If putting together a portfolio is like following a recipe, high-risk investments could be considered the spicier ingredients.
And while spicy investments can add excitement to the dish and make it more rewarding, they also increase the chance of an adverse reaction.
Hitting the right flavor combination for your investment portfolio shouldn't be a matter of luck, though. It should be more a reflection of your ability to cultivate, source, and blend the right investments into a delectable entree that satisfies your needs.
This article focuses on high-risk investments, but they're just one ingredient in the recipe for building your portfolio. To reach your financial goals, you may need to substitute other, more nutritious ingredients that are less spicy than the high-risk varieties found in this article.
Still, it's not bad to learn about high-risk investments so you can make informed decisions. Here's what to know when considering whether your strategy should include high-risk investments:
- What are high-risk investments?
- What are the highest-risk investments?
- How do you plan your strategy for managing risk?
What is a High-Risk Investment?
Risk comes in different forms and varies according to the circumstances. However, when people talk about high-risk investments they are generally referring to those that are subject to wide price swings and even the possibility of permanent losses.
Why would anyone take on added risk?
Generally, it's because that risk opens up the possibility of higher returns.
The tricky thing is that high returns are just a possible reward for taking risks. They are by no means guaranteed.
Your time horizon can greatly affect the risk of an investment. The longer you can wait for your investments to pan out, the more latitude you can allow for wide price swings and even some total failures in the meantime.
The following are some examples of investments that can represent the highest-risk element of a portfolio - and the potential for higher returns.
Stocks are publicly traded ownership shares in companies.
When you own stock in a company, you own a piece of that company (for better or worse). The value of what you own depends on how the company's business is doing.
Part of the risk of stocks is that business fortunes can change - and when they do, it's hard to ignore the fact that prices are affected by investor opinions, which may be misguided.
The bottom line is that, when you own a stock, nothing is guaranteed. Even if a stock pays a dividend, that dividend can be reduced or eliminated if the company goes through a rough period.
The term "penny stocks" now applies to stocks trading under $5 a share.
The appeal of such low-priced stocks is the hope that even a small investment can produce a huge gain. However, penny stocks are generally riskier than stocks in general.
Penny stocks often trade over-the-counter rather than on major exchanges, and may be subject to looser regulations.
In addition, penny stocks tend to have very low trading volume. This means they may trade very inefficiently: Even relatively small buy or sell orders can have a big impact on the price.
That thin trading volume makes them especially prone to scams and manipulation. Speculators may spread rumors to try to pump up a stock's price, knowing that, with a thinly traded stock, they don't have to dupe many people to have a big impact on the price.
One type of penny stock deserves even more caution. When a stock has a "Q" at the end of its stock symbol, it means the company has filed for bankruptcy.
Emerging market stocks
These stocks come from foreign countries that are just beginning to have fully developed economies and financial systems.
Emerging market stocks can create added opportunity, but they also bring added risks including:
- Looser regulations that protect investors
- Less reliable economic performance
- Political instability
- Changing currency values
Futures and options
Futures are a commitment to buy or sell an asset in the future at a price agreed upon in advance.
Depending on how the price varies between now and when you are committed to buy or sell the asset, the difference between the actual price and the prearranged price could represent your profit or loss.
Because you are subjecting yourself to the price changes of an asset before you actually buy that asset, a futures contract can magnify your gains and losses so they represent much more than your original investment.
The potential for losing even more than your original investment is an extreme level of risk. You can mitigate that somewhat while still getting some of the investment characteristics of futures by investing in options.
Calls and puts
Calls and puts are common types of options. A call gives you the right to buy a stock sometime in the future at a prearranged price. If the stock moves higher than that price, the option becomes more valuable.
A put gives you the right to sell a stock sometime in the future at a prearranged price. In this case, if the stock falls lower than that price, your option becomes more valuable.
Options last for a limited period of time and, if the stock does not move in your favor by the end of that period, your option expires worthless. Thus, you should not invest more in options than you can afford to lose.
Junk bonds are bonds issued by companies with shaky finances. They are referred to as being below investment grade, which means they are considered to be speculative in nature.
Junk bonds are sometimes called high-yield bonds. They offer a higher income yield to investors in return for the risk that the bond issuer may not be able to make its interest and principal payments in the future.
You should only invest in junk bonds after examining the financial condition of the issuer so you can at least assess the risk you are taking.
Currencies of different countries move up and down in value relative to one another. Buying and selling a particular currency can be one way to profit from its changes in value.
However, this is a risky strategy because currencies depend on a wide range of economic and geopolitical conditions. Those conditions are often difficult even for experts to predict.
Bitcoin and other crypto-currencies
If traditional currency trading is risky, crypto-currencies like Bitcoin ramp that risk up to another level. This is because crypto-currencies are not backed by any government.
Though crypto-currencies like Bitcoin are intended to act as substitutes for traditional currencies, they have some serious drawbacks. They are not widely accepted and their values fluctuate erratically.
Also, the fact that several rival crypto-currencies have been created poses a risk to the value of crypto-currencies in general. These are highly speculative investments.
Initial Public Offerings (IPOs)
Initial public offerings (IPOs) are brand new stocks. The companies themselves generally aren't brand new but have been around long enough to generate interest from investors.
One risk of investing in IPOs is that the company may not have a long track record of publicly disclosed financial information. That gives investors less to go on in making their decisions.
Also, high-profile IPOs can be hyped so heavily that the stock gets pushed to excessively high prices at first. When that happens, the stock often suffers a steep fall once the excitement dies down.
Day trading is high-frequency trading designed to take advantage of the many small price changes that occur in stocks throughout the day.
This is risky because it is based on trying to anticipate the short-term behavior of other investors rather than on the long-term fundamentals of a company.
Also, frequent buying and selling generates high trading costs, which makes it more difficult to earn a good return. One essential for this strategy is to find an efficient, low-cost broker to try to keep trading costs down.
Venture capital is money invested privately to fund start-up or expanding businesses.
Investing in any form of start-up is inherently risky. Also, you have to be very careful about examining the financials of the venture, since private companies are not obligated to follow the same accounting and disclosure rules as public companies.
Another thing is that venture capital investments require committing your money for long periods of time. Besides requiring a long time horizon, it can be difficult to get out of any investment for which there is not a regularly traded market.
Strategy: Building Your Portfolio for Long-Term Growth
Taking on high risk in search of higher returns is not simply a matter of greed.
An added element of risk can be necessary to increase the odds that your investment portfolio can fulfill long-term goals like beating inflation or meeting retirement plans.
That element of risk might be especially necessary when low-risk investments offer low yields that might have trouble reaching your long-term goals.
Before you decide to take on high-risk investments, you should figure out what your risk profile is.
Your risk profile is determined by your goals, your financial situation, your investment time horizon and your emotional reaction to losses.
Generally speaking, the longer your time horizon, the more high-risk investments you can tolerate. However, there are several variables, so be careful of one-size-fits all approaches such as assuming that everyone of the same age has the same risk profile.
The risk of an investment portfolio is generally not so much a question of which individual investments are in it, but of what the asset allocation is.
Asset allocation is the blend of different securities you have. The proportion of different types of securities goes a long way toward determining the overall riskiness of a portfolio.
For example, a blend of 80% stocks and 20% fixed income securities would generally be considered riskier than a blend of 20% stocks and 80% fixed income securities.
There are many different stock/bond blends that can be used to adjust the risk and reward of a portfolio. Also, the extent to which you choose to mix in some of the riskier investments described previously impacts the riskiness of your overall portfolio.
Where do you start when building a portfolio?
The starting point of building a portfolio should be to determine an asset allocation target that fits your tolerance for risk. Then you can fill in those allocations with individual investments from the right asset classes.
Even if you choose to make some of your own investment decisions, a key role that a financial advisor can play is to help you come to grips with your risk tolerance and an asset allocation that fits that profile.
Whatever your risk profile, planning your risk strategy can provide a framework that helps all your individual investment decisions fall into place.