If the stock market crashed again, would you respond by investing more? Is day trading your sport of choice? Do you smirk at the idea of keeping money in a savings account instead of investing it?
If you answered yes to these questions, you’re probably an investor with a high risk tolerance.
Hold up, Evel Knievel.
It’s fine to embrace a “no-risk, no-reward” philosophy. But some investments are so high-risk that they aren’t worth the rewards. If you’re planning to invest your $1,400 stimulus check, here are 10 investments to avoid if you can’t afford big losses.
10 Risky Investments That Could Lead to Huge Losses
We’re not saying no one should ever consider investing in any of the following. But even if you’re a personal finance daredevil, thing very carefully before you make these investments.
Sure, if things go well, you’d make money — lots of it. But if things go south, the potential losses are huge. In some cases, you could lose your entire investment.
1. Penny Stocks
There’s usually a good reason penny stocks are so cheap. Often they have zero history of earning a profit. Or they’ve run into trouble and have been delisted by a major stock exchange.
Penny stocks usually trade infrequently, meaning you could have trouble selling your shares if you want to get out. And because the issuing company is small, a single piece of good or bad news can make or break it.
Fraud is also rampant in the penny stock world. One common tactic is the “pump and dump.” Scammers create false hype, often using investing websites and newsletters, to pump up the price. Then they dump their shares on unknowing investors.
You and I probably aren’t rich or connected enough to invest in an IPO, or initial public offering, at its actual offering price. That’s usually reserved for company insiders and investors with deep pockets.
Instead, we’re more likely to be swayed by the hype that a popular company gets when it goes public and the shares start trading on the stock market. Then, we’re at risk of paying overinflated prices because we think we’re buying the next Amazon.
But don’t assume that a company is profitable just because its CEO is ringing the opening bell on Wall Street. Many companies that go public have yet to make money.
The average first-day returns of a newly public company have consistently been between 10% to 20% since the 1990s, according to a 2019 report by investment firm UBS. But after five years, about 60% of IPOs had negative total returns.
Proponents of bitcoin believe the cryptocurrency will eventually become a widespread way to pay for things. But its usage now as an actual way to pay for things remains extremely limited.
For now, bitcoin remains a speculative investment. People invest in it primarily because they think other investors will continue to drive up the price, not because they see value in it.
All that speculation creates wild price fluctuations. In December 2017, bitcoin peaked at nearly $20,000 per coin, then plummeted in 2018 to well below $4,000. That volatility makes bitcoin useless as a currency, as Bankrate’s James Royal writes. As of March 17, 2021, bitcoin was trading for over $56,000, though double-digit price swings remain the norm.
Bitcoin has recently become a far more mainstream investment, with big companies like Tesla and Square buying coins. But if you’re considering buying bitcoin with your stimulus check, understand that this is an extremely high-stakes investment.
4. Anything You Buy on Margin
Margining gives you more money to invest, which sounds like a win. You borrow money from your broker using the stocks you own as collateral. Of course, you have to pay your broker back, plus interest.
If it goes well, you amplify your returns. But when margining goes badly, it can end really, really badly.
Suppose you buy $5,000 of stock and it drops 50%. Normally, you’d lose $2,500.
But if you’d put down $2,500 of your own money to buy the stock and used margin for the other 50%? You’d be left with $0 because you’d have to use the remaining $2,500 to pay back your broker.
That 50% drop has wiped out 100% of your investment — and that’s before we account for interest.
5. Leveraged ETFs
Buying a leveraged ETF is like margaining on steroids.
Like regular exchange-traded funds, or ETFs, leveraged ETFs give you a bundle of investments designed to mirror a stock index. But leveraged ETFs seek to earn two or three times the benchmark index by using a bunch of complicated financing maneuvers that give you greater exposure.
Essentially, a leveraged ETF that aims for twice the benchmark index’s returns (known as a 2x leveraged ETF) is letting you invest $2 for every $1 you’ve actually invested.
We won’t bore you with the nitty-gritty, but the risk here is similar to buying stocks on margin: It can lead to big profits but it can also magnify your losses.
But here’s what’s especially tricky about leveraged ETFs: They’re required to rebalance every day to reflect the makeup of the underlying index. That means you can’t sit back and enjoy the long-haul growth. Every day, you’re essentially investing in a different product.
For this reason, leveraged ETFs are only appropriate for day traders — specifically, day traders with very deep pockets who can stomach huge losses.
A lot of people collect cars, stamps, art, even Pokemon cards as a hobby. But some collectors hope their hobby will turn into a profitable investment.
It’s OK to spend a reasonable amount of money curating that collection if you enjoy it. But if your plans are contingent on selling the collection for a profit someday, you’re taking a big risk.
Collectibles are illiquid assets. That’s a jargony way of saying they’re often hard to sell.
If you need to cash out, you may not be able to find a buyer. Or you may need to sell at a steep discount. It’s also hard to figure out the actual value of collectibles. After all, there’s no New York Stock Exchange for Pokemon cards.
Plus, there’s also the risk of losing your entire investment if your collection is physically destroyed.
7. Junk Bonds
If you have a low credit score, you’ll pay a high interest rate when you borrow money because banks think there’s a good chance you won’t pay them back. With corporations, it works the same way.
Companies issue bonds when they need to take on debt. The higher their risk of defaulting, the more interest they pay to those who invest in bonds. Junk bonds are the riskiest of bonds.
If you own bonds in a company that ends up declaring bankruptcy, you could lose your entire investment. Secured creditors — the ones whose claim is backed by actual property, like a bank that holds a mortgage — get paid back 100% in bankruptcy court before bondholders get anything.
8. Shares of a Bankrupt Company
Bondholders may be left empty-handed when a corporation declares bankruptcy. But guess who’s dead last in terms of priority for who gets paid? Common shareholders.
Secured creditors, bondholders and owners of preferred stock (it’s kind of like a stock/bond hybrid) all get paid in full before shareholders get a dime.
Typically when a company files for bankruptcy, its stock prices crash. Yet recently, eager investors have flocked in to buy those ultracheap shares and temporarily driven up the prices. (Ahem, ahem: Hertz.)
That post-bankruptcy filing surge is usually a temporary case of FOMO. Remember: The likelihood that those shares will eventually be worth $0 is high.
You may be planning on turning a quick profit during the run-up, but the spike in share prices is usually short-lived. If you don’t get the timing exactly right here, you could lose big when the uptick reverses.
9. Gold and Silver
If you’re worried about the stock market or high inflation, you may be tempted to invest in gold or silver.
Both precious metals are often thought of as hedges against a bear market because they’ve held their value throughout history. Plus in uncertain times, many investors seek out tangible assets, i.e., stuff you can touch.
Having a small amount invested in gold and silver can help you diversify your portfolio. But anything above 5% to 10% is risky.
Both gold and silver can be volatile in the short term. Gold is much rarer, so discovery of a new source can bring down its price. Silver is even more volatile than gold because the value of its supply is much smaller. That means small price changes have a bigger impact. Both metals tend to underperform the S&P 500 in the long term.
The riskiest way to invest in gold and silver is by buying the physical metals because they’re difficult to store and sell. A less risky way to invest is by purchasing a gold or silver ETF that contains a variety of assets, such as mining company stocks and physical metals.
10. Options Trading
Options give you the right to buy or sell a stock at a certain price before a certain date. The right to buy is a call. You buy a call when you think a stock price will rise. The right to sell is a put. You buy a put when you think a stock price will drop.
What makes options trading unique is that there’s one clear winner and one clear loser. With most investments, you can sell for a profit to an investor who also goes on to sell at a profit. Hypothetically, this can continue forever.
But suppose you buy a call or a put. If your bet was correct, you exercise the option. You get to buy a winning stock at a bargain price, or you get to offload a tanking stock at a premium price. If you lose, you’re out the entire amount you paid for the option.
Options trading gets even riskier, though, when you’re the one selling the call or put. When you win, you pocket the entire amount you were paid.
But if you end up on the losing side: You could have to pay that high price for the stock that just crashed or sell a soaring stock at a deep discount.
What Are the Signs That an Investment Is Too Risky?
The 10 things we just described certainly aren’t the only risky investments out there. So let’s review some common themes. Consider any of these traits a red flag when you’re making an investment decision.
- They’re confusing. Are you perplexed by bitcoin and options trading? So is pretty much everyone else. If you don’t understand how something works, it’s a sign you shouldn’t invest in it.
- They’re volatile. Dramatic price swings may be exciting compared with the tried-and-true approach of investing across the stock market. But investing is downright dangerous when everything hinges on getting the timing just right.
- The price is way too low. Just because an investment is cheap doesn’t mean it’s a good value.
- The price is way too high. Before you invest in the latest hype, ask yourself if the investment actually delivers value. Or are the high prices based on speculation?
The bottom line: If you can afford to put a small amount of money in high-risk investments just for the thrill of it, fine — as long as you can deal with big losses.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].