Some investments sound good in principle but can go south very easily. Sometimes "cheap" stocks, high-dividend stocks, and other appealing investments sound almost too good to be true -- because they are.
Here are three stocks that, although they could prove to quite lucrative, could just as easily take a big chunk out of your portfolio.
Leverage could be your best friend or your worst enemy
Under the right circumstances, leverage can supercharge your investment returns. For example, if you buy stocks on margin, you'll make tons of money so long as they keep going up. However, when things don't go your way, leverage can be devastating.
This is what makes certain mortgage REITs, such as American Capital Agency (NASDAQ:AGNC), a risky proposition. Basically, the company borrows money at low short-term rates and then buys longer-term mortgage securities that pay higher interest rates, profiting from the difference, or "spread," between the two rates. In order to produce double-digit yields for investors, the company uses a great deal of leverage.
Currently, American Capital Agency's leverage ratio is just under seven-to-one, which means that for every $1 in equity the company has, it borrows almost $7. The problem with this business model is that it's highly dependent on interest rate stability. If rates stay the same, or change slowly over time, the company can adjust its portfolio accordingly and still be profitable. However, if interest rates were to spike rapidly (like they did in mid-2013), American Capital Agency's profits could disappear quickly. The mortgage securities would still pay the same interest rates, but the short-term cost of borrowing would rise, which could erode the company's profit margin and even cause it to turn negative in extreme cases.
While American Capital Agency's 12.3% dividend yield may seem tempting, just know that it could be extremely vulnerable if interest rates spike.
Don't try to catch a falling knife
Just because a stock looks insanely cheap doesn't mean that it's a good buy. Just ask people who thought Radio Shack was a great bargain at $1 per share and then watched the company slide into insolvency. Stocks that experience price collapses like that are usually cheap for a reason.
One stock that currently fits this description is metallurgic-coal producer Walter Energy (NASDAQOTH:WLTGQ), which is trading at $1 per share as of this writing. Walter Energy has dropped by more than 90% over the past year and has fallen from a high of nearly $143 per share in 2011. Oversupply has led to lower coal prices, and the company has been hemorrhaging money for some time now.
During the past two years (2013 and 2014), Walter Energy has produced a total loss of more than $10.50 per share, or more than 10 times the current share price. In dollar terms, the company lost about $450 million dollars last year. With available liquidity of less than $500 million at the beginning of this year, Walter Energy can't withstand too many more losses like this.
If the company can miraculously turn around, and fast, shareholders could see a nice payday. However, the more likely scenario is an eventual bankruptcy.
Don't buy long shots just because the rich guys are
Many investors like to keep track of what the billionaires of the world invest in, and why not? They must be pretty good investors to have accumulated so much wealth.
However, bear in mind that billionaires can afford to take risks that you can't. One example of this is Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC), which are owned by several very rich investors, such as Bill Ackman, Bruce Berkowitz, and Carl Icahn. In fact, Ackman is the largest shareholder of Fannie Mae's common stock.
Currently, all of Fannie and Freddie's profits go straight to the Treasury, not to shareholders, which is why both stocks trade in the $2 range currently. Many shareholders are suing the government to have this changed, and if they're successful, several analysts say the share price could increase tenfold or more.
However, this is a very big "if." There's a long way to go, and one judge has already tossed out one group of lawsuits. There is a constant debate on whether Fannie and Freddie entirely should be eliminated entirely, which would likely leave shareholders with nothing at all.
While shareholders may ultimately be successful, it's a total gamble at this point. For the billionaires I mentioned, Fannie and Freddie make up relatively small percentages of their overall holdings, and the investment is being looked at as a calculated risk.
So what should you buy?
The three stocks I mentioned here all have one thing in common: a high amount of risk. In all three cases, conditions need to be ideal for investors to make money (low interest rates, a successful rebound, and a victorious legal battle).
Focus on stocks that don't rely on unpredictable events to be successful investments. Wells Fargo (NYSE:WFC), for example, can be successful in any market environment, as can stocks with rock-solid businesses such as Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ).
In short, don't take unnecessary risks with your money, and definitely don't gamble on things that could happen. Focus on stocks that will do well, and so will your portfolio.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Johnson & Johnson, and Wells Fargo. The Motley Fool owns shares of Johnson & Johnson and Wells Fargo and has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $37 puts on Coca-Cola, short April 2015 $57 calls on Wells Fargo, and short April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.