from just 5 cents to a few thousand dollars.

Bitcoin aspires to be an alternative to currencies associated with governments, like the U.S. dollar or the euro. A large part of its appeal as an exchange mechanism is that it is anonymous and free from the type of regulation and restrictions typically placed on formal currencies. Given the huge amount of money around the world that is laundered for illegal activities or moved offshore for tax evasion or to avoid political risk, there is certainly a market for bitcoin.

Unfortunately, the extreme swings in bitcoin's value belie its aspiration to be a reliable currency alternative. Its value today is largely supported by having become a speculative fad like the dot-com bubble, or even (centuries ago) tulip bulbs. These bubbles become self-fulfilling prophecies until they burst. Investors see the extraordinary returns and pile in regardless of price, desperate to catch a piece of the action.

The problem is, the later to the game they are, the higher the price investors pay. Since more people are attracted to these fads late than early, these bubbles create more losers than winners. If you want to take a flyer on investments like this, try to get in early, and most of all, keep it to a limited enough portion of your investments that you can afford to lose.

In addition to the inherent risk of each of the above, remember there is always a cost to each transaction, so heavy-trading strategies can increase your risk of loss. Transactions costs can be mitigated somewhat through long-term investing and using discount brokers and the best online brokers via online stock trading to reduce commissions.

Risky investments are complicated, but there are at least two simple rules for managing risk: never invest in anything you don't understand, and diversify into a mix of low- and high-risk investments to limit your exposure to any one thing.

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