What kind of stocks are riskier than average?

Question

What kind of stocks are riskier than the 'average' stock, and thus should be avoided? Please articulate the reasoning as much as possible.

Answer 1

The best way to work out the risk of an investment is to work out how volatile it is.

Volatility, is how much the stock moves from the average. A good way to work this out is using standard deviation.

Risk tolerance, you need to work out how much risk you're willing(or not willing to take) take into consideration the below questions:

1. How good are your finances? Do you pay your bills with credit or cash?
2. How comfortable are you with risk? Will you be awake at night with this investment?
3. Will you need that money in 1,5 or 10 years, or can you right it off? Are people dependat on you for that money? Or if you lost it all would you be OK with that.

What is your goal? are you saving for a house, retirement income or just growing wealth? how much will that be?

Risk vs Reward, what kind of return are you expecting? Some invesmtnet have low risk but low return such as a savings account with a 1% saving rate. This might not hit your goal. So you many want to take on more risk.

You need to consider all of these things before working out what investment is right for you.

Answer 2

Risk is defined as the variance in possible future returns. If you work 8 hours at a job that pays minimum wage, you have no risk - you know exactly what you will make that day. If you work in a tipping environment, at the end of the day you might make more or less than you expect, and the difference between a bad tip day and a good tip day is the definition of financial risk.

Some investments have minimal risk - like government-backed T-bills, or GIC's, or any fixed income interest product that is secured by a strong entity. Some investments have higher risk - corporate bonds may have more risk than government bonds [because companies can't raise taxes or print their own money to pay debts in an emergency, and have a risk of bankruptcy], real estate may have more risk than bonds depending on the market [you might not find a renter every month, and property prices might not increase very much or they might increase a lot by the time you sell], and stocks may have more risk than some real estate. Other riskier assets may exist, and these things may fluctuate depending on the circumstances.

But why are stocks on the higher end of the risk spectrum? Because you have no guaranteed return, you are investing at the chance to get future dividends which the company will pay if it is profitable. If the company has a bad year, it may pay no dividends - if it has a great year, it may pay extra dividends. Beyond the dividends, you may personally be able to sell the stocks in the future - to other people who themselves would earn the dividends of the company [the true underlying value of a stock].

So what type of stock would be risky, among its counterparts? Remember, we are really asking - what kind of stock has more uncertainty about how much future dividends it will ever be able to pay?

• A company which is not yet profitable has higher risk - like a junior mining company that hasn't yet found gold, but has 5 mine shafts being dug. Firstly, they won't pay any dividends until they have profit [where would they get the money to pay you dividends from? Corporate law probably even prevents them from paying dividends in that case!]

• A company in a new technology or industry has higher risk - who knows if Tesla will truly break through and Electric Vehicles will get the infrastructure support needed to get mass distribution? What would have happened to Facebook and Amazon if Elizabeth Warren, who promised to break them apart under anti-trust legislation, had become president [there is still a risk that this cause gets taken up in the near or distant future]?

• A company in an aging technology or industry has higher risk - Now may not be a good time for an energy company with only coal-based technology, as government intervention may prevent future plants from being built. Note that this one can be a little harder to see - would you have called Blockbuster or Sears 'aging technologies' 15 or 5 years ago, respectively?

• A company which relies on a single patent, process, idea, or especially government program to be profitable has higher risk. What happens if you own shares in a solar company that relies on government subsidies of clean power, and the government changes policy to remove that benefit? Or how will the WWE make money if live wrestling was banned for censorship reasons?

There are many things that can indicate higher risk for a company, and you might see indications of that by looking at how volatile historical prices are for that company. That could indicate that historically at least, the company was constantly being valued higher and lower than it used to be, because the true value was hard to determine. That might indicate that the future performance would have similar concerns. Small companies can be wiped out with a single bad event, etc. etc. etc.

One final thought - look at the above, see how many different sources of risk there are, and consider whether you might be better off just diversifying your risk by investing in a flat index fund, and having your highs and lows evened out with less time spent, and less management fees on someone trying to pick stocks for you.

As a side note, I will add - increased risk is not an indication to 'steer clear'; in a truly efficient market, risk should be compensated fairly by the chance of higher returns on average, and the question then becomes - do you want more risk in your portfolio, or less? For most people, some amount of risk is a healthy part of a long-term retirement plan, to avoid measly 1% or less interest returns during your working life.