The stock market is generally riskier than keeping your money in the bank or putting it into something like a government bond, and it's possible to find quite high-risk investments on the stock market and in other avenues for investing in shares in companies. While investments with high returns often do carry high risk, it's important to remember not to invest more than you can stand to lose and make sure you understand where you're putting your money.
The Stock Market and Risk
When you invest money in the stock market, there's always a chance that your investment could dwindle to zero or next to nothing. If a company you invest in goes bankrupt, it's possible that shareholders – the company's effective owners – will get nothing once company creditors such as lenders and employees are paid what they're owed.
It's often possible to spot a company headed toward failure, but in some cases, especially when financial fraud is involved, a bankruptcy can come as a surprise, as with the famous Enron case. Sudden economic shifts can also cause companies that seemed to be doing well, albeit often with high debts, to falter, costing investors what they've put in.
Typically, though, thanks to the principle of limited shareholder liability, you can't lose more than you put into the stocks you bought. Even if a company you've invested in through the traditional markets fails, nobody can send you a bill for the company's debts after it fails.
Risky Stocks and Safer Stocks
Of course, not all stocks are equally risky. Blue chip companies with long-lasting, stable businesses, such as utility companies, big banks and big industrial firms, are unlikely to fail overnight. Many of them woo investors by paying out hefty dividends and experiencing relatively small fluctuations in their stock prices over time.
Some industries are inherently more risky. Some classic examples include software companies that have yet to make a profit, hoping they'll be able to turn a new invention into something financially successful, and biotechnology companies, which rely heavily on unproven new medications turning out to be safe and effective when tested in humans. Companies offering real estate in new areas, that may or may not be successful, or searching for natural resources such as gold or petroleum can also be inherently risky, since their efforts simply might not pay off. Other companies, from retail chains to industrial companies, are risky investments because they have a heavy amount of debt, meaning they have little margin to play with if a product doesn't sell as well as anticipated or the market as a whole experiences a downturn.
Look through a company's investor relations material and its filings with the Securities and Exchange Commission to understand the risks involved in its business and make sure you want to invest. Risky stocks can often come seemingly cheap, but there's little point to investing if your chances of getting a return are quite slim.
High-Risk Stocks and Scams
Some of the riskiest stock investments available are so-called penny stocks, which are actually sold for $5 or less due to today's inflation. These stocks are usually either new startups or older concerns that have fallen on hard times. Their shares can be snatched up cheap to reward investors later on if they start doing well, but they also have a risk of failure.
Another issue with penny stocks is that they are often subject to limited trading volume, which attracts fraudsters looking to operate what are known as "pump and dump" scams. These scammers purchase a penny stock and then tout it online through investor message boards, fake news websites or social media posts, hoping to get other investors to get excited about the stock and purchase their shares at an inflated price. Then, once they've sold or dumped their shares, they stop pumping the price up, letting it fall to its previous level.
Beware of stock tips from unusual or anonymous sources, since it's possible that they have a vested and undisclosed interest in what it is they're promoting. Do your own research as thoroughly as you can before making any investment.
Selling Stocks Short
Generally, if you own a stock and believe the price is destined to fall, you can sell your stock and try to grab what profit you've already made or avoid a steeper loss. If you don't own a stock, though, you can still profit from its predicted decline through a system called short selling.
Short selling enables you to borrow the stock from someone else, sell it immediately and then buy it back at a later date to return to the lender. This will let you make a profit if the stock declines. The risk, though, is that you can be on the hook for an arbitrary amount if the stock actually rises in price, since you still need to return the stock to the original lender, even if you have to pay more for it than you sold it for.
You can generally arrange short selling through your brokerage. Make sure you understand the rules and fees involved before you get started.
Buying and Selling Options
Rather than buying and selling stock directly, you can also buy or sell the option to buy or sell a certain stock at a certain price at a certain time. Options to buy are known as call options and options to sell are known as put options.
If you guess wrong about where the price is headed, you can lose money buying or selling options. If you buy an option to buy stock for more than it's worth or sell it for less than the going price, the option won't do you any good. If you sell someone the option to buy it for less than it's worth or sell it for more, you'll essentially lose the difference.
You can sell someone the option to buy a stock that you own, which is called a covered option, or you can sell the option to buy a stock you don't have, called a naked option. Your potential losses are higher selling a naked call option since, similar to shorting a stock, you may need to buy the stock or pay the difference in price.
Trading on Margin
Trading on margin refers to using borrowed money from your broker to buy stocks. If stocks go up, it can be lucrative, but if they go down, it can prove risky, since you're on the hook for the loan.
There are generally rules at different brokers about who can open a margin account and how much they must put down themselves on stock purchases. Some of these are set by individual brokers and some are set by industry regulators.
Capital Gains and Losses
If you make high-risk stock investments and they pay off, keep in mind you will likely owe tax when you sell the stock. On the other hand, if the investments don't pan out, you may be able to take a capital loss on your taxes when you sell.
If you make money on your stock market investments, you will likely have to pay tax when you sell your shares. If you have held on to stocks for more than a year, you can pay at the federal long-term capital gains rate, which is generally 15 percent. Some investors will pay zero percent or 20 percent based on their total income.
If you lose money on stock transactions, you can take a capital loss on your taxes. A capital loss can offset capital gains in the same year or up to $3,000 in ordinary income, such as from work. You can roll capital losses into future years to offset gains or income if you need to do so.
Video of the Day
- Investopedia: Market Risk
- Investopedia: The Importance of Diversification
- Investopedia: Limited Liability
- Investopedia: Low-Risk vs. High-Risk Investments for Beginners
- US News: Penny Stocks: 5 Ways to Spot a Pump-and-Dump Scam
- Kotak Securities: Chapter 2.8: Understanding Covered & Naked Options Contracts
- Investopedia: Naked Option
- Investopedia: Margin Trading
- IRS: Topic Number 409 - Capital Gains and Losses