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Understanding the Pros and Cons of High-Risk Investments

Understanding the Pros and Cons of High-Risk Investments
A Look at Seven High-Risk Investment Options for the Investor with High-Risk Tolerance

There is no one right way to invest. Smart investing takes into consideration the individual and their personal preferences, and these preferences include things like risk tolerance and overall comfort as an investor. This is because there is a broad spectrum of investment options available, and some are inherently riskier than others. As the level of risk increases, so too do the possible gains – and the potential losses. While some level of risk is a natural part of investing, high-risk investments aren’t a good fit for most people. Still, if you have tolerance for it, you may be able to reap great rewards by adding them to your investment portfolio.

Below we’ll discuss the pros and cons of seven of the most popular high-risk investments.

1.     Leveraged Investments

Leveraging is when you borrow funds to increase your investment. This strategy can help you double or triple your gains on an investment, and there are several exchange-traded funds (ETFs) that offer leveraging. Of course, if the market performs poorly, leveraging can also double or triple your losses.

You’ll want to be careful with these ETFs because they are calculated on a day-to-day basis — one bad day on the market, and you could find yourself with tripled losses. However, it’s worth noting that leveraged investments are useful for quick turn arounds if you aren’t interested in long-term growth.

2.     Options

Perhaps the most confusing of the high-risk investments, trading in options is a way to find high returns despite the fluctuations in the overall market.

When you buy an option, you are buying the right to buy or sell a specific security, by a specific date, for a specific price. Below are some of the key terms to know.

  • call — the right to buy an option
  • put — the right to sell an option
  • strike price — the price at which you have agreed to either buy or sell
  • covered option — you own the security you are selling
  • naked option — you do not own the security you are selling

Naked options have the potential for a massive loss. For example, imagine you bought the right to sell stock X at $100 per share by a specific date. When the date arrives, the stock has risen to $150 a share. You will have to cover the cost of the difference to your buyer. Because the market has the potential for unlimited fluctuation, this is known as being at “unlimited risk.”

Trading in options should only be for the experienced. Even with expert knowledge of the market, you can end up losing big.

SEE ALSO: Impact Investing: Pros and Cons

3.     High-Yield Bonds

For generations, bonds have been a tried-and-true way to create a steady income for your portfolio. Most purchased bonds offer consistent growth and rarely default. These bonds are not what you’d typically consider high-risk investments. However, you may be able to increase the rewards by investing in riskier bonds.

Bonds are rated on a scale based on the borrower and their credit. The scoring system starts with AAA at the top and ends with D at the bottom. Anything below a BBB- is considered a ‘junk bond.’ One strategy is to buy some of these lower-rated junk bonds and speculate that they will be paid off and not default.

Due to the odds, you probably won’t want to put a large portion of money into this strategy but making some speculative plays in the lower-ranked bonds can pay off.

4.     Global Currency

Global currency investments are also considered high-risk investments. You can make enormous gains but, at the same time, currency can generate some of the greatest losses on your investments.

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Using the Foreign Exchange Market (FX) you will be able to invest in a currency the way you would any other security. Outside the United States, you can find dramatic fluctuations in different currencies. Being able to predict these rises and falls is where you will make money with your investment. Currency can collapse, though, so it is wise to keep in mind that there is the potential to lose everything.

5.     Emerging and Frontier Markets

The biggest advantage to investing in emerging and frontier markets is the opportunity to get in on the ground floor. The U.S. stock market is well-established and rather stable, so emerging and frontier market investing lets you buy small with the potential for larger growth.

Emerging markets are countries that recently transitioned or transitioning from a developing nation to a developed nation. These include countries like China, Brazil, India, and Mexico.

Frontier markets tend to be smaller countries with fewer gains and more risk in their markets. These include countries like Lithuania, Kenya, Jordan, and Vietnam.

Strategically, you will want to include a mix of emerging and frontier markets in your portfolio. You will need to be careful about relying on them too heavily, however, because they tend to be less stable and will sometimes default on debts. Political or economic issues can cause instability that affects these markets, too.

SEE ALSO: How to Maximize Your Stock Options

6.     Penny Stocks

Penny stocks are the shares for companies that have been de-listed or are too small to appear in the NYSE or NASDAQ. Penny stocks are found through Pink Sheets and purchased over-the-counter for prices often $5 or lower. Seeing a stock bought for pennies expand into a huge earning can be an incredible experience.

However, there is a reason these stocks are sold through Pink Sheets. The companies represented tend to be much smaller, meaning limited growth, and are not subject to the same regulatory oversight as the NYSE or NASDAQ. Also, be wary of scams — it is not unheard of to see a company’s shares falsely promoted to manipulate stock prices. It is a way for dishonest sellers to make money.

7.     Niche ETFs

There are thousands of Exchange-Traded Funds to choose from, and the numbers continue to grow. Many ETFs are based on following the overall trend of the market through indexes. In recent years, there has been an explosion in niche ETFs pursuing specific areas of the market.

This specificity can be focused on a theme, meaning pursuing the same sector. Specificity can be good if you trust in an emerging trend or technology and predict it will be gaining ground due to innovations or necessity. There are also niche ETFs that pursue more abstract paths like attempting to duplicate the volatility index or an inverse of the market. While the inverse ETF works well when things take a turn for the worse, it will be losing you money while the market is doing well.

Concluding Thoughts: High-Risk Investments and Rolling the Dice

Each of the seven high-risk investments above offers both advantages and disadvantages. Ultimately, how you choose to invest boils down to your tolerance for risk and loss. No matter your risk tolerance, however, it is always a good idea to have diversity in your investment portfolio and to not put all your eggs in one basket. Any type of investing is a bit like rolling the dice, so educate yourself and decide what options are right for you.

Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”).  This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.

Zachary Morris

Zachary Morris, CFP®

Having traveled to over 35 countries, Zach is a believer in Ralph Waldo Emerson’s statement that Life is about the journey, not the destination. Being a CERTIFIED FINANCIAL PLANNER™ provides Zach the opportunity to help clients define and realize their journey, and co-founding Paces Ferry Wealth Advisors, an independent firm, allows the freedom to define the client experience along the way.