“The Wall Street Jungle,” written by Richard Ney in 1970, compares the stock market to a shadowy, sometimes impenetrable wilderness filled with dangerous beasts and hidden treasures. Blindly venturing into this unknown world can easily end in disaster.
Often, predators such as con artists, thieves, and bandits lurk and set traps for overconfident, naive adventurers foolish enough to believe that a free lunch is possible. Inexperience can lead to a failure to recognize risk — or to underestimate it — and result in poor decisions and financial loss.
However, overconfidence is more often the cause of investment catastrophes, especially when coupled with the innate tendency of people to follow the herd. In his 1871 book “The Descent of Man,” Charles Darwin wrote, “Ignorance more frequently begets confidence than does knowledge.”
No investment is free of risk, but the following are among the riskiest investments on the market. If you want to protect your investments, read this guide carefully.
The Riskiest Investments on the Market
Any time you make an investment — whether it be in the stock market, gold bars, real estate, or even in your savings account — you’re accepting some risk. However, some investments are far riskier than others. Below are some investment vehicles most investors should avoid because they represent the riskiest investments you can make and expose you to significant losses.
1. Penny Stocks
Penny stocks generally trade with a share price of under $5 per share and represent small companies with market capitalizations of under $500 million. Many of these are micro-cap stocks with valuations below $300 million and represent startups that haven’t quite proven their business models.
In most cases, penny stocks are found on over-the-counter (OTC) markets, which means they don’t face the same financial reporting requirements as companies listed on the major U.S. stock exchanges. Although the few penny stocks traded on the Nasdaq and NYSE do file quarterly and annual reports, even they are considered high-risk stocks because they generally lack profitability and a history of strong performance.
Due to the low price and low supply of shares typically associated with penny stocks, these securities are often targeted by con-artists looking to pull off pump-and-dump schemes, which can result in significant losses for investors.
Although some investors view penny stocks as growth stocks with the potential to generate significant gains, these stocks are highly volatile and often represent companies with unproven business models.
For all these reasons, penny stocks are incredibly risky investments. The allure of the fast money that can come as a result of trading penny stocks grabs the attention of new investors all the time, but these investors should consider the following before accepting the risk:
- Volatility. Penny stocks are riddled with volatility. These high levels of volatility make it difficult to plan entrances and exits. While high volatility opens the door to significant fast-paced gains, it also opens the door to extremely painful fast-paced losses.
- Non-Reporting. The vast majority of penny stocks are non-reporting or underreporting. This means that they don’t regularly file financial reports with the Securities and Exchange Commission (SEC) and that the financial data available about them is often outdated or incomplete, making it difficult to make educated investment decisions.
- Liquidity. The demand for penny stocks is substantially lower than the demand for stocks that represent more established companies with a history of producing profits and a proven business model. Therefore, when it’s time to sell, you may have a difficult time finding a buyer, meaning that you could find yourself stuck in a losing investment.
- Manipulation. Because it’s relatively easy to cause price manipulation in penny stocks, fraudsters and con-artists often latch onto stocks in this category, ultimately adding to the risk for the average investor.
- Follow-the-Money Mentality. Because many in the penny stock category don’t have a clearly outlined business model, they tend to latch onto what’s hot in the market in order to garner demand for their stock. For example, when the coronavirus pandemic spread and investors jumped on any opportunity they could find in the space, tons of new penny stock companies started to come out of the woodwork, claiming to be working on a therapeutic drug, vaccine, cleaning product, or personal protective equipment associated with combating COVID-19. Although they garnered investor interest, many of these companies never actually developed a marketable product.
The allure of trading in the penny stock category is simple. You read stories about how people go from rags to riches trading in these high-risk assets all the time. While some investors do find their calling in the pink sheets, the vast majority of retail investors who invest in penny stocks will experience losses.
Don’t risk your hard-earned dollars on such a shaky investment concept. Instead, look to growth-focused ETFs, as these growth investments are built around diversified portfolios of stocks and industries known to generate significant growth, ultimately giving you access to growth without undue risk.
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2. Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) have grabbed the attention of investors for years. REITs pool assets from a group of investors that are used to buy real estate, manage properties, and cover any costs associated with doing so.
In return, the REIT either hires a real-estate management company to rent the properties out, or rents the properties out themselves, saving on management fees.
When rent starts to roll in, those who invested in the REIT will share in the profits. The problem is that there aren’t always profits to speak of, and the risks associated with REITs are worth paying close attention to:
- Interest Rate Risk. When interest rates are low, the demand for REITs tends to climb. Low interest rates means lower costs associated with purchasing property. Moreover, lower rates means that other investments, such as bonds, don’t generate strong returns, leading to increased demand for REITs. However, when interest rates increase, better returns on bonds lead to a rush of funds out of REITs, reducing their value for those who hold on too long.
- Rental Income. REITs are built around rental income. If nobody’s there to rent the real estate owned by the REIT, there is no rental income to be made. Moreover, if too many renters default, significant losses can be accumulated. This risk was clearly demonstrated during the coronavirus pandemic, when an eviction moratorium led to tenants not paying rent and dramatic losses in many REITs.
- Liquidity. REITs aren’t always liquid investments. When an investor jumps into a REIT, their funds are used for acquiring new real estate as well as management expenses. The money is gone, and in some cases locked in for a minimum of seven years. So, if you need access to your money quickly, you’ll be hard pressed to find a way to get your hands on the green.
- Fees. Managing real estate is no small task, and the cost of doing so can be exorbitant. Managing an investment portfolio also comes with pretty steep costs. Combine the two and you’ll end up with a high-cost investment in which the costs dig into the profits and could lead to losses in extreme cases.
- Taxes. Dividend payments from REITs are taxed at the ordinary rate. This means your capital gains will be taxed at the higher income tax rate, rather than the capital gains rate, further digging into your potential profits.
Like all investment vehicles, REITs have their place among investors who understand the risks and are willing to accept them. Moreover, investors should be knowledgeable about the real estate market and REITs in general before investing. For the average investor, it’s best to stay away from REITs.
3. Savings Accounts
When you think of the safest place to keep your money, chances are the first place you think to squirrel it away is in a savings account.
That may be the biggest financial mistake you ever make.
Savings accounts are known for generating incredibly low returns. Think about it — what’s the interest rate on your savings account? If you’re like most people, your account pays an APY around the average of 0.05%. That means that you’ll only earn a small fraction of a penny per year for each dollar you have in your savings account.
Sure, interest rates are low, but at least your money in savings is safe, right? How are savings accounts risky?
You’re losing money in more ways than you think:
- Inflation Risk. Inflation represents the process of prices rising over time. According to Statista, the rate of inflation in the United States has ranged from 0.12% to 3.14% since the year 2010. Moreover, projections for the inflation rate for 2021 sit at 2.24%. So, if you’re only being paid 0.05% interest on your money, you’re actually losing buying power.
- Opportunity Cost. If you earn $15 in an hour, but you had the opportunity to earn $25 in an hour, that hour cost you $10 in opportunity cost. Instead of earning money in savings accounts, what you’re actually doing is racking up opportunity cost. The funds you have in savings could be used to tap into nearly 10% average annual gains seen in the stock market, or even between 5% and 6% average gains in less risky bond investments.
- Bank Fees. Some banks charge fees to open and maintain a savings account, especially if minimums aren’t met. While these fees may seem minimal, they can be quite expensive over the long run.
The bottom line is that while a savings account is great for emergencies, it’s not a good place for your nest egg. There are better places to save your money — places where you’ll earn much more money, outpacing inflation and letting your money work for you.
4. Commodity Futures
Commodity futures for a variety of agricultural products, minerals, and currencies trade on exchanges throughout the United States — the oldest and largest being the Chicago Board of Trade. Understanding the mechanics and risks of commodity futures trading is essential before venturing into an investment.
Commodity futures speculation is a high-risk venture for individual investors due to the following:
- Lack of Investor Resources. Specialized trading firms including investment banks, hedge funds, and commodity trading funds spend millions of dollars acquiring and maintaining expensive software and hardware to watch and analyze commodity markets. Their systems are programmed and tested by mathematicians and market experts to instantly recognize trading patterns with the slightest profit opportunity and enter transaction orders directly to the exchange for execution. Few individuals can afford to make the significant capital investment required to compete with these larger trading entities when trading in this asset class.
- Lack of Investor Time. Active traders must always be aware of the market and their positions. Off-hours are spent searching news and market reports for information that might affect their holdings. Commodity futures trading is not a part-time activity. In fact, most people simply don’t have enough spare time to effectively trade commodity futures.
- Leverage. The price to acquire a single futures contract is a fraction of the total contract’s value, compounding potential gains and losses. For example, a corn futures contract is 5,000 bushels. Subject to the minimum account balance required by the commodity brokerage firm, a buyer of a single contract of corn with a value of $20,000 is required to deposit slightly less than 5% of the contract’s value to open a position. In contrast, buyers of a common stock on the NYSE are required to deposit 50% of a trade’s value.
- Trading Price Limits. Many commodities are subject to a maximum daily price fluctuation during the trading session, depending on the exchange where the commodity is traded. Trading is halted if the limit is reached and does not resume until the next day.
- Impact of Unknown Events. Projections of future commodity price levels and events are notoriously unreliable due to the vagaries of weather, disease, and natural or human-made disasters, as well as economic conditions, government actions, and erratic consumer behavior.
- Extreme Price Volatility. Volatility is the rate of price change that a commodity experiences during a trading session. Some commodities have high volatility and require investors to assume a greater potential for loss.
- Investor Psychology. The ability to initiate or maintain an investment position is directly dependent upon an investor’s risk profile and resilience. Losses are inevitable, despite a trader’s knowledge and experience. Robert Rotella, the author of “The Elements of Successful Trading,” says, “Any trade, no matter how well thought out, has a chance of becoming a loser. Many people think that the best traders don’t lose any money and have only winning trades. That is absolutely not true.”
Futures trading is a zero-sum game. For every winning trade, there is a corresponding losing trade. Individual commodity traders competing against Wall Street firms and multinational hedgers is akin to a high school football team beating the New England Patriots. Miracles can happen, but it is extremely unlikely.
5. Tax Shelters
In 1935, Judge Learned Hand ruled in the Helvering v. Gregory decision — subsequently upheld by the Supreme Court — that every American has the right to reduce one’s tax liability as low as possible. With that, the market for investments with tax benefits boomed.
Permitting certain expenses or income to be deducted from income taxes can be good public policy, encouraging investments that benefit the country as a whole. For example, the ability to deduct (rather than capitalize) intangible drilling costs from income tax incentivizes investment in oil exploration, just as individuals and companies are encouraged to convert to solar systems by making their costs deductible.
However, investing in tax shelters can be perilous for the following reasons:
- Complexity of Tax Law. While the ultra-wealthy have been exceptionally efficient using the loopholes and complexity of the tax code to their advantage, the key to their success is their ability to afford sophisticated tax advice and legal fees. In an interview with The New York Times, Professor Jeffrey Winters of Northwestern University noted that the ultra-rich “literally pay millions of dollars for these services [tax advice and defense] and save in the tens or hundreds of millions.” Most Americans cannot afford such expert advice.
- Investors’ Lack of Control. Tax shelters often require investments in limited partnerships where investors cede control to and rely upon a general partner for management and preparation of tax filing documents. In other words, they have little recourse if adverse consequences surface. In many cases, neither the salesperson nor the general partner is financially capable or obligated to defend the limited partners’ deductions if challenged by the Internal Revenue Service (IRS).
- Investors’ Lack of Objectivity. Investors tend to overlook the economic aspects of tax shelters due to their focus on the tax deductions. Con-artists exploit this tendency, assuring potential investors that the government takes the investment risk because the cost of the investment will be recovered through the client’s reduced tax liability.
- Heightened IRS Scrutiny. The IRS actively pursues promoters and investors in “abusive tax shelters” with its powers of audit, summons enforcement, and litigation. In some cases, the IRS files criminal charges. An abusive tax shelter is a scheme involving artificial transactions with little or no economic reality, according to the IRS. If an investor is guilty of having participated in an abusive shelter, the IRS will recover any claimed tax savings plus penalties and interest. Potential investors in a tax shelter should be sure of the potential economic benefits of all investments, especially tax shelters, before investing.
- Offerings May Be Unregistered. Promoters of tax shelters often provide limited, exaggerated, or false information about the details of the investment operations, management fees or experience, or the tax law basis for the deductions or credits.
The implications of investing in tax shelters are scary. Sure, it’s possible to make money doing so, and plenty of investors do. But, without a detailed understanding of tax law and the complex inner workings of tax shelters, the average investor should stay away from this investment vehicle.
It wasn’t long ago when the first major cryptocurrency — Bitcoin — was born in 2009. Investors who purchased $100 worth of Bitcoin in the beginning, when it was worth about $0.0008 per coin, would have seen their value grow to more than $4.5 billion by the beginning of the year 2021.
Talk about a winning lottery ticket!
With the sharp rise in the value of Bitcoin came competition in the cryptocurrency space. Today, there are enough altcoins — Bitcoin alternatives — out there to make your head spin, each trying to become the next Bitcoin.
Cryptocurrencies have perceived value because there is a finite supply and they provide an anonymous digital currency, but they also pose serious risks to investors, including:
- Transaction Costs. Cryptocurrency runs on the blockchain, which comes with transaction costs every time a coin trades hands. As demand for Bitcoin and other cryptocurrencies rise, these transaction costs rise, making Bitcoin and many other cryptocurrencies less viable as they grow in popularity.
- Lack of Market Acceptance. Sure, Bitcoin and some other popular cryptocurrencies are being accepted by select online stores and even in a few brick-and-mortar retailers. The problem is that even though cryptocurrency has become so valuable and well-known, it hasn’t been implemented into payment systems as we know them today. Bitcoin has been a hot topic for several years, yet the cryptocurrency still lacks widespread acceptance.
- Volatility. Like penny stocks, cryptocurrencies are highly volatile investments. Demand rises and falls sharply from minute to minute, making prices do the same. While high levels of volatility can lead to strong short-run gains, they can also work against you, leading to dramatic declines in the blink of an eye.
- Cryptocurrency Theft. Cryptocurrency and the blockchain are relatively new technologies. As a result, they haven’t quite been perfected. This has left a back door open for hackers and con-artists to steal cryptocurrency from unsuspecting victims. In 2019, the Independent reported on $143 million worth of Bitcoin vanishing from a dead owner’s cryptocurrency wallet. In 2014, popular cryptocurrency platform Mt. Gox had $460 million in Bitcoin seemingly disappear into thin air, according to Wired.
- Little to No Regulation. As a new form of currency, cryptocurrency regulation is lacking, to say the least. While the SEC and the Commodities Futures Trading Commission both have regulatory authority over the cryptocurrency market, few resources have been geared toward regulating it. So, the cryptocurrency market is today what the stock market was just before the Great Depression — a financial Wild West.
Cryptocurrency is an exciting emerging market. However, the cryptocurrencies of today are far too risky to dabble in casually. If you’re interested in investing in the space but don’t want to take on the risk, consider investing in the technology companies that are developing the microchips and processors to make the mining and maintenance of cryptocurrencies possible.
7. Alternative Investments
Alternative investments — also known as “structured products” or “exotic investments” — are named for their geography or complexity.
These investments are usually illiquid, such as private equity, hedge funds, or real estate. Many are old products — collateralized mortgage obligations — repackaged for modern times or into new, high-risk investments. They include complex derivatives and arbitrages, such as power reverse dual-currency notes designed to exploit the inefficiency of interest rates in two different economies.
Attracted by their popularity, many investment managers of mutual funds are offering alternative investments funds, employing exotic investments in their portfolio to reduce risks or increase returns. While professional fund managers have had limited success with alternative investments, they are not appropriate for the average investor due to the following characteristics:
- Complexity. Understanding and evaluating alternative investments is a full-time job, according to Nadia Papagiannis, Director of Alternative Investment Strategy at Goldman Sachs Asset Management, in Barron’s. The combination of different assets, their relationship to each other, the changing economic environment, and the various risks that affect each asset can be mind-boggling, often requiring sophisticated mathematical models and extensive experience to understand.
- Lack of Transparency. Many exotic investments are not bought or sold on public exchanges and rely upon private transactions and Regulation D offerings to get around SEC registration requirements. According to William Bernstein, an investment advisor and author, “The information asymmetries are industrial-grade. You’re being offered a share of a business that you know nothing about and the person selling knows everything about. Are you going to come out ahead on that one? I don’t think so.”
- Volatility. The return on alternative investments varies tremendously from year to year in comparison to the market as a whole. Dick Pfizer, founder and CEO of AlphaCore Capital, stated in a CNBC interview, “There may be a 1% difference in returns between large-cap value funds in any given year. With an alternative fund, the best manager may be up 10% and the worst, down 10%.”
- Poor Historical Performance. According to Dan Egan, Director of Behavioral Finance and Investments at Betterment, returns on exotic investments don’t live up to their hype due to their higher fees — up to 10 times greater than an exchange-traded fund (ETF) — costs to participate, and the risks involved. Morningstar calculates the average three-year total return for multi-alternative funds to be 0.69% versus the long-term average return of the S&P 500 around 10% annually.
Unless you are an experienced investor with a high tolerance for risk, you should generally avoid investing in exotics. As William Bernstein bluntly states, “Most people have about as much business investing in alternatives as they do trying to do their own brain surgery.”
Collectibles come in all shapes and sizes. From high-end art to McDonald’s Happy Meal Beanie Babies, baseball cards, antiques, stamps, and even classic cars, there’s a long list of collectible goods.
Some people collect these goods because it makes them feel good. Others collect them as an investment. The idea is that if something is rare and collectible and holds meaningful value now, it will be far more rare and valuable in the future.
Why shouldn’t you hold such assets in your investment portfolio?
There are quite a few reasons:
- Speculation. Investing in collectibles is a speculative bet at best, not an investment. When you invest in them, you’re making a bet that there will be a market and a buyer willing to pay more than you paid for the collectibles in the future. There’s no guarantee of that. In fact, collectibles fall out of favor all the time, and when they do, their value drops dramatically, sometimes falling all the way to zero. After all, collectible items are only worth the amount of money a buyer is willing to pay for them.
- Little Data to Research. Publicly traded companies and other investment-grade assets generally have a history of returning value to investors. However, when dealing in collectibles, there is little information available to the general public. So, when you make an investment in the space, it’s akin to making an investment in a stock you know little to nothing about, which is always a dangerous move.
- Liquidity Is Nonexistent. With most stocks, if you want to pull your money out of the investment, all you need to do is sell your position and your money will be returned to you relatively quickly, as is the case with ETFs and several other investment-grade assets. When it comes to collectibles, there’s no guarantee that someone will want what you have to sell. If you’re not able to find a buyer, you’re stuck in that investment until the tides change, if they ever do.
- Scams. The collectibles market is riddled with scams. Knowing that collectibles come with high price tags, con-artists target the industry, making knockoff versions of highly valuable assets. To the average investor, these fakes may look like the real thing, but when it’s time to sell, you may find that the collectible you’ve been sitting on for years is nothing more than a pretty paper weight.
Even billionaires with a knack for picking collectibles can become victims to collectibles fraud. Moreover, with a lack of liquidity, little data to research, and no guarantee a buyer will come running when you’re ready to sell, collectibles can be risky business, and they have no place in the average investor’s investment portfolio.
9. Binary Options
Finally, binary options are a type of derivative investment that carry absolutely no value of their own. Instead, they offer a win-or-lose proposition. When purchasing a binary option, the investor sets a strike price and chooses an expiration date. If the price of the underlying asset covered by the binary options reaches or exceeds the strike price, the investor earns a return, if not, the investor loses 100% of the principal investment.
While winning trades can be overwhelmingly lucrative, losing 100% of the principal investment you put up to buy a binary option can be a painful occurrence. Moreover, your chances of losing are better than your chances of winning.
Here are the risks you should consider before diving into the binary options market:
- Your Broker Is Betting Against You. When trading binary options, your broker is essentially betting against you. When your option ends in the money, your broker has to dig into their own pocket to pay out your profits. As a result, the party in control is naturally going to tip the scales in their favor. It’s best to make investments that aren’t bets against your broker.
- Issues Withdrawing Funds. There are several overseas brokers in the binary options space. Unfortunately, users have experienced issues attempting to withdrawal their funds from these brokers, ultimately leading to a loss of principal investment.
- Short-Term Predictions Are Rarely Accurate. If you were to predict that it was going to rain in the Sahara Desert tomorrow, chances are you’d be wrong; however, if you bet it will rain in the Sahara at some point over the next year, your likelihood of being right would climb dramatically. Investing follows the same logic. Short-term predictions often lead to losses. However, long-term research-based investments have a history of generating compelling gains.
- Lack of Regulatory Oversight. A large percentage of overseas binary options brokers operate in regions where regulatory oversight is minimal at best. These companies choose these regions in order to get around regulation that may tap into their profits by making the trading of binary options fair and equitable. As such, this lack of regulatory oversight poses a significant risk to the investor, making trading binary options — especially with overseas brokers — a high-risk, often dangerous investment model.
Investing will always come with risk, no matter what asset you choose to buy. However, accepting undue risk is never a good idea. Sure, plenty of people have made money using the investment vehicles above, just as plenty of people have money as professional athletes, musicians, and artists. However, for the average investor, athlete, musician, or artist, tapping into vast riches overnight is nearly impossible.
For the average investor, a well-thought-out approach to long-term investments in the stock market using investing strategies like value investing or growth investing, or by simply buying ETFs and index funds, is far more advantageous than taking part in the risky investing models above.