Risks associated with a given investment vehicle may result from a combination of possible sources. A prudent investor considers how sources of risk might affect potential investment vehicles.
While having a well diversified portfolio can mitigate some risks, some investments can be a particularly high risk venture. Such high risk investments include but are not limited to penny stocks, leveraged or inverse ETFs and options. While NYLIFE Securities does not recommend or endorse these specific types of investments, we would like to provide you with resources and tools that can provide you with additional detail on the risks of investing.
Type of Risk
Risks as Part of Your Investment Portfolio
All investments involve some degree of risk. Generally risk is categorized as:
- Market Risk or Systemic Risk - The risk that general market changes can negatively affect an entire asset class.
- Unsystematic Risk – The risk associated with an individual investment or a small number of investments. For example, a large product recall could have a large impact on one company but little or no effect on the industry or the market as a whole.
Examples of Types of Market Risk (Systemic Risk)
- Interest rate risk is the risk that your bond investment will lose value if the interest rates rise. For example, If you buy a bond earning 6% interest at $100 and current investors can get an equivalent rated bond paying 10%, your bond's current market value will be less than $100.
- Inflation risk is the risk that the dollars one invests will buy less in the future because prices of goods and services rise. This risk especially affects securities earning a fixed rate of return that might otherwise be considered less risky investments.
- Exchange rate risk is a risk specific to investments or business operations across international borders. For example if you invest in a company that has the majority of their operations in Japan, your returns or loses can be reduced if the yen loses value compared to the dollar.
- Legislation or Political risk is the risk that changes in the legislation in a given country's political structure or policies that can lead to investment loses. Examples of this include higher taxes, tariffs, or government instability.
Examples of Types of Unsystematic Risk
- Business Risk – Refers to the impact of management decisions on a company’s profitability and stability.
- Liquidity risk is the risk that an investment cannot easily be converted to cash. If there is not enough of a market for a security converting that security to cash can cause you to sell at a much lower price than expected.
- Credit Risk – The risk that a company may not have sufficient cash flow to pay off principle and interest on its debt obligations.
- Event Risk is when something happens to a company that has a sudden and substantial impact on its financial condition. It typically involves an unexpected event that has a significant and usually immediate effect on the underlying value of the investment.
High Risk Ventures
Some securities carry a much larger level of risk than other potential investment opportunities. The list below is not intended to be an all-encompassing list of these types of investments. It is intended to provide you with information on sometimes misunderstood risks.
- Penny Stocks
- Liquidity Risk. The term spread is used to describe the difference in the Bid and Ask price for a security. (The price you can buy it for and the price you can sell it for). Spreads on these securities can be very high. Therefore the price you can sell a security, you just purchased, may be significantly below your purchase price, causing you to incur liquidity risk.
- Manipulation – Because of the low trading volume in these shares, a small level of trading activity can move the price quickly. This can lead an investor to believe this is a hot stock. Trading activity along with sometimes fictitious news about the financial health of the company can be very deceiving to a potential investor. Accurate detailed information on these companies can be difficult to obtain. Investors should be very wary before investing in these securities.
- Leveraged or Inverse ETFs
Exchange-traded funds (ETFs) that offer leverage (i.e. seeking to deliver multiples of the performance of the index or benchmark they track) or that are designed to perform inversely to the index or benchmark, or both are growing in number and popularity. Many investors may be turning to these funds as part of a long-term strategy to weather unfavorable market conditions. However, how these funds long-term performance is related to the underlying index is commonly misunderstood. Most leveraged and inverse ETFs reset daily, meaning that they are designed to achieve their stated objectives on a daily basis. To accomplish their objectives, these funds pursue a range of investment strategies through the use of swaps, futures contracts and other derivative instruments which have high levels of risk in themselves. Due to the effect of compounding interest, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.
- The Dow Jones U.S. Oil & Gas Index gained 2 percent, while an ETF seeking to deliver twice the index's daily return fell 6 percent and the related ETF seeking to deliver twice the inverse of the index's daily return fell 26 percent.
- An ETF Seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent. The related ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.
The term "Penny Stock" is used to describe stocks that trade for less than $5/share in the over the counter market. While these may include some well known companies, there are many small not well known companies that fall into this category. Some of the risks specifically associated with these securities include:
The following examples, taken from a FINRA Investor Alert, demonstrate real life examples of how investment performance of ETFs with longer periods can differ significantly from the performance of the underlying indexes during the same time period.
Between December 1, 2008, and April 30, 2009:
Therefore, inverse and leveraged ETFs, whose investment target is reset daily, are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.
Options are securities that give the investor an opportunity to sell or buy another security at a specified price over a given period of time. However, purchasers of options are not guaranteed any return and could even lose the entire amount invested.
Filing for bankruptcy is an extremely complex process. A company in the midst of bankruptcy may form a liquidation company to divest its assets. Some investors may be tempted to invest in a previously well performing company in the hopes of it emerging from bankruptcy. Most never do.
Many investors may purchase shares of a bankrupt company with the belief that a profitable company will emerge out of bankruptcy. Legally the new company can be a separate and distinct entity. Often the owners of the shares of the old company are left with no value even if there is a new viable company.
Debt High Yield bonds or Junk bonds are highly speculative securities that have received low, sub-investment grade ratings. These bonds are issued primarily by corporations and municipalities. Junk bonds generally take the form of subordinated debentures, which means that the debt is unsecured and has a low claim on assets. The high yields are available only because of the correspondingly higher risk of default. Much of the risk in High Yield Securities can be mitigated by investing in large diversified portfolios with different issuers, sectors, etc. Mutual funds can offer investors with a lower initial investment amount a way to get exposure to a diversified highyield portfolio.
High Yield Securities
Securities with higher yields typically carry risk at a commensurate level. As used in finance, risk is the chance that actual investment returns will differ from those expected. The broader the range of possible values or returns associated with an investment, the greater the risk. Speculation in such high yield instruments offers highly uncertain returns and future value, so it is a high risk investment. Because of the greater risk, the returns associated with speculation are expected to be greater.
- For example, a company, whose stock is paying a dividend significantly higher than the market average, can be associated with the market believing that the company will soon be reducing the dividend rate. Investors who analyze the underlying company’s earnings reports, balance sheets, and growth outlook may see a trend of dwindling sales, diminished or negative free cash flows, or other factors that would lead a prudent investor to question the companies long term outlook and its viability.
- For additional information please visit one of these web sites.
FINRA - Smart Investing
FINRA - Investor Alerts
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