Understanding The Top Investment Risks And Their Impacts

When it comes to investing, there is always an element of risk. The higher the expected return on an investment, the greater the risk. While some investments are relatively low-risk, they still carry some danger of losses. Conversely, high-risk investments offer the potential for substantial growth and higher returns but come with increased volatility and a greater chance of loss.

Some of the high-risk investments include:

- Options

- Initial Public Offerings (IPOs)

- Foreign Emerging Markets

- REITs

- High-yield bonds

- Currencies

- Penny Stocks

While these investments can provide lucrative returns, they are marred by different types of risks. Investors need to be aware of these dangers and carefully consider their risk tolerance before diving into high-risk ventures.

Foreign emerging markets

Secondly, emerging markets are subject to non-normal distributions. In other words, emerging markets are undergoing constant changes, making it difficult to utilise historical information to draw correlations between events and returns. This makes it challenging to accurately value investments in these markets using financial models.

Thirdly, emerging markets often have lax insider trading restrictions, with less rigorous enforcement of laws against insider trading compared to developed markets like the US. This introduces market inefficiencies, with equity prices deviating significantly from their intrinsic value, leading to extreme speculation and potential manipulation by those with privileged information.

Furthermore, emerging markets may have difficulty raising capital due to poorly developed banking systems. This limits firms' access to financing, resulting in a higher cost of capital and fewer profitable projects.

Poor corporate governance is another risk factor in emerging markets. In these markets, management or the government may have a greater voice in the firm than shareholders, reducing the incentive for management to perform.

Lastly, emerging markets may have increased chances of bankruptcy due to weak accounting audit procedures and a poor system of checks and balances. Political instability, such as the possibility of war, tax increases, or changes in market policy, further contributes to the risk of investing in these markets.

While investing in foreign emerging markets can offer substantial returns, investors must carefully consider and assess these risks before committing capital.

REITs

Real Estate Investment Trusts (REITs) are investment vehicles that pay dividends to investors. They are traded like shares of stock on exchanges, providing investors with exposure to diversified real estate holdings. REITs can be classified as publicly traded or non-traded.

Risks of Non-Traded REITs:

• Share Value Risk: Non-traded REITs are not publicly traded, meaning there is a lack of public information available for investors to research and determine the value of the investment.
• Lack of Liquidity: Non-traded REITs are illiquid, meaning there may not be buyers or sellers in the market when an investor wants to transact. These investments often cannot be sold for at least 10 years, locking in investor money.
• Distributions Risk: Non-traded REITs pool money to buy and manage properties. However, distributions may be paid out as dividends from another investor's money rather than income generated by the property. This practice limits cash flow for the REIT and diminishes the value of shares.
• Fees: Non-traded REITs typically charge high upfront fees, ranging from 8% to 15%. They may also incur external manager fees, reducing investor returns.

Risks of Publicly Traded REITs:

• Interest Rates: Rising interest rates may reduce demand for REITs as investors may choose alternative investments, such as U.S. Treasuries, which offer a fixed interest rate.
• Sector Choice: Choosing the wrong sector to invest in can be risky. For example, with the rise of online shopping, REITs focused on suburban malls may be a risky investment.
• Taxes: REIT dividends are taxed as ordinary income, so investors must consider their tax bracket and the potential tax implications when investing in REITs.

Overall, investing solely in REITs carries more risk than including them as part of a diversified portfolio. REITs are sensitive to interest rates and may not offer the same tax benefits as other investments. Additionally, investing in a REIT concentrated in a specific sector that experiences negative impacts can lead to amplified losses.

High-yield bonds

Advantages of High-Yield Bonds

• Higher payouts compared to traditional investment-grade bonds: Junk bonds offer a higher return on investment (ROI) than similar-sized investment-grade bonds.
• Potential for appreciation: If the issuing company improves its credit standing, the value of the high-yield bond may also increase.
• Bondholders are prioritised over stockholders: In the event of a company's failure, bondholders will be paid out before stockholders during the liquidation of assets.
• Higher payout than stocks with more dependable ROI: The payout of high-yield bonds is consistent each pay period, unlike stocks, where payouts can vary based on company performance.
• Recession-resistant companies: Some companies that issue high-yield bonds are recession-resistant and may even thrive during economic downturns, such as discount retailers and gold miners.
• Less vulnerable to interest rate fluctuations: High-yield corporate bonds are less susceptible to changes in interest rates, making them attractive for stock investors looking to diversify their portfolios.

Disadvantages of High-Yield Bonds

• Higher default rates: High-yield bonds carry a greater risk of default than traditional investment-grade bonds, and a default would render the bonds worthless.
• Less liquid than investment-grade bonds: The stigma associated with "junk bonds" makes investors hesitant to invest, making it more difficult to resell these bonds.
• Vulnerable to credit rating changes: A drop in the issuer's credit rating can negatively impact the value of a high-yield bond.
• Sensitive to interest rate changes: High-yield bonds are sensitive to changes in interest rates, and an increase in interest rates will lead to a decrease in the value of the bond.
• Vulnerable during recessions: The junk bond market is typically hit hard by recessions, and most high-yield bonds will be at high risk of becoming worthless during an economic downturn.

Currency trading

There are several risks associated with currency trading. Firstly, transaction risks arise from exchange rate changes between the opening and settlement of a contract. As forex trading occurs on a 24-hour basis, exchange rates can change before trades are settled, resulting in currencies being traded at different prices during trading hours.

Secondly, interest rate risks can cause forex prices to change dramatically. When a country's interest rates rise, its currency strengthens due to increased investments, and vice versa. The differential between currency values due to interest rates can significantly impact forex prices.

Thirdly, counterparty risk refers to the possibility of default by the dealer or broker in a transaction. During volatile market conditions, counterparties may be unable or unwilling to adhere to contracts, creating liquidity issues and credit risks.

Additionally, currency crises, such as the Asian Financial Crisis and the Argentine Crisis, can lead to the collapse of a currency, further exacerbating the risks in forex trading.

Leverage is another important factor in currency trading risk. Forex markets allow for high leverage, with brokers offering 50:1 leverage as a standard. While this provides access to substantial trades with a small initial investment, it can also result in losses exceeding the initial investment if not used appropriately.

Overall, currency trading is a high-risk endeavour that requires careful consideration and a good understanding of the market and potential losses.

Venture capital

Risks of Venture Capital

One of the biggest risks is the drain that research and development can have on finances. Startups often need to test their solutions on existing clients, and the bugs associated with downtime and failed software can lead to uneven revenue or no revenue at all. This requires VCs to invest more money to keep the initiatives going.

Another common risk is the technology itself. Patents in startup tech companies often end up being challenged, or the technology can be stolen, copied, or "leapfrogged" by competitors. This was the case with BlackBerry, whose global market share dropped from around 50% in 2009 to less than 3% in 2013 due to competition from Apple's iPhone.

Other challenges include growth and related personnel issues, such as not being able to find the capital needed to maintain operations, raw materials, or personnel to produce the software or products. Due diligence issues are also common in venture capital investing. It is important to assess whether the person or team being backed is worth trusting with the money invested, and whether they can effectively turn an idea into a real company.

Mitigating Risk

Diversification can be achieved through industry, stage, and geographical diversification, reducing industry-specific risk, exposure to risks specific to different startup stages, and regional-specific risks. Due diligence is crucial for understanding the potential issues and challenges associated with an investment, and syndication allows multiple investors to share a deal and bring different perspectives to the table.

Staged financing involves providing capital in stages, with startups needing to meet predetermined milestones before receiving more funding. This gives VCs the option to abandon the project without penalty if it doesn't meet expectations.

Finally, purchasing insurance coverage can protect VCs from legal claims or financial losses due to unforeseen risks such as data breaches, lawsuits, regulatory fines, and liability claims.

Benefits of Venture Capital

Despite the risks, venture capital can be beneficial for investors. It provides an opportunity to invest in risk and fuel innovative and disruptive ideas, with the potential for immense profits.

Google, now Alphabet, is an example of a successful VC investment, founded after a VC investor gave two college students a $100,000 check. Alphabet is now a trillion-dollar publicly traded company.

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