The Wall Street Jungle, written by Richard Ney in 1970, compares the field of investments to a shadowy, sometimes impenetrable wilderness filled with dangerous beasts and hidden treasures. Blindly venturing into this unknown world can easily end in disaster.
Often, predators such as con men, thieves, and bandits lurk and set traps for overconfident, naive adventurers foolish enough to believe that a free lunch is possible. Inexperience can lead to a failure to recognize risk (or underestimate it) and result in poor decisions and financial loss.
However, overconfidence is more often the cause of investment catastrophes, especially when coupled with the innate tendency of people to follow the herd. In his 1871 book The Descent of Man, Charles Darwin writes, “Ignorance more frequently begets confidence than does knowledge.”
No investment is free of risk, but the following seven are particularly dangerous. If you want to protect your investments, read this guide carefully.
The Most Dangerous Investments
1. Penny Stocks
Common stocks trading for less than $5 per share are called “penny stocks” by the Security and Exchange Commission. Their stock prices are quoted on the “pink sheets,” an over-the-counter market that connects traders electronically. The companies are not required to register with the SEC and typically do not file periodic or annual reports with the Commission.
Penny stocks are the preferred vehicle for “pump and dump” schemes, fraudulently manipulating prices upward to sell owned shares with huge profits. Testifying before the House Subcommittee on Finance and Hazardous Materials, Committee on Commerce, SEC Director Richard H. Walker stated that organized crime families have been actively involved in manipulating penny stock since the 1970s. The New York Times reported activities of the New York and Russian mafias in two New York brokerage firms: White Rock Partners & Company and State Street Capital Markets Corporation.
Penny stocks attract gangsters and con men because they are easy to manipulate due to the lack of the following:
- Information. Since companies are not required to file information with regulators, determining the value of such businesses and their securities is difficult, if not impossible. Also, much of the information may be provided by questionable sources.
- Minimum Standards. Virtually any company can be traded on the pink sheets, regardless of their assets, revenues, profits, or lack thereof. For example, according to Forbes, Cynk Technology had one employee, substantial losses, no turnover, no assets, and a $4.5 billion valuation.
- History. The companies listed on the pink sheets are typically startups or bordering on bankruptcy. Many have a history of changing names and industries to attract investors. For example, Quasar Aerospace Industries, Inc. changed its name to Green Energy Enterprises, Inc. in 2015. Until 2009, Quasar was known as Equus Resources, Inc. The company was incorporated in 1976 as Hunter International Trade Corp. Its primary business was initially financial services until reforming as a foreign pilot training company in Florida, and now participation in the medical marijuana industry.
- Liquidity. Market liquidity refers to the ability to buy or sell an asset without drastically affecting its price. Most stocks listed on an exchange have high liquidity, often trading millions of share a day with a change in price under 1%. A stock with limited liquidity experiences drastic price moves despite the low volume of shares traded. Penny stocks are illiquid and are uniquely suited to pump and dump schemes.
Congress considered penny stock shares so risky that it passed the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 requiring broker and dealers to make broader disclosures to those seeking to purchase or sell penny stocks. The likelihood of loss is sufficient enough to cause many brokerage firms to require customers to sign statements that they acknowledge the receipt of the broker’s warnings and elect to proceed with such transactions regardless.
2. Commodity Futures
Commodity futures for a variety of agricultural products, minerals, and currencies trade on exchanges throughout the United States – the oldest and largest being the Chicago Board of Trade. Understanding the mechanics and risks of commodity futures trading is essential before venturing an investment.
Commodity futures speculation is a high-risk venture for individual speculators due to the following:
- Lack of Investor Resources. Specialized trading firms including investment banks, hedge funds, and commodity trading funds spend millions of dollars acquiring and maintaining expensive software and hardware to watch and analyze commodity markets. Their systems are programmed and tested by mathematicians and market experts to instantly recognize trading patterns with the slightest profit opportunity and enter transaction orders directly to the exchange for execution. Few individuals can afford to make the significant capital investment required to compete with these larger trading entities.
- Lack of Investor Time. Active traders must always be aware of the market and their positions. Off-hours are spent searching news and market reports for information that might affect their holdings. Commodity futures trading is not a part-time activity. According to commodity broker Capital Trading Associates, “Most people do not have the time or experience to trade futures profitably.”
- Leverage. The price to acquire a single futures contract is a fraction of the total contract’s value, compounding potential gains and losses. For example, a corn futures contract is 5,000 bushels. Subject to the minimum account balance required by the commodity brokerage firm, a buyer of a single contract of corn with a value of $20,000 is required to deposit slightly less than 5% of the contract’s value to open a position. In contrast, buyers of a common stock on the NYSE are required to deposit 50% of a trade’s value.
- Trading Price Limits. Many commodities are subject to a maximum daily price fluctuation during the trading session, depending on the exchange where the commodity is traded. Trading is halted if the limit is reached and does not resume until the next day.
- Impact of Unknown Events. Projections of future commodity price levels and events are notoriously unreliable due to the vagaries of weather, disease, and natural or man-made disasters, as well as economic conditions, government actions, and erratic consumer behavior.
- Extreme Price Volatility. Volatility is the rate of price change that a commodity experiences during a trading session. Some commodities have high volatility and require investors to assume a greater potential for loss.
- Investor Psychology. The ability to initiate or maintain an investment position is directly dependent upon an investor’s risk profile and resilience. Losses are inevitable, despite a trader’s knowledge and experience. Robert Rotella, the author of The Elements of Successful Trading, says, “Any trade, no matter how well thought out, has a chance of becoming a loser. Many people think that the best traders don’t lose any money and have only winning trades. That is absolutely not true.”
Futures trading is a zero-sum game. For every winning trade, there is a corresponding losing trade. Individual commodity traders competing against Wall Street firms and multinational hedgers is akin to a high school football team beating the New England Patriots. Miracles can happen, but it is extremely unlikely.
3. Tax Shelters
In 1935, Judge Learned Hand ruled in the Helvering v. Gregory decision – subsequently confirmed by the Supreme Court – that every American has the right to reduce one’s tax liability as low as possible. With that, the market for investments with tax benefits boomed.
Permitting certain expenses or income to be deducted from income taxes can be good public policy, encouraging investments that benefit the country as a whole. For example, the ability to deduct (rather than capitalize) intangible drilling costs from income tax incentivizes investment in oil exploration, just as individuals and companies are encouraged to convert to solar systems by making their costs deductible.
However, investing in tax shelters can be perilous for the following reasons:
- Complexity of Tax Law. While the ultra-wealthy have been exceptionally efficient using the loopholes and complexity of the tax code to their advantage, the key to their success is their ability to afford sophisticated tax advice and legal fees. In an interview with The New York Times, Professor Jeffrey Winters of Northwestern University noted that the ultra-rich “literally pay millions of dollars for these services [tax advice and defense] and save in the tens or hundreds of millions taxes.” Most Americans cannot afford such expert advice. Potential tax shelter investors who rely on the advice of experts should recall the opinion of Fred Drasner in the book Contemporary Tax Practice: Research, Planning, and Strategies. Drasner said, “The First Rule of Practicing Tax Law: If someone has to go to jail, make sure it’s the client.”
- Investors’ Lack of Control. Tax shelters often require investments in limited partnerships where investors cede control to (and rely upon) a general partner for management and preparation of tax filing documents. In other words, they have little recourse if adverse consequences surface. In many cases, neither the salesperson nor the general partner is financially capable or obligated to defend the limited partners’ deductions if challenged by the IRS.
- Investors’ Lack of Objectivity. Investors tend to overlook the economic aspects of tax shelters due to their focus on the tax deductions. Con men exploit this tendency, assuring potential investors that the government takes the investment risk because the cost of the investment will be recovered through the client’s reduced tax liability.
- Heightened IRS Scrutiny. The Internal Revenue Service actively pursues promoters and investors in “abusive tax shelters” with its powers of audit, summon enforcement, and litigation. In some cases, the IRS files criminal charges. An abusive tax shelter is a “scheme involving artificial transactions with little or no economic reality.” If an investor is guilty of having participated in an abusive shelter, any claimed tax savings will be recovered plus penalties and interest. Potential investors in a tax shelter should be sure the potential economic benefits of all investments, especially tax shelters, before investing.
- Offerings May Be Unregistered. Promoters of tax shelters often provide limited, exaggerated, or false information about the details of the investment operations, management fees or experience, or the tax law basis for the deductions or credits.
4. Digital Currencies
Digital currencies, sometimes called cryptocurrencies or virtual currencies, entered the public sphere in 2009 with the popularity of Bitcoins. Electronic versions of money are not regulated by national governments and are based upon extremely complex code systems that rely upon advanced mathematics and computer engineering principles that make them virtually impossible to duplicate or counterfeit.
According to CoinMarketCap, there are 709 different cryptocurrencies with a total market value of $13.6 billion. Bitcoin remains the largest, accounting for 84% of the total market.
Digital currencies are popular due to their finite supply as well as their anonymity. The latter makes them ideal for illegal activities such as tax evasion and purchasing drugs. While Bitcoin enjoys an avid set of supporters, Mark Gilbert of Bloomberg View characterizes such enthusiasts as “hackers whose resources depend upon the Ponzi scheme nature of the enterprise itself.”
What are the risks of investing in digital currencies? Consider the following:
- Lack of Government Backing. According to Brad Templeton, chairman of the Electronic Frontier Foundation and Singularity University, a digital currency with no intrinsic value or [government] backer works because people believe that other people will accept it in trade. As a consequence, Templeton projects that digital currencies will rise and fall in value. When replaced by a more modern version, the older digital currency will fall to little or no value. In a CNBC report, Templeton says, “I would tell them [investors] don’t invest in Bitcoin, but invest in the companies that are building on that technology.”
- Limited Market Acceptance. While an increasing number of online e-commerce businesses (such as Microsoft, Dell, and Overstock) accept Bitcoins for payment, the vast majority of companies do not accept any digital currencies. According to Wired, only about 20% of transactions in Bitcoins involve payments or uses as a currency. It is likely that most owners hoard Bitcoins speculating on future price gains. At Quartz, Matt Phillips says Bitcoin “never was a currency, but rather a plaything of speculators.”
- Price Volatility. Since January 1, 2013, the price of a single Bitcoin in U.S. dollars has ranged from $13.29 to $1,022.37. Prices in 2016 prices have ranged between $374 to $750. The lack of available Bitcoins in circulation contributes to extreme volatility. In 2014, The Guardian and the website Quartz declared that Bitcoins were the “worst investment of the year.”
- Computer Hacks and Thefts. According to Bloomberg View, Hong Kong-based Bitfinex (a Bitcoin exchange) was hacked, resulting in depositors losing $71 million (36% of deposits) in mid-2016. This follows a $350 million hack and the failure of the MtGox exchange in 2014. A study funded by the U.S. Department of Homeland Security and shared with Reuters showed that one-third of the Bitcoin exchanges had been hacked since the creation of Bitcoins and March 2015. Since many exchanges are poorly financed and operate on thin margins, the likelihood of recovering lost Bitcoins is small.
Unlike conventional currency, digital currencies have no support structures to prop them up in the event of a disaster. As a consequence, Dave Hrycyszyn, an expert on new technologies, advises, “Do not treat [digital currency] as a long-term store of value to fund your retirement.”
5. Alternative Investments
Alternative investments – also known as “structured products” or “exotic investments” – are named for their geography or complexity.
These investments are usually illiquid, such as private equity, hedge funds, or real estate. Many are old products – collateralized mortgage obligations – repackaged for modern times or new high-risk investments, such as viatical settlements securitized to reduce risk, according to The New York Times. They include complex derivatives and arbitrages, such as power reverse dual-currency notes designed to exploit the inefficiency of interest rates in two different economies.
Attracted by their popularity, many investment managers of mutual funds are offering alternative investments funds, employing exotic investments in their portfolio to reduce risks and increase returns. While fund managers have had limited success with alternative investments, they are not appropriate for the average investor due to the following characteristics:
- Complexity. Understanding and evaluating exotics is “a full-time job, which is why advisors find it hard to do it themselves,” claims Nadia Papagiannis, a director of alternative investment strategy at Goldman Sachs Asset Management, in Barron’s. The combination of different assets, their relationship to each other, the changing economic environment, and the various risks that affect each asset can be mind-boggling, often requiring sophisticated mathematical models and extensive experience to understand.
- Lack of Transparency. Many exotic investments are not bought or sold on public exchanges, and rely upon private transactions and Regulation D offerings. According to William Bernstein, an investment advisor and author, “The information asymmetries are industrial-grade. You’re being offered a share of a business that you know nothing about and the person selling knows everything about. Are you going to come out ahead on that one? I don’t think so.”
- Volatility. The return on exotics varies tremendously from year to year in comparison to the market as a whole. Dick Pfizer, founder and CEO of AlphaCore Capital, states in a CNBC interview, “There may be a 1% difference in returns between large-cap value funds in any given year. With an alternative fund, the best manager may be up 10% and the worst, down 10%.”
- Poor Historical Performance. According to Dan Egan, director of Behavioral Finance and Investments at Betterment, returns on exotic investments don’t live up to their hype due to their higher fees (up to 10 times greater than an ETF), costs to participate, and the risks involved. Morningstar calculates the average three-year total return for multi-alternative funds to be 0.69% versus an S&P 500 return of 11.3% as of January 31, 2016.
Unless you are an experienced investor with a high tolerance or risk, you should generally avoid investing in exotics. As William Bernstein bluntly states, “Most people have about as much business investing in alternatives as they do trying to do their own brain surgery,”
According to a report by Deloitte, the market for collectibles was $362 billion in 2012 and was expected to grow to $621 billion by 2017. Deloitte consequently concluded that collectibles were an ideal hedge for “high net worth individuals” against inflation and an important part of portfolio diversification.
Should the average investor include such assets in their asset portfolio? Most financial experts do not think so. The reasons for dismissing collectibles as valid opportunity for most include:
- Speculation, Not Investment. Collectibles are only worth what someone will pay for them – there is no business, no cash flow, and no guarantee that there will be a future market. Owning collectibles for future gains relies upon the “greater fool” strategy, i.e., buying something in the belief that someone (the greater fool) will come along later and pay more.
- Lack of Expertise. Unlike stocks and bonds, there is usually little public information available for individual collectibles. Experts develop their expertise through technical education and experience, usually at considerable expense. In addition, no two collectibles of the same type are identical, so relying upon comparable prices to estimate value is uncertain.
- Illiquidity. There are no public markets for collectibles, and the number of buyers and sellers is usually limited. The spread between bids and offers can be 25% or more. Finding a buyer for a particular object can be time-consuming without any assurance that the desired sales price can be achieved. Most experts advise potential investors in collectibles to be sure you enjoy the object since there is no guarantee when or for how much you can sell it.
- Fraud. The collectibles market is swarming with counterfeiters and con men. In 2016, the Chicago Sun Times reported the sentencing of an auction house owner for activities such as using fake bidders to drive up prices, selling a fake 1869 Cincinnati Red Stockings trophy baseball and a fake lock of Elvis Presley’s hair, and altering an ultra-rare 1909 Honus Wagner baseball card to enhance its value.
Even experienced businessmen like billionaire William Koch are victims. He estimates in Forbes that fake wine sales amount to several hundred million dollars each year, noting, “I bought a lot of fake wine at auction – that’s where I got most of it – but I’ve even bought fake wine at charity auctions! I’ve been given fake wine as a present.”
Despite stories of ordinary investors who find a lost masterpiece at a garage sale, most financial experts discourage significant investments in collectibles, considering them too high risk for anyone other than experts. As Terence Odean, professor and chair of the Finance Group at the Haas School of Business at University of California, advises in The Wall Street Journal, “The bottom line is that if you like collecting comic books or want to buy a painting and you can afford to do so, go ahead, but don’t tell yourself that doing so is a surefire investment.”
7. Binary Options
Many investors are familiar with the regulated stock options traded on one of the U.S. Exchanges. The establishment in 1973 of the Chicago Board Options Exchange (and its subsequent growth) has provided an avenue for controlled speculation and risk reduction for investors of all types.
Before the Exchange’s creation, those investors who traded options relied on private transactions and their accompanying illiquidity, uncertain security, and high spreads between bid and offer prices. U.S. Exchange-traded options have eliminated most (if not all) of these concerns.
Binary options were initially developed by online gaming companies seeking a product that is “easy to trade, highly rewarding, and tied to the financial markets,” according to The Binary Options Brokers Association. Unlike traditional options that provide investors the opportunity to buy an asset at a fixed price for a fixed period, binary options are simply a wager on the price movement of an asset, typically within a period much shorter than a traditional option (60 seconds to one week).
The owner of a binary option either receives a predetermined price if his or her choice is correct on the price direction, or loses his or his investment if wrong. Buying a binary option is very similar to a sports bet or a wager on the roulette wheel – this is why binary options are also referred to as “all or nothing” or “high-low” options.
In the United States, binary options are primarily traded on the North American Derivatives Exchange (Nadex) of the Cantor Exchange (CX), each regulated by the Commodity Futures Trading Commission. In the U.S., an auction process between buyers and sellers facilitated by an exchange determines the price.
Foreign brokers who participate on one side of the transaction also sell binary options. For example, each firm – called a “market maker” – establishes a bid and an offer price based on demand. A speculator then purchases the option from the market maker at the offer price, or sells the option back to the market maker at the bid price.
While all binary options are akin to gambling, options purchased from foreign brokers are especially risky. In the U.S., binary options are essentially a zero-sum proposition – whenever someone wins $100, another loses $100 – while foreign options typically pay 60% to 70% of the contract value to the winning side. As a consequence, a speculator has to correctly pick the right direction almost 60% of the time to breakeven.
The high risk associated with binary options is due to the difficulties of the following:
- Correctly Projecting Short-Term Price Movements. According to the Random Walk theory proposed by University of Chicago professor Eugene Fama, past price movements or historical trends are not valid in predicting the future price. In other words, it is impossible to call the market over the short-term.
- Withdrawing Funds From Foreign Investment Accounts. Restrictions are often in place to “keep the better [speculator} at the table.”
- Lack of Regulation and Supervision. Foreign firms dealing with binary options operate in locales with little or no governmental oversight. As a consequence, identity theft and price manipulation is a common complaint. Gordon Pape calls the binary options market the “financial Wild West.”
Have people made money in these seven investments? Yes, but in all cases, they were either lucky or were investment professionals who carefully studied their markets, managed the risks, and learned from their mistakes. Just like explorers in a new wilderness, they are constantly on alert for any sign of danger. Successful adventurers and investors follow carefully devised strategies, exercise emotional control, and know when to retreat if circumstances warrant.
Have you taken a risk on any of these dangerous investments? What was your result?