If you play with fire, prepare to be burned every once in a while.
All investments are risky, but some far more risky than others. There's a world of difference between buying shares in Foreign & Colonial Investment Trust (LSE: FRCL) and a small oil company that has bet the farm on a single well being drilled off the Falkland Islands.
Since Foreign & Colonial owns shares in more than 600 companies all over the world, its share price will closely reflect how the world's stock markets perform. But the oil company's share price could easily double or fall by more than 50% depending upon the drilling result.
That comes with the territory. The nature of some companies' businesses means that they offer massive potential returns with a fairly large chance that you could be wiped out.
Black gold
One of my favourite sectors is oil, specifically small oil exploration companies that are drilling for oil. That's because a decent discovery can totally transform a small company's prospects but will have little effect upon a supermajor like Royal Dutch Shell (LSE: RDSB).
Over the years I've owned several oilers whose shares have increased by more than 1,000%, such as Dragon Oil (LSE: DGO), Northern Petroleum (LSE: NOP) and Fool favourite Soco International (LSE: SIA).
But I've also had my fair share of horrors, like Frontera Resources (LSE: FRR) and Nighthawk Energy (LSE: HAWK), whose share prices collapsed when things didn't turn out as expected. The oil sector contains a surprisingly large number of companies whose shares are 90% or more off their peak, and occasionally you'll see one collapse when it runs out of cash before finding anything.
By investing in these sorts of companies, you're playing with fire -- so you have to expect to be burned now and again. Don't invest more than you can afford to lose.
Be a venture capitalist
I treat these investments as if I was a venture capitalist. So I expect the majority to do badly but for the winners to do so well that their gains will more than compensate for the inevitable losses.
My philosophy is that some of these investments are such high risk that I mentally write off 100% of the investment when I make them. So far, I'm well up by using this strategy, though I've cut back on this part of my portfolio during the last few years.
Sometimes it can feel like putting £50 on a 200-1 shot in the big race. The odds are firmly against you, but if it works out as you hope then the payoff will be massive.
An Xciting ride
One of my recent successes was with the Canadian company Xcite Energy (LSE: XEL), which is developing the Bentley oil field in the North Sea and whose share price is currently 105p. You could have picked up Xcite's shares for just over 3p in January 2009 and barely two years later they hit 390p. Fortunes have been made, and lost, in Xcite.
I was in and out of Xcite in about six months, making a profit of about 250% in the process after doing something that I rarely do, setting a price target at which to sell and then sticking to it. You're never going to see that sort of return if you restrict yourself to huge companies like Diageo (LSE: DGE) and Unilever (LSE: ULVR), but they do make it easier to sleep at night!
My Xcite investment was a relatively small part of my overall portfolio, so if its shares had fallen to nothing it wouldn't have damaged my portfolio to any great extent. This is not the sort of thing in which to invest your life's savings, though if you're young with a steady job, few commitments and a few thousand pounds to invest, then this strategy is worth considering.
It's how I started off. One of my first investments was putting several months' salary (about 80% of my portfolio at the time) into Amstrad shares in the mid-1980s.
Why so volatile?
Shares in companies like Xcite are very volatile because they depend upon a single asset whose value is rather uncertain, to put it mildly. The share prices of small information technology companies are prone to behaving similarly, mostly because of investors' concerns as to whether their technology is better or worse than that of their competitors.
Plenty of these companies came and went during the dotcom boom of the late 1990s. One of the earliest social networking websites, theGlobe.com, was valued at almost $850 million on the day it went public. Two years later its shares had fallen by over 95% as the market gradually woke up to the fact that it wasn't going to make any money.
In Xcite's case, the concern is whether Bentley can be commercially developed. In the first few months of 2011 the consensus was that it would be extremely profitable, so Xcite's shares had risen almost eightfold in 12 months. Now the outlook is much less certain, particularly after Xcite filed a material change report in May that cast doubts over the project.
Be prepared
Of course, whether you're prepared to invest in the sort of company whose share price could fall by 90% overnight is highly dependent upon your personal circumstances, net worth and your attitude to risk.
Funds that invest in countries that are in turmoil might be worth considering as a punt because if their situation ever improves, this should lead to a re-rating of their stock markets. Top of my list for this would be Pakistan (civil war, corruption, terrorism) followed by Russia (institutionally corrupt), though I don't touch Russia nowadays having had a nasty experience several years ago.
Apart from oil, the next best sector for companies whose shares could multiply several times or collapse rather quickly is mining. But not the big miners like BHP Billiton (LSE: BLT); you've got to look at the small companies that have projects that they're still trying to develop.
You might pick up a life-changing bargain, or lose your shirt in the process!
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More from Tony Luckett:
> Tony owns shares in BHP Billiton, Diageo, Dragon Oil, Soco International and Unilever. The Motley Fool owns shares in BHP Billiton and Unilever.
