Not all investment opportunities are created equal, we all know that. They all differ in terms or risks and rewards. However, there are special types of investments that the novice investor should not even look into, however tempting they might be at first glance. They may be profitable for those with long years of investment experience that provide them with the special skills and knowledge. If, however, you’ve worked hard in a 9 to 5 job to save enough so you can start investing then steer clear of these investment paths.
Futures and Options: Complex, Risky, Stressful
No less than investment icon Warren Buffet once accused derivatives of being “financial weapons of mass destruction.” And although he may have softened his stance in recent years, he still approaches derivatives with much caution. That’s Warren Buffet with billions of dollars to play around with. What more for ordinary investors?
Futures and options are derivatives. In plain English they’re contracts to buy and sell an amount of something for a pre-agreed price at a pre-agreed future date. Simple when viewed this way, except that the value of the contracts are based on the value of an underlying asset, and what’s being traded are not the actual assets but the contracts. More of the confusion later.
The futures market is a global marketplace for the world’s most important commodities. Pork bellies for bacon, corn for chips, oil, sugar, wheat, coffee and anything else that the world needs in large amounts are traded as commodities. The futures market was born out of necessity. Imagine a farmer bringing tons of tomatoes to the market and no one ends up buying them? Or, on the other hand, a ketchup maker who needs tons of tomatoes and goes to market but can’t find any? To lessen the risk of both waste and scarcity, both the farmer and the ketchup maker can agree to a contract that binds the farmer to sell a quantity of tomatoes to the ketchup maker at a specific price on a future date.
Players in this type of contract are either hedgers or speculators. Hedgers minimize risk by buying now to avoid rising prices, or selling at today’s price anticipation of lower prices in the future. Speculators take the opposite position and aim to profit from the risk that hedgers are protecting themselves against. Hedgers are usually those who have a need for the physical commodity being traded (i.e. the tomato farmer and the ketchup maker). Speculators are those who buy and sell contracts but don’t actually need to have 20 tons of tomatoes delivered at their doorstep.
The futures market is attractive to experienced investors because it’s highly leveraged. For a relatively small investment, you have control over the full amount of the contract. A margin is your deposit of good faith on the contract and it’s usually priced at just 10% of the total contract price. Daily, as the price of the underlying asset moves, amounts get debited or credited to your margin. Leverage is a double-edged sword because you stand to earn big gains from even the slightest movement in the prices, but your potential for loss has the same magnitude. There’s a chance to lose all of the margin that you deposited and then some, because when your margin falls under an agreed maintaining balance you’re required to top it up.
If you’re a novice investor in all probability you’ll belong to the speculator class. The math behind futures contracts is so complex and demands deep knowledge of a commodity’s historical value and the factors that its price is sensitive to. Do you really want to spend your day looking at charts and graphs?
Options are similar to futures but trade is done in stocks, and there is no obligation on the part of the buyer to exercise the option to buy. Like futures, however, the seller is always obliged to sell. Here, instead of a margin, buyers pay a premium which can be viewed as fee for the privilege of not being obliged to buy the underlying asset if the prices are not favorable to the buyer. A premium is the maximum amount that a buyer of options can lose.
The amount of the underlying asset is what usually sets futures and options apart. Futures contracts can be many times bigger than an options contract and the potential losses can be just as big. However, despite being less risky, novice investors are still warned of the many dangers posed by options. If the price of the stock goes nowhere or rises only a little during the period when you hold the option to buy, the option expires as worthless, and you lose all of your investment – 100% of the premium that you paid. Even binary options which offer fixed risks and rewards (see the article Binary Options Trading: An All or Nothing Gamble?) have a level of uncertainty that novice investors will find unattractive.
In a recent article, the New York Times declared that while companies such as ETrade, Ameritrade and Charles Schwab serving retail investors are making money, small individual investors engaging in options are blowing up and burning through the money in their accounts at an alarming rate. Customers who invested in options only made a fifth of those who did not.
At best, futures and options are nothing short of gambling. You have very little control over the outcome of your investment and although you might win big time, the odds are heavily stacked against this happening consistently. When you lose, no one shares the loss with you. Investing in futures and options, in a manner of speaking, is assuming someone else’s risk. History has proven that weather, war, wanton behavior can change the outcome of the futures and options game drastically. Unless you have a very valid reason for playing the game (you’re an industrial producer or consumer of commodities, or you have various stock market holdings that you need to protect from losses), look somewhere else. There are safer and less stressful ways of participating in the commodity and stock markets.
Precious Metals: No Pot of Gold at the end of the Rainbow
There are many reasons why people buy gold and other precious metals as a legitimate investment and not because these metals glitter and look good around the neck and finger.
It’s a physical commodity. You can actually touch it and benefit from the security of the knowledge that you actually own it. Of course you can also spend sleepless nights worrying that someone will steal it from you. But, unlike stock certificates, they’re not just pieces of paper that represent something of value.
It’s limited commodity. There’s only going to be so much of it ever extracted from the earth. Scarcity is built into it and common economics sense dictates that the scarcer an item, the more valuable it becomes.
Value appreciation is inversely proportional to the health of the economy. This is particularly true in the United States. The noise on gold gets louder as the economy gets worse and the recent jump in the prices of gold and silver directly reflects investor confidence in the US economy post-recession.
Despite these, precious metals are still a dicey investment. Here’s why:
They don’t pay any dividends. The only payout you’ll get is when you sell them, and you’re in luck if you get the timing right. About the only practical purpose you’ll have for them is in the pawnshop for quick cash during emergencies, but with the exorbitant interest rates you’ll need to pay for short-term loans, you’ve already lost a good chunk of your investment.
Prices are extremely volatile. It’s not unusual to see 50% drops or gains within a single year. This rollercoaster ride is often fueled by paranoia, certainly not a good investment criteria to go by. And this paranoia is often fueled by media personalities predicting doom for the US economy.
Increase in price doesn’t keep up with increase the cost of living. Most investments in precious metals are long-term and over that course of time, adjusting for inflation, you’ll find out that you’ve barely made a profit, if at all.
Speculators will eat you alive. A limited market like precious metals is rife with savvy speculators who know exactly what they’re doing. You don’t. They have deep pockets. You don’t. In this playground, the same rules apply as in the schoolyard. Don’t play with the big boys.
There’s a silver lining in all of this, though. If your heart is really into precious metals there’s a way of investing in it without assuming all of the risk. Investment in mutual funds that focus on stocks of companies involved in precious metals tend to have better returns than if you invested in precious metals directly. These precious metal mutual funds are professionally managed, have industry insight and are generally diversified.
Collectibles: Not Unless You Really Enjoy Them
We all know about works of fine art that are practically priceless. Investing in these collectibles might be out of reach for most of us. But there are other collectibles that fall within the common investor’s range of affordability. Comic books, stamps and coins, first edition hardbound books, dolls, rare china, avant-garde up and coming painters and sculptors selling their work for a meal, and other possibilities only limited by a fickle public’s tastes and preferences.
The key to investing in collectibles is forecasting the trend of that fickleness far into the future. It’s almost like gazing into a crystal ball and the conversations around the buying and selling of collectibles can sound more like fan chatter than serious business. Who knows what people will want to own many years from now? Collectibles have little intrinsic value and their worth is measured in the pleasure people will have of owning them. Unquantifiable, unpredictable pleasure.
Experts at the Wall Street Journal all caution against collectibles, as do many others. Some of the reasons provided for passing up on collectibles include:
Huge markups. Sellers usually get collectibles at wholesale prices and retail them for huge markups.
Hidden costs. If you’re collecting expensive items, you’ll need to pay appraiser’s fees. Storage and insurance costs are recurring expenses you’ll have to pay year after year.
Deterioration. This is especially true for comic books. Yes the value does appreciate but only if you keep them in mint condition. Very few have been successful with this. Mold, mildew, sunlight, and moisture will all conspire to decrease the value of your collectible.
Poor profit. Return on investments rarely keeps up with inflation and ranges poorly against comparative investments in stocks, bonds and real estate.
However, if you do love the collectible and are an avid collector yourself, then you have a reason to go ahead. If you’re collecting them expecting to get high returns down the line then you’re in it for the wrong reason. Also, if you already own the item and it’s dear to you or your family, that’s another good reason for keeping it around instead of selling it off if you think it will be valuable in the future. This is not a license to hoard, however. Be discerning. Junk is junk.
For a primer on real investment opportunities that will help you reach your financial goals, check out Stocks, Bonds, Real Estate and Small Businesses: Get Your Investment Basics Right.