---
title: "What Makes a Risky Investment Risky?"
description: "What makes a risky investment risky? Why make an investment if you know it has risk? Why high risk stocks may or may not make sense for your portfolio."
canonical_url: https://trendshare.org/how-to-invest/what-makes-a-risky-investment-risky
markdown_url: https://trendshare.org/ai/what-makes-a-risky-investment-risky.md
published: 2014-09-15
last_updated: 2020-12-31
content_license: https://trendshare.org/about/disclaimer
---
# What Makes a Risky Investment Risky?

Source: https://trendshare.org/how-to-invest/what-makes-a-risky-investment-risky
Updated: 2020-12-31
Not all investments are the same. A thousand dollars invested by one person
may grow ten or twenty times, whereas the same thousand dollars invested by
another may lose money. (No investor wins if all investors are the same.)
Stocks, bonds, funds, and other places to put your money are all different;
they have [different levels of investment safety](https://trendshare.org/how-to-invest/what-is-a-safe-investment).

Even though an investment can seem safe on the surface (in that it offers a
good return after taxes and inflation), [factors inherent to the investment itself produce different levels of risk](https://www.investopedia.com/exam-guide/finra-series-6/evaluation-customers/types-investment-risks.asp). To
build real wealth in the stock market, you must understand and manage the risks
of your investments.

## What Makes an Investment Risky?

Apart from more exotic investments such as options and futures, the
intrinsic risk of any stock is that the company will go out of business and
you'll lose all the money you spent buying the stock. You get to keep [dividends](https://trendshare.org/how-to-invest/why-do-companies-pay-dividends) you've received, though [a company in financial trouble probably won't pay dividends](https://trendshare.org/how-to-invest/why-do-some-companies-not-pay-dividends).

This risk is present in *any* stock—even [Coca-Cola](/stocks/KO/view) *could* go bankrupt—but it's
less likely for *good* stocks. What keeps a good stock likely to stay
good is the strength of the company in several aspects, including but not
limited to the quality of upper management, the presence of [a durable competitive advantage (a moat)](https://trendshare.org/how-to-invest/what-is-an-economic-moat-for-a-stock), the [reliability of earnings](https://trendshare.org/how-to-invest/earnings-matter-most), the
periodicity of the business, the debt structure and return on invested capital
of the business, the [sector](/stocks/list_sectors) and [industry](/stocks/list_industries) of the business, and the [size of the business](https://trendshare.org/how-to-invest/what-is-market-capitalization).

These aren't the only factors, but if you know enough about the business to
assess these qualities, you'll have a good sense of the underlying risk.
Remember, though: the risk of losing all of your money is serious, but so is
the risk of losing out on a better return from a different investment.

## Why Do Some Investors Pursue Risk?

Have you ever bought a lottery ticket? For $2 you buy the chance to win
millions of dollars. The odds of winning the jackpot are terrible, but millions
of people buy tickets anyway. The expected payoff is high and the penalty
(losing $2 and having nothing to show for it but the entertainment of dreaming
"What if I won?") is small.

Investing $10,000 in a new, high-tech startup with no earnings and only the
possibility that one day it'll be the next [Amazon](/stocks/AMZN/view) or [Facebook](/stocks/FB/view)
is similar. In the absence of strict metrics to run past the risk criteria
described earlier, you have to tell a story about your hope that this little
company will outperform the market and find a profitable niche from which to
grow quickly (lest it suffer the fate of the other 99.9% of high tech
startups). Looking for risky stocks to invest in? Find one with more hope than
data.

Unless there are other "no risk, no reward" investors lining up to throw
money at this company, you can probably buy shares of its stock cheaply. The
market tends toward efficient pricing (no revenue? what's it worth liquidated?)
which you can measure via methods such as [intrinsic value](https://trendshare.org/how-to-invest/what-is-intrinsic-value) and [discounted cash flow](https://trendshare.org/how-to-invest/what-is-discounted-cash-flow).
This is one reason [penny stocks](https://trendshare.org/how-to-invest/risks-of-penny-stock-trading) are
so cheap. Their businesses are worthless and probably won't ever turn
around.

Yet there's always a *chance*, and you can decide what that chance is
worth. It's generally worth nothing, but if you have money to burn, the
riskiest stocks of 2021 offer a tiny chance....

## How to Make Buying Stocks Less Risky

You can't avoid all risk in investing. There are too many factors to
predict, from the interconnections of the global economy to human error and
malfeasance to the impossibly complex web of human desire, fear, and behavior
which governs how all of the shareholders of a stock will trade over time.

You *can* stick with good stocks. Pick companies with known
histories. Pick companies which have trends of making money. Pick businesses
which have demonstrated that they know how to navigate the competitive
landscape of modern business and generate real revenue for their
shareholders.

Alternately, [put your money in a good index fund such as the S&P 500](https://trendshare.org/how-to-invest/buy-the-s&p-index-fund) and wait 10, 20, 30, or 40 years.

## Can Diversification Reduce Risk?

Some advisors suggest that diversifying your investments across sectors and
industries helps you avoid risk. That's not necessarily true. Obviously, if
you've done your homework and chosen five really great companies and bought
them at good prices, the risk of you losing your money from all five companies
going out of business is less than the risk of losing your money if you
invested in only one doomed company.

That kind of diversification—investing in several good
companies—is good. It's done with research and thought. One of the
drawbacks of diversity for its own sake (buying shares of every company in a
sector or one company in every industry) is when you have an equal chance of
buying shares of a good company as shares of a bad company.

Does the S&P 500 index apply? Certainly some companies underperform
every year and get removed from the index and other companies outperform and
never make it to the index, but the fact that you have the 500 largest
companies in American business coupled with the fact that very few
professionally managed funds match the performance of the index on a regular
basis, especially when accounting for risk and [broker fees](https://trendshare.org/how-to-invest/broker-fees) means that this is one case where broad diversification is worthwhile.
(This is especially true, considering how boringly good this index fund
is.)

In short, diversification is good when you spread the risk around *good
companies*. It's useless (perhaps even harmful) otherwise.

## Do Riskiest Stocks Provide Greatest Rewards?

In purely rational economic terms, it makes sense to buy the riskiest
investment where the [present value](https://trendshare.org/how-to-invest/what-is-present-value) of the
expected payout is worth the risk of losing everything. Dropping $2 on a
lottery ticket every now and then won't break the bank (though you're likely to
get a better result saving that money and investing it over a period of
decades). Dropping your entire $20,000 budget into a single penny stock will
end in tears.

No one operates on those pure rational economic terms. Everyone has a taste
for risk and a level beyond which it makes no sense to gamble.

The mathematics of a stock going from $0.10 per share to $10.00 per share
look impressive, but the likelihood of a company going from just about
worthless to worthwhile in the time it would take to get your money back is
low. That's the risk. There are safer investments which probably will never
have the possibility of earning you 100x what you've invested, but which will
produce a boring, safe return of 15% a year—and you won't have to be
glued to stock pages, worrying that you'll miss that split-second window in
which you can buy and sell.

After all—you have to pay for the risk by convincing yourself there's
a bigger reward *and* by suffering through the psychological strain of
continually worrying that you're going to lose everything.

Stick with $2 on a lottery ticket every now and then, if you feel the need
to dream big and invest a little bit of money on a losing proposition.