Investing in volatile stocks can be profitable if your fundamental analysis indicates that a stock is underpriced. And investing in risky stocks of the volatile kind can be very dangerous if you neglect to do your homework. As all too many investors learned to their dismay in the 2008 market crash, big stocks are not necessarily safe stocks. Insurance companies like AIG and HIG, Hartford Financial, typically carry a two-fold risk. Historic natural disasters like hurricanes can bring them low and their own trading mistakes can make thing even worth. An apparent stalwart like AIG was caught short in derivative trading as the 2008 market went south and required a government sponsored bailout to stay alive.
Best Times and Places for Investing in Risky Stocks
The oft repeated comment of Rothschild that the best time for investing is when there is blood in the streets holds true today just as when he said it long ago. The trick is recognizing when things are likely to go bad and to get out of investments that do not make sense before they go bad. Then, when the market has tanked and everyone has run away it is time for investing is risky stocks, because they do not have far to fall. As always an investor needs to look at fundamentals. Intrinsic value and margin of safety are critical to investing in risky stocks in a down market. A stock with a strong margin of safety will commonly weather the storm and a stock with a promising future, strong intrinsic value, will be severely under priced if you compare stock earnings to stock price, especially in a down market.
Anticipating the Future
How do you know that you are investing in risky stocks when the market keeps going up and up? On the eve of the dot com bubble, a well-known investor sold all of his internet related stocks saying that he really had no idea how to value these investments. Note: when investors who have been successful for decades through good and bad times start to bail out, maybe those who remain are investing in risky stocks. Following the herd can be profitable if you believe that investor sentiment will rule the day forever. But, then stock prices repeatedly outstrip fundamentals it is commonly time to quit investing in risky stocks and diversify into less risky investments or simply hold cash. To the extent that one is investing in growth stocks and has sufficient expertise to see the possibilities of a new market, investing in risky stocks can be rewarding. The key is to diversify risk, limit risk, or hedge risk.
Hedging the Risk of Investing in Risky Stocks
Options trading offers a means of hedging risk when investing in risky stocks that have risen significantly but now hold the possibility of a big correction. A useful strategy in a stock that might fall is to purchase puts on the stock. In doing so the owner of the stock guarantees himself a price at which to sell the stock, no matter how far it might fall in case of a market turnaround. He will view the price of the put options contract as insurance against loss. Meanwhile he can still establish further gains if the stock advances farther. He will simply swap out one options contract for another in protecting his gains. And one should always consider what is a profitable investment timeline. If a stock has run its course and is likely going to level off there is nothing wrong with selling, taking profits, and looking for other investments.