How to know if a stock is risky

TL;DR:

  • No investment is without risk. Although the U.S. stock market has gone up, in aggregate, over time, individual stocks have varying levels of risk.
  • Not all investors will share the same comfort level with risk. It’s important to understand how much risk you’re willing to take on before investing.
  • There are some stocks deemed overall less risky than others (e.g. large cap or blue-chip stocks). The SEC spells out some categories of stocks that may carry more risk.
  • Shorter-term trading tends to be riskier than longer-term trading.

Over time, the U.S. stock market has produced returns of about 10% annually, on average. Yet within this trend, it’s true that some stocks go up and some stocks fizzle. That’s why many investors want to build a diversified portfolio, which is just a fancy way of saying they will create a mix of stocks designed to weather fluctuations that may impact a particular stock or group of stocks in the bunch.

Some investors chase extremely volatile stocks with the aim of riding an upswing. These risky investments might have a higher upside, but they come with greater risk. Taking on this degree of risk isn’t for everyone, so before you begin picking stocks or building a portfolio of many stocks, it’s crucial to understand how much risk you are willing to take on. Experts will say: only invest what you could afford to lose.

So, how do you know how much risk to take on? And what are some ways to identify a stock that might be risky?

Assessing your investment style

When looking at risk, it’s worth noting the typical risk profile of long-term vs. short-term investors. A short-term investment isn’t defined by what the stock is, but rather how long the investor holds it for. Making a last-minute investment in a volatile stock before earnings, in the hopes for a “pop,” is typical of a shorter-term investment strategy. Holding on to that same stock and building a position over time, through what is called “dollar-cost averaging,” is more aligned with a longer-term approach.

Short-term investments (trading):

  • Are typically held anywhere from a few minutes to a few weeks, at most for anytime less than a year.
  • Seek to profit off volatility and near-term gains rather than long-term underlying factors having to do with a company’s financials or management.
  • Oftentimes require less time to make gains, but greater effort when it comes to monitoring news and trends in real-time to “time” the buy.

Long-term investments (investing):

  • Are typically held anywhere from a year or longer to sometimes over the course of one’s career.
  • Seek to grow and profit from the long-term success of a business over many months or years.
  • Though not without risk, have longer time horizons to make gains and can, therefore, ride out increments of volatility that may occur over time.

Why time horizon is important

The big difference between short- and long-term investment strategies is the time horizon. 

The short-term investor will have significantly less time to recoup losses caused by a negative earnings report than a long-term investor who can ride out dips over time. Long-term investors will have years to recoup losses if the company whose stock they own performs poorly in any given year. 

Before selecting stocks, it’s important to define yourself as an investor. Are you looking to track the trends of a business and/or category over time? Are you seeking to put your money into companies you believe in for the long-term? If that sounds like you, then you’re likely a longer-term investor. If you’re looking for something somewhat more transactional, then you might fit the profile of a trader. Of course, many investors reflect a mix of the two.

Determining your risk tolerance

An important step in one’s investing journey is understanding how much risk you’re willing to take on and how to understand the relative risk of an investment. A good place to start is with your “why.” Why are you looking to get into investing and into stock market investing overall? 

Some questions to ask yourself:

  • What are you saving for? 
  • How much do you have to save, and how much do you want to end up with? 
  • Do you plan on adding money every month? 
  • Do you plan on taking money out at any point? 
  • Does your interest lie in the fluctuations in the market, or in broader business trends?

These are all important questions to ask yourself as they will help guide you towards investments that are more likely to fit your goals and risk profile. The most important thing that all financial experts will agree on is that you should not take on any more risk than you can afford to lose. 

Attributes of potentially risky stocks

When it comes to investing, “risk” is relative to the investor and how much they are willing to take on. For some investors, a growth stock might be deemed too risky for their appetite. For others, growth stocks might make up a sizable portion of the portfolio.

That said, relatively speaking, there are some things to look out for when selecting individual stocks to invest in. The SEC identifies a few signals that could mean a stock is risky. Importantly, not all stocks within these criteria will be bad investments. Some might turn out to be good investments, but those would likely be the exception and not the rule.

Here are some attributes of potentially risky investments, as outlined by the SEC.

Bankrupt companies

Companies that have filed for bankruptcy tend to be risky. That’s because when it comes to stocks, ownership does not legally entitle you to much if the company goes bankrupt. While it is possible that shareholders get paid out, there is often little to pay out and most of this goes to people earlier in precedence than shareholders, such as bondholders. 

Some investors will flock to invest in companies in financial trouble if they think there is a chance the company will make it out and rise from the ashes. They are seeking to get in at a low price and ride the wave back up to previous levels. Historically, this rarely happens and sadly, many people have lost a great deal of money this way.

A recent example of interest in a bankrupt company came with Hertz sought to temporarily issue more shares in June 2020, despite filing for Chapter 11 bankruptcy. Despite many analysts saying that those shares would likely be worthless to the average retail investor, Hertz made this move because they saw demand in the market. Public responded to this by temporarily halting trading of Hertz on its platform.

Very small market cap

Market cap describes the size of a company in terms of its total market value based on outstanding shares. Compared with blue-chip giants like Apple (NYSE: AAPL), companies with very small market caps tend to have little recorded operational history, with unproven track records and unknown management. By the nature of their size, these stocks often have poor liquidity, making it difficult for investors to actually sell their shares when they want to. This can force an investor to have to wait longer than they’d like to sell their shares, potentially losing money and taking on more risk than expected. 

Additionally, small-cap companies tend to have less access to capital and financing than larger companies, meaning they have fewer resources to bridge gaps in cash flow or fund growth into new sectors. For these reasons, the SEC cites companies with market caps less than $300 million to be riskier than larger companies.

Specialized ETFs

Not all ETFs are created equal and some are riskier than others. As a refresher, an ETF is a collection of stocks that can be bought at once. ETFs are categorized by investment objectives or themes. Outside of the traditional ETFs, which carry varying degrees of risk, there are specialized ETFs that the SEC deems somewhat riskier.

An inverse ETF is an exchange-traded fund created by combining various derivatives to profit from the decline of something, often a benchmark. It holds a similar effect to shorting something. However, by the usage of derivatives, inverse ETFs can carry a lot of risk and cause large losses if an investor bets wrong on the market’s direction. Additionally, inverse ETFs are short-term only, carrying more risk. 

A leveraged ETF is an exchange-traded fund that also uses derivatives and debt to amplify the returns of an index, essentially magnifying any returns or losses. While this might be great to have when the underlying index is doing well, an index drop of only 3% would mean a 3x leveraged ETF of that index would incur a loss of 9%, a major loss.

To help novice investors identify potentially risky stocks in the context of their investing, Public appends Safety Labels to these three types of stocks. Safety Labels give the investor more context without restricting their ability to trade.

Other factors to consider

Beyond these major signals outlined by the SEC, investors can look to some other indicators, as well. Consider the following when vetting any individual stock investment:

  • Leadership turnover: Do things appear to be rocky or unstable at the top?
  • Major lawsuits or trade disputes that could negatively impact the business.
  • Beta scores, which measure how big a stock’s share price swings are relative to the rest of the market. A stock with a Beta of 1.0 fluctuates just the same as the rest of the market. A beta of 0.5 means a stock’s price swings are typically half the size of those of the rest of the market (a more conservative stock), and a beta of 2.0 means a stock’s price swings are typically double the size of those of the rest of the market (a more aggressive stock), of course up and down. 

Bottom line

At the end of the day, all investments carry risk. No matter what stock, ETF, mutual fund, or index fund one invests in, there is a chance they will lose money. As you go through the early stages of your investing journey, you’ll get a better idea of what your risk tolerance is and what you’re looking to get out of investing. Regardless of this, it’s good to remember the SEC recommendations for gauging risk and to assemble a checklist of things you will personally research before investing in an individual stock.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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