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What Makes a Risky Investment Risky?

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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.

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. 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 you've received, though a company in financial trouble probably won't pay dividends.

This risk is present in any stock—even Coca-Cola 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), the reliability of earnings, the periodicity of the business, the debt structure and return on invested capital of the business, the sector and industry of the business, and the size of the business.

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 or Facebook 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 and discounted cash flow. This is one reason penny stocks 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 2016 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 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 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 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.