High-Risk Investment Techniques
A high-risk investment is one that is made in the hope of earning a relatively large profit in a short time. Some securities may by their very nature be quite risky. (In this sense, a bet on a roulette wheel in a Las Vegas casino is a high-risk investment.) However, most high-risk investments become so because of the methods used by investors to earn a quick profit. These methods can lead to large losses as well as to impressive gains. They should not be used by anyone who does not fully understand the risks involved.
Buying Stock on Margin
An investor buys stock on margin by borrowing part of the purchase price, usually from a stock brokerage firm. The margin requirement is the proportion of the price of a stock that cannot be borrowed. This requirement, which is set by the individual stock exchanges, is generally no greater than 50 percent of the value of securities purchased.
Today, investors can borrow up to half the cost of a stock purchase. But why would they want to do so? Simply because they can buy twice as much stock by buying on margin. Suppose an investor expects the market price of Bombardier's common stock to increase in the next month or two. Let's say this investor has enough money to purchase 500 shares of the stock. But if she buys on margin, she can purchase an additional 500 shares. If the price of the Bombardier stock increases by $5 per share, her profit will be $5 x 500, or $2,500, if she pays cash. But it will be $5 x 1,000, or $5,000, if she buys on margin. That is, by buying more shares on margin, she will earn double the profit (less the interest she pays on the borrowed money and customary commission charges).
Financial leverage is the use of borrowed funds to increase the return on an investment. When margin is used, the investor's profit is earned by both the borrowed money and the investor's own money. The investor retains all the profit and pays interest only for the temporary use of the borrowed funds. Note that the stock purchased on margin serves as collateral for the borrowed funds. Margin investors are subject to two problems. First, if the market price of the purchased stock does not increase as quickly as expected, interest costs mount and eventually drain the investor's profit. Second, if the price of the margined stock falls, the leverage works against the investor. That is, because the margin investor has purchased twice as much stock, he or she loses twice as much money.
Moreover, any decrease in the value of a stock bought using leverage is considered to come out of the investor's own funds, not out of the borrowed funds. If the stock's market value decreases to approximately half its original price, the investor will receive a margin call from the brokerage firm. The investor must then provide additional cash or securities to serve as collateral for the borrowed money. If he or she cannot provide additional collateral, the stock is sold and the proceeds are used to pay off the loan. Any funds remaining after the loan is paid off are returned to the investor.
Normally, investors buy stocks expecting that they will increase in value and can then be sold at a profit. This procedure is referred to as buying long. However, many securities decrease in value, for various reasons. More risk-oriented investors can use a procedure called selling short to make a profit when the price of an individual stock is falling. Selling short is the process of selling stock that an investor does not actually own but has borrowed from a brokerage firm and will repay at a later date. The idea is to sell at today's higher price and then buy later at a lower price.
To make a profit from a short transaction, the investor must proceed as follows:
- Arrange to borrow a certain number of shares of a particular stock from a brokerage firm.
- Sell the borrowed stock immediately, assuming that the price of the stock will drop in a reasonably short time.
- After the price drops, buy the same number of shares that were sold in step 2.
- Give the newly purchased stock to the brokerage firm in return for the stock borrowed in step 1.
The investors profit is the difference between the amount received when the stock is sold in step 2 and the amount paid for the stock in step 3. For example, assume that you think that Toronto Dominion Bank (TD) stock is overvalued at $58 a share. You also believe the stock will decrease in value over the next three to four months. You call your broker and arrange to borrow 100 shares of TD stock (step 1). The broker then sells your borrowed TD stock for you at the current market price of $58 a share (step 2). Also assume that three months later, the TD stock has dropped to $46 a share. You instruct your broker to purchase 100 shares of TD stock at the current lower price (step 3). The newly purchased TD stock is used to repay the borrowed stock (step 4). In this example, you made $1,200 by selling short ($5,800 selling price - $4,600 purchase price = $1,200 profit). Naturally, the $ 1,200 profit must be reduced by the commissions you paid to the broker for buying and selling the TD stock.
People often ask where the broker obtains the stock for a short transaction. The broker probably borrows the stock from other investors who have purchased TD stock through a margin arrangement or from investors who have left stock certificates on deposit with the brokerage firm. As a result, the person who is selling short must pay any dividends declared on the borrowed stock. The most obvious danger when selling short, of course, is that a loss can result if the stock's market value increases instead of decreases. If the market value of the stock increases after the investor has sold it in step 2, he or she loses money.
Other High-Risk Investments
We have already discussed two high-risk investments — margin transactions and selling short. Other high-risk investments include stock options, com-modites, precious metals, gemstones, coins, and antiques and collectibles.
Without exception, investments of this kind are normally referred to as high-risk investments for one reason or another. For example, the gold market has many unscrupulous dealers who sell worthless gold-plated lead coins to unsuspecting, uninformed investors. With each of the investments in this last category, it is extremely important that you deal with reputable dealers and recognized investment firms. It pays to be careful. Although investments in this category can lead to large dollar gains, they should not be used by anyone who does not fully understand all of the potential risks involved.