Investing

How to Know If an Investment Is Too Risky

Research the company you’re investing in. If a business is too small, too new, or has had major issues such as bankruptcy or lawsuits, it might be too risky. Look for companies with a proven track record and solid leadership.

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If you want to be rich, saving part of your earnings every month is inadequate. You also need to invest, but investing can be highly risky if you don’t know what you are doing. Here’s how to tell if an investment is too risky for you and how to create an investment strategy that works.

Features of Potentially Risky Stocks

Investing in the stock market is a popular short- and long-term investment option. However, individual stocks from different companies come with exceptional levels of risk. It’s up to you to determine if the risk involved is too high or if the potential investment returns outweigh the risks.

Potentially high-risk stock investments have the following features:

Bankrupt Companies

Buying company stocks from a business that has filed for bankruptcy is very risky. Owning stocks means you own a piece of the company. However, if a business becomes bankrupt, your stock ownership will not automatically entitle you to company assets equal to your holdings.

It is common for investors to snatch up company stocks after their value reduces due to financial trouble. Such investors do so with the mindset that the shares purchased at low prices will appreciate when the company bounces back. Such comebacks do happen, but they are rare, and when they happen, the returns are usually significant.

Companies with a Micro-Cap

The SEC describes investing in companies with market caps under $300 million as high-risk. Market cap refers to a company’s total market value based on outstanding shares.

Companies with a small market cap typically haven’t been in business long and have unknown management with unproven track records. Investing in such a company is risky because you have no guarantees the company will still exist in the next few months.

If you buy stocks from such a company and want to liquidate your assets, you may have trouble finding interested buyers. That’s because most investors won’t want to buy the stocks until the company proves itself.

Unless a small market cap company suddenly booms in value, investing in such shares is equivalent to having your money tied down in non-liquid assets.

Specialized ETFs

An exchange-traded fund (ETF) is a collection of stocks you can buy at once. Various types of ETFs are available, and investors categorize them according to their themes or objectives.

The SEC considers specialized ETFs, such as leveraged and inverse ETFs, to be high-risk investments. An inverse ETF comes about by betting on a venture to fail. It can be a profitable short-term investment, but if your market direction forecast is wrong, significant financial losses can occur.

Leveraged ETFs make a profit by magnifying returns or losses on a venture. Leveraged ETF investors get significant returns as long as the underlying index does well, but even as little as a 3% drop in the index will lead to substantial losses.

High Leadership Turnover

Frequent changes at the top affect shareholder confidence. When shareholders are uncertain, they tend to dump their shares, leading to a fall in share prices. Minimize your risk of losing money by only buying individual stocks from companies with strong and stable leadership.

Major Lawsuits

An expensive and embarrassing lawsuit can destroy a company. Trade disputes can also affect a company’s stock market performance by raising fears about its financial future. Before investing, do your due diligence to identify if the company is facing damaging lawsuits or trade disputes.

Note that not all stocks with the above features turn out to be bad investments. Some can be very profitable, but they are rare, and you can’t tell if your gamble will pay off.

Deciding Whether an Investment Is Too Risky

Once you’ve put together a list of possible investment options, pick the ones compatible with your level of risk tolerance. Do this by considering these factors:

How Badly Will a Loss Affect Your Finances?

Investing all or most of your savings in an opportunity is highly risky. If the investment fails, you might struggle to recover. Your safest option is investing in opportunities that require amounts you can afford to lose if the investment fails.

How Volatile Is the Investment?

Extremely volatile investments, such as cryptocurrencies, aren’t for everyone. The volatility of the asset can swing in your favor or the opposite direction. If the investment is prone to constant and unpredictable changes in value, carefully weigh your options before investing.

When investing in highly volatile assets, I recommend investing with a long-term mindset. That way, if the value of your investment drops, you can wait until it bounces back before you liquidate.

Do You Need Stable Income?

If you need a stable income, you are better off with low to medium-risk investment options. Compared to high-risk opportunities, return on investment from minimal risk opportunities are typically lower, but you can count on them.

For example, during your retirement planning, avoid investments that can wipe out all your savings and leave you vulnerable if something goes wrong. People in such scenarios are better off with low-risk investments that can provide a steady income, such as mutual funds and Senior Citizens Saving Schemes (SCSS).

Are You Taking a Loan to Invest?

If taking a loan to invest, you need guarantees you’ll at least get back your capital. Otherwise, if the investment fails, you’ll find yourself with no profit and bank debt that’s accruing interest.

How to Determine Your Risk Tolerance

Your risk tolerance is your psychological ability to bear losing money on an investment. Your risk profile is your ability to take risks, and it determines your risk tolerance. Some investors prefer high-risk investments, while others prefer minimal levels of risk.

A high investment risk typically leads to higher rewards but an equally high chance of not getting a return on investment. Low- and medium-risk investments may offer lower rewards, but your chances of losing are lower.

To identify investments fitting your risk profile, ask yourself:

  • Why are you investing?
  • How much do you want to make, and how quickly do you want to earn it?
  • How will you fund your investment?

The general advice from financial experts is to avoid risking more than you can afford to lose. To figure out how much risk to take, consider the following.

Time Horizon

The time horizon is how long you have to wait to reap the fruits of your investment. A short time horizon is typically one to four years, while a long time horizon is four years or more.

If your time horizon is short, do not invest in high-risk assets. That’s because the asset’s volatility may force you to sell at a lower price than you intended. You are better off with low-risk assets that are more likely to deliver the expected return on investment when you need it.

If you have a longer time horizon, you can invest in assets with higher risks. You may have enough time to monitor the investment and sell when its value peaks.

Bankroll

The bigger your bankroll, the more risk you can afford. For example, one person owns $2 million, and another has $30,000. They both invest $25,000 in cryptocurrencies, and the value of the asset suddenly drops.

The wealthier investor can afford to wait until the value of the asset comes back up. The other party’s bottom line will suffer and might force them to take drastic decisions to stay afloat.

What Are the Riskiest Investments?

If you’re an investor having trouble understanding how to know if an investment is too risky, read on for high-risk investments to avoid.

Options

Unless you are an experienced trader who knows how to perform technical analysis, options trading is extremely high-risk. Technical analysis will help you predict price changes in the options market and avoid losing your principal. Another investment option that’s just as risky is a futures contract.

Penny Stocks

Penny stocks are company shares available at bottom prices, and these stocks can sell at double their value within a short time. If you invest in the right company, penny stocks can be highly profitable. However, most penny stocks are bad investments due to their high volatility and difficulty in liquidating quickly.

Alternative Investments

Hedge funds, art, and collectible items can yield impressive returns if you make the right purchase. They can also suddenly lose their value for various reasons. Another danger of investing in alternative assets is they attract significant taxes. Before investing in alternative assets for long-term purposes, consult an expert.

Junk Bonds

Companies that offer junk bonds offer higher rates of interest to attract investors. However, junk bonds are often unstable, and the companies offering them tend to default on their obligations. If the company defaults or becomes insolvent, you may lose your principal.

Leveraged ETFs

The tax, trading, and portfolio risks associated with leveraged ETF trading far outweigh its potentially high returns. The instrument may link to the S&P 500 or another underlying index or benchmark. It will move tangentially or conversely with the index and trade in multiples of two or three against its benchmark.

Crypto Assets

Despite the inherent risks, more individuals and businesses, including Tesla, are investing in cryptocurrencies.

Crypto assets include cryptocurrencies, initial coin offerings (ICOs), and blockchain companies. Investors in such opportunities have a track record for yielding impressive returns, but crypto assets are also high-risk due to the industry’s volatility and speculative nature. The lack of government regulation also contributes to the riskiness of crypto-asset investments.

Initial Public Offerings (IPOs)

Many people are still upset about ignoring initial public offerings from Google, Amazon, and Facebook. However, not every IPO leads to huge returns, especially from a new company with zero current outstanding shares.

Do you plan to invest in IPOs from new tech companies? Note that over 60% of more than 7,000 IPOs between 1975 and 2011 failed after five years in the secondary market.

What Are the Safest Investments?

Now that you know the types of investments to be wary about, let’s look at safer options.

High-Yield Savings Accounts

One of your safest investment options is a high-yield savings account. You deposit into it like a regular savings account, but it yields 20 to 25 times more than a standard savings account. The Federal Deposit Insurance Corporation (FDIC) insures the bank accounts, and they are immune to market fluctuations.

The main risk associated with this type of investment is that if inflation rises above your annual percentage yield (APY), the value of your returns will reduce.

Certificates of Deposit

Certificates of deposit are a low-risk investment option that yields a small but reliable return. They are a great choice if you don’t need your money immediately and want it to earn interest until you need it.

If you try to withdraw your money before the agreed term, you may have to pay penalties. No-penalty certificates of deposit are also available, but they offer lower yields.

Gold

For centuries, gold has been a safe investment option, especially during periods of economic turmoil. Warren Buffet, Ray Dalio, and other major investors all recommend gold for long-term investing. If you don’t want to invest in gold itself, you can invest in gold ETFs.

U.S. Treasury Bonds

Another reliable investment option is U.S. Treasury bonds. Investors trust this instrument because the U.S. government has yet to default on its debt. Like other low-risk investments, treasury bonds have a low yield. On the upside, you get some inflation protection.

Play it safe when investing in treasury bonds by buying directly from the U.S. Treasury via an online brokerage platform. Besides being less secure, buying from the secondary market comes with extra costs.

Related: Bonds vs. CDs

Mutual Funds

A mutual fund is a company that receives money from investors and invests in stocks, bonds, and other assets. Each investor owns a part of the company’s portfolio and gets a piece of its income. Depending on the mutual fund, your return can be high for a short- or long-term investment.

Series I Savings Bonds

Series I Savings bonds have a higher yield than most high-yield savings accounts, and these instruments also offer better protection against inflation. You have to hold a bond for at least a year before you can liquidate it, and it can earn interest for up to three decades. Note that you cant invest more than $10,000 a year.

Corporate Bonds

For even higher yields, buy corporate bonds. The higher yield comes with medium risk, but it’s still very tolerable for most investors. The safest corporate bonds have an AAA investment grading. Lower-graded options offer higher yields to attract investors, but they are usually riskier.

Preferred Stocks

Preferred stocks are hybrid securities with features of both stocks and bonds. They offer the ownership stake and appreciation potential of common stock and the income potential of bonds. Compared to bonds, preferred stocks can rise to far higher values.

On the downside, they tend to undergo severe depreciation during periods of economic turmoil. Regardless of what’s happening in the market, you will receive income from preferred stocks because they come with guaranteed dividends.

Use Safety Labels to Identify Potentially Risky Investments

Another tip for knowing if an investment is too risky is to look out for safety labels.

Public is adding safety labels to specialized ETFs and other high-risk investment options. If you’ve never heard of Public, it’s an investment platform where new investors can learn about opportunities and purchase stocks and ETFs.

The safety labels make it easier for users to make better-informed decisions regarding investing in potentially risky stocks and ETFs. Besides Public, a few other platforms are using safety labels.

These platforms identify risky investments with the help of SEC guidelines. According to the SEC, high-risk investments include:

  • Companies that filed for bankruptcy
  • Stocks with market caps between $50 million and $300 million
  • Leveraged and inverse ETFs

You can still buy these instruments, but you do so at your own risk if you choose to ignore the safety label. Even if you don’t intend on purchasing stocks or ETFs via Public, consider using the platform to check an instrument’s safety before investing.

Bottom Line

If you prefer high-risk investments that deliver more returns, opt for long-term investments that allow you to ride out value fluctuations caused by the asset’s volatility. For example, if you invest in Bitcoin now that it’s at peak value, if it crashes, you only have to wait until it rebounds.

When making a high-risk investment, only invest money you won’t need for a long time. Otherwise, you might have to liquidate your assets at an unideal time.

If your risk tolerance is low, try short-term investments you can quickly liquidate when the assets volatility shifts in your favor. Alternatively, opt for low-risk, long-term investments. The yield is lower, but you’ll enjoy peace of mind regarding the safety of your principal and expected returns.


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