As the fifth part of our series unfolds we are now moving up to the very top of our investment pyramid into the highest risk category of investing, Futures, Options and Low-Priced and Penny Stocks.
Let’s review the elements of this high-risk category and discuss if these investments play a part in your investment portfolio.
Risk is defined as the possibility of suffering a loss. The greater the risk the greater the reward and with this in mind, many individuals feel that they can “handle” a certain amount of risk. All of us assume risk everyday and with many activities that we take for granted. For example, driving a car. The more miles we drive every year, or the faster we drive, the greater the chances of having an accident. However, we calculate these risks to be low, because our perception of that risk is low. Perception of risk is defined as ones understanding of the outcomes of a loss. There is also the perception of life experience. One assesses his or her risk tolerance by what has happened to them throughout their lifetime. As you can see there are many elements to one’s ability to handle risk.
Many investors prior to 2000 were more than willing to invest in the category of investments that we are discussing today. These same investors made a lot of money in the stock market. They now realize, after the recent down turn of the financial markets that this is not a comfortable place for their money. They learned that they were really “risk adverse” when it came to investing in the stock market and not “risk tolerant”.
Commodity Futures are contracts to buy and sell items that are mined and grown-corn, coffee, pigs, cattle, crude oil, etc.-at some time in the future. The investor is betting on the future movement of prices, a speculative activity even for those who know the markets well. This is treacherous territory for a beginning investor. The risks are high as are the rewards. Often these investments are marketed as a once-in-a-lifetime chance to make a killing in commodities.
Financial futures and currency futures are contracts involving future price directions of items such as Treasury bonds, Bank CD’s, the NYSE Index, foreign currency and the Euro. This is also a highly speculative area to invest in and is used by professionals for complicated hedging purpose. Hedging is a strategy involving the sale of a call option to supplement a long position in an underlying asset or more simply put it is a way to protect an investment by buying the right to another investment. It is like insurance on an investment.
An option is a contract to buy or sell a stock at a certain price during a specified period of time. The investor is betting on the future direction of the price of that stock. Small price swings in the underlying stock will have a multiplier effect on an option’s price. Large percentage gains or losses are characteristic of options. An option is a short-term vehicle used primarily by people who trade stocks. It is not for long-term investors, especially beginners.
Low-Priced and “Penny” Stocks
A low-priced stock sells for under $5.00 per share, a penny stock for under $1.00 per share. In general, these stocks are very small companies with no or minimal track records. In the penny stock investment arena, you may even find companies with no revenues and no earnings, only a corporation set up to pursue a future dream. Low-price stocks are highly speculative and look very tempting but should be avoided by the beginning investor.
The high-risk portion of our investment pyramid is filled with speculation. Many investors venture into this with less than optimal results. Often people are misled with cold calls and advice from less than scrupulous investors, seeking to make quick money off of others. It is best to deal with a Registered Financial Advisor or an investment professional that knows all aspects of investing and understands your individual risk tolerance.
To recap our high-risk category, it is one that is very speculative, risky and can have huge and frequent swings from highs to lows in the matter of hours or days. This category is not for everyone and should never represent more than 10% of your portfolio. It should not be in a portfolio of an investor who cannot sacrifice the money as a total loss and most certainly it should not be in a portfolio for someone who needs the assets to support their yearly income.
Remember if an investment sounds too good to be true it probably is. It is always best to stay within your comfort zone knowing that your investments are safe and sound. Contact us to determine if and how high risk investments are appropriate for your portfolio.