So-called "toxic investments" gained notoriety during the 2008 financial crisis because they seemed to be everywhere. Even previously well-regarded blue chip stocks like AIG were inundated with investments that were essentially worthless, requiring the federal government to step in and buy them before they dragged down these companies along with the entire U.S. economy.
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Now, as the U.S. braves yet another recession caused by the coronavirus pandemic and inflation-- while the stock market endures volatility -- toxic investments are once again a burning topic of conversation. These days the term "toxic investment" can be more liberally applied to investments that the average investor should simply avoid. To make the most of your money, be aware of the investment mistakes you could be making.
1. Subprime Mortgages
Subprime mortgages are mortgages taken out by the least credit-worthy customers, meaning they have very low credit scores. Statistically speaking, borrowers with lower credit scores are more likely to default on their loans. These mortgages do pay higher interest rates to investors, but they involve significant additional risk.
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Why Subprime Mortgages Are Toxic
Subprime mortgages are the poster child for toxic investments. In the 2008 financial crisis, these were the investments -- many of which ended up worthless -- that dragged down some of the biggest names in the stock market, including Lehman Brothers. Although lending regulations have tightened since 2008, subprime mortgages are still literally "subprime," meaning they are low-rated investments with a higher potential for default. With so many other investment options available, the checkered history and low standing of subprime loans make them toxic investments.
There are two main types of annuities: fixed and variable. With a fixed annuity, you pay a premium to an insurance company in exchange for guaranteed income payments, either for a certain period of time or for your entire life. With a variable annuity, your money is invested in mutual fund-like buckets that provide a variable rate of return that might ultimately be more or less than with a fixed annuity.
Why Annuities Are Toxic
Annuities serve a useful purpose for certain select investors. But for the most part, you can use other investments to accomplish everything an annuity can without dealing with the more toxic aspects, such as high fees and high surrender charges that can cost 7% or more if you withdraw money in the first few years after purchase. Annuities also have the same restrictions as IRA accounts in that you can't withdraw money before age 59 1/2 without facing tax penalties.
3. Penny Stocks
According to the SEC, penny stocks are usually issued by very small companies that trade for less than $5 per share. In common Wall Street parlance, however, a penny stock is one that trades for less than $1 per share. Penny stocks capture the imaginations of many investors because they are cheap and the smallest move can translate into a huge percentage gain. For example, if you buy a penny stock at 50 cents and it climbs just 10 cents per share, that's a 20% gain.
Why Penny Stocks Are Toxic
There's a reason penny stocks trade at such low prices, and it's usually because the company behind them is losing money and might be on its way to bankruptcy. Penny stocks are always a gamble because there's so much manipulation in the market. Stock promoters publish articles about how XYZ penny stock is "the next Microsoft" or "the next Apple," trying to pump the share price up so they can sell out at a profit. At best, penny stocks are a speculation, but they're also subject to market manipulation, making them toxic investments.
4. High-Yield Bonds
"High-yield" is the relatively modern term for what used to be primarily known as "junk" bonds. Junk bonds receive low ratings from credit agencies regarding their ability to pay off their debts. Since they are by definition riskier investments, they typically pay higher interest rates, thus the term "high-yield." Particularly in a low interest-rate environment, these higher-than-average yields can entice investors to take on added risk in an attempt to earn a higher return.
Why High-Yield Bonds Are Toxic
Companies with low credit ratings are just like people with low credit ratings -- they're more likely to default or go bankrupt. If you own a high-yield bond of a company that goes bankrupt, you'll likely lose your entire investment. It's hard for individual investors to get all the detailed information necessary to understand what's really going on at a company, so choosing a high-yield bond that will survive is a challenge. Buying high-yield bonds via a mutual fund is a way to lessen this risk, but it doesn't entirely eliminate it.
5. Private Placements
Private placements are sales of stocks that don't trade on the public markets. To invest in a private placement, you must be an "accredited investor." According to the SEC, to qualify as an accredited investor, one must have income exceeding $200,000 -- or $300,000 together with a spouse -- in either of the two previous years, with expectation to make the same in the current year. You can also be considered an accredited investor if you have a net worth over $1 million.
Why Private Placements Are Toxic
There are certain situations where private placements are legitimate investments. However, for the average investor -- who can't possibly get enough information on a private placement to determine its legitimacy -- these types of investments are toxic. Much like penny stocks, private placements are often pushed by stock promoters who fraudulently tout the upside of the stock without any information about the worst-case scenario. Private placements can also be hard to sell -- at least until after the big shots involved in the placement have already sold their positions at a profit.
6. Traditional Savings Accounts at Major Banks
Savings accounts are secure, FDIC-insured investments that don't fluctuate in value and provide investors with regular interest payments. They can be found in nearly any bank in the country, from long-standing, traditional banks to upstart online banks. So how can they be considered toxic?
Why Traditional Savings Accounts Are Toxic
Obviously, savings accounts are not "toxic" in the sense that they will lose all your money. However, "toxic" can be a very relative term. For starters, many of the most well-known banks in the world pay just a token interest rate. Chase and Wells Fargo are a couple of examples, with both paying investors a minuscule 0.01% on their basic savings plans. Even the national average savings rate is only 0.05%. When you factor in inflation and taxes, your savings account money isn't doing anything for you but sitting there. Keeping your money in this kind of savings account won't ever generate the kinds of returns you should be shooting for in a long-term investment account or even what you could get with a high-interest savings account.
7. The Investment Your Neighbor Just Doubled His Money On
We've all had one -- the neighbor who boasts about the hot stock he just doubled his money on. It's certainly easy to get caught up in the excitement; after all, who wouldn't want to double their money? Sometimes there's the added enticement of secrecy or an "I shouldn't be telling you this" level of intimacy that makes you feel special that you have a chance to get in on the action.
Why Your Neighbor's Stock That Doubled Is Toxic
Even if your neighbor is telling the truth about his stock gains -- and remember, humans do have a propensity to exaggerate -- buying the same stock is rarely a good idea. For starters, if a stock has already doubled in price, it may have run its course, particularly if it's a legitimate company. If it's a penny stock, as mentioned above, it might be peaking thanks to stock promoters and insiders who only want you to buy in so they can leave you holding the bag. In any case, you shouldn't be randomly buying stocks based on the performance claims of others. Only make investments you have thoroughly researched yourself and that meet your personal objectives and risk tolerance.
8. The Lottery
Lotteries are booming in the U.S., with most states now offering at least some form of the game. Since every multimillionaire created by the lottery is splashed all over the national news, it's easy to get caught up in lottery fever, where a simple $1 or $2 ticket could change your life forever.
Why the Lottery Is Toxic
Want to know how hard it is to hit it big in the lottery? The odds of winning the Powerball jackpot are in the neighborhood of one in 292 million. This means you're more likely to find a pearl in an oyster shell, get struck by lightning or date a supermodel than win the Powerball. It's even more likely that an asteroid hits the Earth. There's nothing wrong with occasionally playing the lottery for fun, but as an investment strategy, it's toxic. To hammer this point home, consider that you're also one million times more likely to catch the coronavirus than you are to win the lottery.
9. Promised Returns in Double Digits
You probably see ads all the time for investments that are "guaranteed to return 20% per year" or even more. Often, details are scarce about what the investment actually is. The more audacious promoters might even throw in keywords like "government-backed" or "insured." Particularly in years when your own portfolio isn't doing much, it can be enticing to check these "investments" out. Who wouldn't want to earn a guaranteed 20% per year?
Why Investments Guaranteeing Double Digit Returns Are Toxic
For starters, no investment is guaranteed to deliver that kind of return. Some are insured, and Treasury securities are backed by the federal government, but none can "guarantee" you double-digit returns. To place things in context, it helps to know that the average annual return for the S&P 500 from 1926 through 2018 was about 10% -- and even that return is far from guaranteed. Additionally, the S&P's performance has been rocky of late, sliding 20% in the first six months of 2022. Bottom line: Any investment that a friend, stock promoter, or online website tells you is "guaranteed to return 20%" is definitely toxic and possibly a scam.
10. 'The Nigerian Prince'
You open your email one day and see a letter penned by a Nigerian prince. The prince needs help! He has millions of dollars locked away and it can only be freed if you send some of your own money. The details may vary, but essentially the promise is that if you send enough money it will be used to pay fines, fees or bribes that will allow the Nigerian prince to free up his millions and send you a huge cut.
Why 'the Nigerian Prince' Is Toxic
The Nigerian Prince (or "419") was one of the original, well-publicized email scams, and by now most people have gotten wind that it's toxic. However, variations of this original scam have gotten increasingly more sophisticated. In addition to requesting money, these scams may ask for your bank account information and even impersonate you to take over your financial life. If you ever get any type of unsolicited "investment opportunity," be very wary and do your homework. Even if it seems like an investment opportunity is from a legitimate firm, consult a financial advisor to verify the sender -- and never provide your personal and financial information to an unknown source.
11. 'Fallen Angels'
A "fallen angel" is a stock or bond that has fallen from its lofty perch back down to Earth. In the bond world, it usually means a company that has had a formerly high credit rating reduced to junk status. For stocks, it can refer to any high-flying stock that is now in the dumps. These investments are often tempting for investors because it's human nature to remember former highs and think the current lows will eventually pass.
Why 'Fallen Angels' Are Toxic
Stocks that are falling sharply are also known as "falling knives" because, just like with a knife falling through the air, the odds that you catch it without getting hurt are minuscule. Many stocks that drop by 50%, for example, continue straight down until they have lost 70%, 80% or even 100% of their value. Since it's nearly impossible to catch a stock at its absolute low, it's a much safer course of action to wait to invest until a stock is back in a confirmed uptrend; only then does a stock have the potential to transform from a toxic investment to one with long-term growth potential.
12. Airline Stocks
Airline stocks include some of the most familiar names in the world, particularly for people who travel a lot. Delta, American, United, Southwest, JetBlue and others all have their own publicly traded stocks. The COVID-19 recession has all but decimated airline companies -- but even before the travel sector was crushed by the pandemic, airline stocks were potentially toxic investments.
Why Airline Stocks Are Toxic
Back in 2013, Warren Buffet famously called airlines a "death trap for investors." He soon after changed his tune and went on to become the largest shareholder in Delta, Southwest, United and American airlines. Now, it looks like Buffet is back to his previous "death trap" stance; The Berkshire Hathaway Chairman said that Berkshire sold the entirety of its equity position in the U.S. airline industry, CNBC reported.
The list of airlines that have gone bankrupt over the years (some more than once) reads like a "who's who" of the industry. The list ranges from Delta and United to Northwest, US Airways, TWA and Pan Am. This should serve as a cautionary tale that while there may be periods of strong financial results, the potential for an airline bankruptcy is always out there -- and it's more likely than ever amid the pandemic.
13. These 3 Canadian Cannabis Companies
The cannabis sector has emerged as a viable category on the market, but the pandemic has thrown the blossoming industry some curveballs, and Canadian companies that were hurting even before the pandemic are in an especially unstable place. Certainly not all cannabis companies in the Great White North are bad bets, but after 2020, at least three are in trouble.
Why These 3 Canadian Cannabis Companies Are Toxic
A cluster of Canadian cannabis companies were in pain at the same time. In September 2020, Aurora Cannabis reported a loss of more than C$3.3 billion -- about $2.5 billion-- in the 2020 fiscal year. Just days later, Nelson Peltz, the organization's strategic advisor resigned from the role just 18 months after signing on. It's looking downhill for this former investment darling.
Cronos was looking attractive when the tobacco corporation Altria Group claimed a 45% stake in it for $1.8 billion in cash. That was back in early 2019 though and as 2020 ferociously proved a lot can happen in a year. Cronos, which has products in the vaping space, was soon after hit hard by growing concerns over the health effects of vaping and bans on e-cigarettes in some areas.
Yet another Canadian cannabis company on the outs at the moment is HEXO. A few problems can be found here including multiple rounds of layoffs that don't appear to have offset lackluster sales and a share price locked at under $1. The low price puts the company at risk of being delisted by the New York Stock Exchange in January 2023, Yahoo Finance reported.
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Nicole Spector contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: 13 Toxic Investments You Should Avoid