Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
High-risk investments are securities and other investments where investors are exposed to the potential for significant losses, alongside significant gains.
Generally, high-risk investments tend to be from cyclical, volatile industries, or they take the form of equity in relatively new, untested companies. In contrast, lower-risk investments tend to be related to more established businesses or sectors.
That said, there are many types of high-risk investments. These can include stocks, alternative investments, derivatives, and more. The important thing to know about high-risk investments is that the higher the potential reward, the higher the risk of loss.
Key Points
• High-risk investments are securities that expose investors to the potential for significant losses as well as gains.
• High-risk investments may originate from cyclical, volatile industries or new, untested companies.
• Common characteristics of high-risk investments include high volatility, lack of transparency, lower regulatory oversight, and greater complexity.
• Examples of high-risk investments include: penny stocks, IPO stocks, commodities and futures, options, leveraged ETFs, hedge funds, and venture capital.
• Portfolio risk management typically involves determining personal risk tolerance, prioritizing diversification, and adhering to the principle of only investing what you can afford to lose.
What Defines a High-Risk Investment?
A high-risk investment is one that will expose you to a higher risk of losing money. High-risk investments also typically come with the potential for higher gains, which is why some investors consider them.
The question for most new investors will be how much risk they are willing to take on (here’s how to determine your risk tolerance). If you’re looking to take on substantial risk to reap potential rewards, you may want to consider certain types of investments. But remember that the more risk you take on, the more you could potentially lose.
Qualities of a High-Risk Investment
High-risk investments include certain types of stocks, bonds (i.e., junk bonds), as well as derivative products like options, futures trading, and commodities. Alternative investments are also considered high risk.
The common thread among these assets is they expose the investor to one or more of the following conditions: high volatility, a lack of transparency, lower regulatory oversight, higher complexity.
It may be helpful to think of risk as relative, too. If a Treasury bill, for instance, is generally considered to be a low-risk investment, a more volatile penny stock may exist on the other end of the spectrum.
Understanding Volatility and Probability of Risk
Volatility is a factor in high-risk investments. Volatility can refer to variations in a security’s price when the price diverges from the mean: the greater the swings in price, the higher the volatility, and the greater the probability of risk when investing online or via a traditional brokerage.
When considering a type of investment, it’s important to consider what may cause price volatility. For example, in commodities trading, oil prices may be more stable under certain geopolitical conditions, but more volatile when oil-producing regions are under strain.
Volatility can also refer to market conditions. Some markets are more volatile than others. Investors can gauge how volatile a market sector might be by looking at the performance of its benchmark index. How much the index varies from its mean is another indicator of market volatility.
It’s important to remember that no matter what you’re adding to your portfolio, investing almost always involves risk. In other words, there are no “safe” investments when trading stocks and other securities, but some may be lower risk than others.
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Common Examples of High-Risk Investments
As noted, high-risk investments can take many forms. Here are some common and higher-risk investments you may encounter.
Highly Volatile Stocks
Experts typically consider stocks to be one of the riskier asset categories to invest in, especially compared to bonds or certificates of deposits. But not all types of stocks have equal risk profiles. There are different classes of stocks that are riskier than others.
Penny Stocks
Broadly defined as stocks that trade at a market value of less than five dollars per share, penny stocks are high-risk securities that can be found across a variety of industries.
But penny stocks are not necessarily listed on public exchanges. They may trade over-the-counter (OTC), and as such can be more volatile and less liquid than other types of stocks.
Penny stocks might represent shares of companies in utilities, energy, gold mining, technology, or anything else.
Like other high-risk, high-reward stocks, penny stocks may yield high returns in a short amount of time. However, the risks of penny stocks may outweigh the potential for high rewards due to low trade volumes, lack of information on the companies, possible fraud, and other risks.
IPO Stocks
Investing in the stock of newly public companies can also be higher risk. These initial public offering (IPO) stocks are untested by the market, which means they are inherently less transparent, making them more prone to price spikes and drops.
When a company wants to go public, they hire an underwriter, e.g., an investment bank, that structures the IPO and generates interest among investors. Not everyone can buy shares at the IPO price, however. IPO stocks are offered to institutional investors and others close to the company first. Individual investors may be able to access shares via their brokerage, but IPO shares are limited, and brokerages may impose restrictions.
Commodities and Futures
Commodity stocks, or stocks of companies that produce raw materials like oil, grains, and metals, tend to be highly volatile. That’s partly because these commodity industries are cyclical, or closely tied to economic growth. But commodities are also vulnerable to other conditions, including weather events and geopolitical issues, making them higher risk.
Investors may invest in commodities by owning the physical product or trading individual stocks or shares of a commodity ETF. Commodities are frequently traded on futures markets, however. Futures are contracts between traders who promise to buy or sell a given commodity for a specific price at a specific time in the future. Advanced traders may buy and sell commodity futures to speculate on the price movements of the underlying commodity.
Because commodity prices change on a weekly and sometimes daily basis, futures trading can be risky to all parties involved.
Recommended: Why Is It Risky to Invest in Commodities?
Options Trading
Instead of buying an asset such as company stock outright, an options contract is a derivative that allows the investor to try to benefit from price changes in the underlying asset without actually owning it.
In stock options, a contract is typically equal to 100 shares of the underlying asset, offering investors a type of leverage when placing trades. Leverage allows options traders to control a larger position with less capital, amplifying potential returns, but likewise amplifying potential losses.
Trading options contracts is highly complex, and available only to experienced investors who obtain approval from their brokerage to place options trades.
Leveraged ETFs
A leveraged investment vehicle may offer returns (and losses) several multiples higher than the amount someone has to invest, which makes an asset like a leveraged exchange-traded fund (LETF) potentially high risk.
Unlike ordinary ETFs, leveraged ETFs use debt or derivatives in an attempt to deliver two or three times the daily performance of an underlying index. Importantly, because leveraged ETFs are based on daily performance objectives, the SEC warns that holding them longer could potentially lead to “significant and sudden losses.”
There are leveraged ETFs that rise in price along with the assets they track (bull ETFs) and those that rise in price when the assets they follow go down in price (bear ETFs, also known as leveraged inverse ETFs).
Hedge Funds
A hedge fund is a private fund, often not registered with the SEC, which invests in a variety of assets, using a range of strategies, to attempt to deliver higher-than-average returns.
While these are pooled investment funds, like mutual funds, they’re usually available only to institutional investors or qualified individuals (i.e., who meet the criteria as accredited investors). Hedge funds are generally not accessible to retail investors, although some funds may offer exposure to these strategies.
Hedge funds charge high investment minimums, and they rely on opaque, high-risk strategies with significant fees. In addition, hedge funds typically don’t have to follow regulations that govern most mutual funds and ETFs, including rules about the use of leverage, disclosure requirements, transparency about share pricing — increasing their overall risk exposure.
Venture Capital
Venture capital is a form of private equity financing that targets a new company and seeks to help it grow so that VC investors may see a profit. VC investing is typically provided by high-net-worth investors, investment banks, and other financial institutions — and isn’t generally available to retail investors (except via certain types of mutual funds).
VC companies generally focus on startups and smaller businesses that demonstrate potential for significant long-term growth. Venture capital is a form of alternative investment, and considered high risk given the potential for the startup to fail. Like all types of private equity funding, venture capital isn’t highly regulated, and it generally lacks transparency.
Angel Investing
Angel investing is also a form of equity financing — a way for businesses to fund their operations in exchange for offering an investor a stake of ownership in the company. Compared to venture capital, “angel investing” is a more generic term that applies to anyone willing to take a gamble on a new startup.
Angel investors are often high-net-worth individuals looking for significant returns on their investments. Angel investors may invest in a few budding enterprises, but the ratio of failure to success is high.
Crowdfunding
Crowdfunding helps entrepreneurs pool together small amounts of money from many investors, in order to raise sufficient capital for their venture. Crowdfunding typically relies on an online crowdfunding platform; these may give entrepreneurs access to a wider network of potential funders, but there may be restrictions as well as fees.
Crowdfunding provides an alternative route to traditional business funding through equity or debt. And anyone can participate in crowdfunding. In most cases, though, crowdfunding is not an investment, per se. It’s more like a type of donation.
In some cases, the terms of the crowdfunding include shares or equity that may provide a return over time. This is governed by the SEC’s Regulation Crowdfunding rule.
The Pros and Cons of High-Risk Investing
Investors may invest in high-risk stocks and similar securities because they may provide substantial returns. Very few people would consider it wise to put the majority of their portfolios into high-risk investments, however. Individual investors must determine how much risk they can take on as part of their broader asset allocation strategy.
The Potential for Growth
Investors are ideally able to take on just enough risk to potentially increase their returns without derailing their long-term prospects, should they lose a significant percentage of their allocations to high-risk assets. The balance between high- and low-risk investments tends to be determined by individual investor goals and timelines, as well as tolerance for risk.
Conventional wisdom often says that younger investors in their 20s or 30s tend to be able to afford greater risks since they will, in theory, have the majority of their working lives to earn back any potential losses. Meanwhile, investors closer to retirement may focus on relatively safer investments that are more likely to produce more reliable, albeit smaller, returns.
The Reality of Total Loss
The potential downside of many high-risk investments is the possibility of total loss of capital. In some cases, such as with derivatives, investors risk losing even more than the principal invested.
While total loss is generally not common when investing in more traditional assets such as publicly traded stocks and bonds (although there are no guarantees), high-risk investments may not be well regulated, they may use high-risk strategies, and they can be opaque—all of which can expose investors to greater market volatility or to the potential failure of a company.
Liquidity Concerns
High-risk assets are generally less liquid than traditional assets, which also increases their risk factor. When an asset isn’t liquid, like real estate, it may be difficult to sell and retain the original cash investment when circumstances require it.
How to Manage Risk in Your Portfolio
There are different ways to attempt to measure risk. Some are objective measurements of aspects of a specific investment, while others are more generic insights. Penny stocks and IPOs tend to be riskier than shares of big companies, for example, because their underlying businesses generally aren’t as stable or profitable.
Statistically based risk measurements, such as standard deviation, seek to assign mathematical value to the risk involved in a particular investment. Calculating portfolio beta is another way to monitor how sensitive your stock holdings are to broader swings in the market.
Determining Your Risk Tolerance
Are high-risk investments suitable for you? The best way to find out is to determine your risk tolerance. Understanding the degree to which you can tolerate the possibility of losing money is an important step when setting up your portfolio.
The Importance of Diversification
Diversification is important when considering your portfolio’s asset allocation and exposure to risk. By spreading your investments across a variety of asset classes, industries, and risk profiles, you may reduce your portfolio’s overall volatility and risk.
In this way, allocating a smaller amount to higher risk strategies limits your risk exposure, and may help protect your assets in the long-term.
Only Invest What You Can Afford to Lose
When it comes to high-risk stocks and other investments involving significant risk, investors should consider the adage: Never invest more than you can afford to lose.
Remember, too, that it may also be worthwhile to discuss your strategy with a financial professional.
Indicators of High-Risk Stocks
Common indicators of high-risk stocks include beta values, earning volatility, and trading volume. Understanding a few basic parameters can help you decide which stocks to invest in.
High Beta Values
A stock’s beta value refers to how volatile the stock is. Beta is a measure of market sensitivity, with 1.0 indicating that a stock is in sync with the market. b. A stock with a beta of 1.10 is 10% more volatile than the market, as measured by the benchmark index for that stock.
You can also consider beta as a measure of lower volatility. A stock with a beta of 0.80, for example, would be 20% less volatile than the market.
The top 100 most volatile U.S. stocks are tracked by the S&P 500 High Beta Index; this provides a frame of reference when choosing (or avoiding) more volatile companies.
Earnings Volatility
A company with greater earnings volatility tends to have commensurate volatility in its share price. In order to explore this particular risk factor, earnings volatility can be tracked over time via company earnings reports.
Because earnings volatility is correlated with the cost of capital, greater volatility in earnings may lead to insolvency.
Low Trading Volume
Trading volume refers to the number of shares of stock traded during a certain period of time. Higher trading volume can signal strong demand and higher liquidity. By contrast, low trading volume can indicate lower demand, market uncertainty, and lower liquidity — a potential risk factor.
The Takeaway
High-risk investments are just that — risky. But that might not necessarily mean you should avoid them. If you have the risk tolerance, you may be able to utilize high-risk investments to help build wealth and meet your financial goals. Investing in more volatile companies may help individuals benefit from the potential growth of these businesses.
You can also stick to a broader investment strategy that incorporates high-risk investments balanced with more conservative ones. A financial professional can also help you review options and allocations based on your risk-tolerance, if you need guidance.
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FAQ
Which asset classes are generally considered the highest risk?
Higher risk investments include derivatives (such as options and futures), certain types of stocks (penny stocks, for instance), hedge funds, venture capital, and alternatives, among others. That said, risk can vary across specific securities and underlying assets.
What characterizes a high-risk stock?
Common characteristics of high-risk stocks include high volatility, lack of transparency, lower regulatory oversight, and greater complexity.
How much of my portfolio should be in high-risk investments?
There is no single formula for deciding how much to invest in higher-risk stocks or other assets. Determining your risk tolerance is an essential part of determining how much of your portfolio should be allocated to higher-risk investments.
Can high-risk investments lead to debt?
Yes, because high-risk investments include the potential for total loss, it’s possible to find yourself in debt. This is particularly true if you’ve used borrowed funds (a.k.a., margin) to invest, since this could expose you to the risk of losing even more than the principal invested.
What is the difference between volatility and risk?
Volatility is one type of risk factor, but there are many different types of risk, depending on the type of investment or strategy involved. Investors need to consider interest rate risk, economic risk, geo-political risk, climate risks, and more.
Are IPOs considered high-risk investments
Yes, the shares available from an initial public offering are considered highly risky, as the company is new and investors may drive up the share price initially. But the investment could result in a steep loss if there is a sell-off.
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