Warren Buffett, the most famous and possibly most risk-averse investor of all time, has distilled his principles for investing down to two rules:
- Don’t lose money.
- Don’t forget the first rule.
A high-risk investment is one that has a significant probability of losing some or all of its value. Every investment has some level of risk, in other words, every position has a probability of losing money, but safe investments have extremely low probabilities of loss.
Whether you have money in a savings account, brokerage account, or under your mattress, you are assuming varying levels of risk. While holding cash is not going to top our list of high-risk investments, there is risk in holding cash. Hyperinflation, for example, is when a currency loses its purchasing power, eroding the real value of the currency. It’s not likely the US Dollar will experience hyperinflation, but the probability is not zero.
Risk to Reward Ratio
One way to think about high-risk investments is their risk-to-reward ratio. This ratio compares the potential return to the downside risk and looks for an asymmetric risk/reward ratio. An asymmetric risk to reward ratio means there is more opportunity on the upside than there is for a potential catastrophic loss.
If there is a significant probability that you could lose your entire investment and a capped upside, there would be a negative risk/reward ratio and would not be ideal:
Ray Dalio, arguably the most successful hedge fund manager of all time, considers how market correlation and diversification can impact a portfolio’s return to risk ratio, which is why having some exposure to multiple types of risk is better than having concentration in one asset class that also assumes the same risk factors.
Types of Risk
One way to manage high-risk investments is to understand what the potential risks are that can impact the investment’s viability. There are a number of factors that can influence the inherent risk in your investments:
1. Macro Risk
The global economy is intrinsically linked and a major shock to the system can have wide-reaching impacts. Even if everything about your investment is otherwise sound and growing, a macroeconomic shock can erase unrealized returns, at least on paper.
While macro risk is unavoidable, there inevitably will be certain asset classes that perform best in down markets, which is why hedging your investments can be a viable strategy.
2. Position Size and Correlation Risk
Having a plan for position size, dollar-cost averaging, rebalancing, and more are all strategies that should be executed consistently to avoid risk. Having an outsized position can put the returns of the entire portfolio at risk.
In a previous article we discussed the importance of understanding correlation to achieve risk parity so we will only touch on it briefly here. Highly correlated assets go up and down together, which is great when everything is doing well, but when things turn negative, the importance of diversification becomes apparent.
3. Sector Risk
Some sectors are more vulnerable to this type of risk than others. Sector risk is usually exposed when there is breaking news or legal precedent regarding a prominent company within the sector that impacts the price of other companies in sympathy despite being unrelated to the event.
Correlation is also present within industries and sectors and can be difficult to identify. A commodity investment, for example, could be correlated with a certain industry if that industry is a major consumer of the raw material. Understanding every component of the supply chain and how investments are correlated is essential for avoiding sector risk in a portfolio.
4. Asset Class Risk
There are certainly risks that are exposed to each individual asset class, such as equities, real-estate, or cryptocurrencies. One clear example of an asset class risk is if legislation is passed hindering the asset’s returns.
If a government viewed cryptocurrencies as a threat to their monetary base, as an example, they could make efforts to outlaw the use of cryptocurrency, likely causing a negative impact on the asset class as a whole.
This is not out of the question, since the US government took similar action in 1971, restricting the convertibility of gold. In order to halt the run on gold, the government stopped honoring the exchange of dollars for gold and eventually eliminated the gold standard altogether.
5. Volatility Risk
A position with high volatility is one that moves erratically in price. While high volatility can strike even the most stable investments in times of market turmoil, there are certainly markets, instruments, and investments that offer protection from volatility.
Take real estate as an example — the asset class as a whole experiences annual fluctuations in price of only a few percentage points. You’re not going to see a one or five year percentage increase in real estate prices break into the thousands as we have with cryptocurrencies, recently.
High Risk Investments (With Potentially High Returns)
When considering high-risk investments, it’s important to understand and consider the risks of each and consult a professional financial advisor. The high-risk investments discussed below are by no means recommendations to invest or otherwise investment advice.
As the technology for blockchain and decentralized finance (DeFi) has grown in popularity and sophistication, digital currencies, known as cryptocurrencies, have shown real wealth creation and global adoption. In fact, the global crypto market is worth more than $1.75 trillion.
Bitcoin, the most popular and widely used cryptocurrency, has risen by more than 8,000% over the last five years and has reached a current all-time high price of $65,000 for a single bitcoin.
There are many other cryptocurrencies that are less popular, although no less significant in disruption to fiat currencies. Popular ones include Ethereum, Ripple, and even the meme-inspired Dogecoin.
2. Equity Crowdfunding
Investing in private businesses, whether in startups or established companies, can certainly carry an element of risk compared to publicly traded equities mostly due to the lack of available information. Regulations for public companies are much more stringent than those for the private sector.
Investing at these early stages, however, is where a ton of wealth creation is passed on to investors when the company goes public or gets acquired. This is why there is an entire industry — angel and venture capital — dedicated to funding companies in early funding rounds, more on this shortly.
Equity crowdfunding has made startup investing more accessible for all accredited investors and even some non-accredited investors. Giving more people the opportunity to have a successful exit and more companies the opportunity to raise capital. Equity crowdfunding is beneficial for everyone involved.
With the right analysis and investment temperament, one can de risk their equity investments and turn the high-risk of startup investing into high rewards.
3. Derivatives Trading
Derivatives, or options as they are commonly known, are highly leveraged instruments that allow investors to speculate on price movements of the underlying stock. Option trading strategies are typically short-term and in some cases, can result in a 100% loss of capital.
Options do present opportunities to hedge a portfolio because they offer the ability to “short” the market, or profit if the price moves lower than the purchased strike price. There are many strategies that can be used to protect the investor’s downside, although these can be extremely complicated and risky if not well understood.
4. High Yield Bonds and REITs
Yield-seeking is a common way investors expose themselves to risk. Whether it be high-yield bonds or real estate investment trusts (REIT) that offer a healthy dividend, high yields are how these instruments compensate investors for their riskiness.
High-yield bonds are those that have a higher likelihood of default, compared to safer bonds like US treasury bonds that currently only offer fractional yields, currently maxing out at 2.29% for 30-year bonds.
5. Angel and Venture Capital
We briefly touched on these high-risk investments, but they deserve a section of their own.
Angels and VCs invest their own capital and the capital of their limited partners into early-stage companies, with the understanding that many of their investments will fail, a few will have moderate success, and even fewer will become billion-dollar unicorns that return the entire fund.
A common analogy for venture investing is baseball, where you very often strike out (the company fails), sometimes hit a single or a double (1x or 2x your investment), and rarely hit a home run or even a grand slam (have one or more unicorn exits).
Due to the high-risk nature and amount of capital to invest, this asset class is typically reserved for high net worth individuals.
Invest According to Your Risk Appetite
Portfolio construction has been the holy grail for many, if not all investors. Understanding how markets, instruments, and investments are correlated and how to utilize strategies like diversification to de risk your portfolio is vital.
One thing is pretty clear, high-risk investments should not be relied upon for the entirety of your portfolio but there is likely a place for a small percentage, just to gain exposure to uncorrelated and diverse positions.
If equity crowdfunding, angel or venture investing, or otherwise investing in private businesses is an asset class that interests you, EquityNet is the best place to turn a high-risk investment into a high-reward opportunity. We’ve spent the last 16 years building proprietary data to help investors gain a better understanding of the private businesses they are investing in.