[Editor's Note: This guest post was submitted by Michael Fishman, MD, MBA. He started his post-graduate training as a surgery resident, where he saw the light on the other side of the curtain. In transitioning to Anesthesiology, he took a year off and did an accelerated MBA at Drexel University’s LeBow College of Business. After anesthesia residency at Yale, he is now a Multidisciplinary Pain Medicine fellow at Stanford. This Pro/Con series started out like most of them, with a guest poster submitting a guest post I disagree with. I almost just flat-out rejected this one, but since I frequently hear doctors, both in real life and online, advocating similar methods, I thought it was worth a discussion here. We have no financial relationship.]
Pro: Physician Investors: Stick to your Core Competency
Michael Fishman, MD, MBA
I first got involved in biotech trading by sheer luck – I was made aware of a company that had an upcoming reporting of phase III results and started to become more aware of the significance of the Food and Drug Administration’s (FDA) calendar. There are a number of binary events that have known dates. As a physician scientist, we have journal access and knowledge to interpret published data. There are Advisory Committee (AdComm) panels that meet typically one month or so prior to a decision date, on which a panel of independent experts vote on safety, efficacy, and other concerns regarding drugs and devices. The briefing documents from the FDA and the sponsor company are available two business days prior to that event. They are public knowledge and published free of charge on the FDA website. Interpretation of AdComm data has proven to be highly lucrative for me.
Sources of Information
I subscribe to a few sources, which I rely on for four main resources: a database of companies with upcoming catalysts, analytical articles, a current FDA calendar, and real-time Twitter updates on events. I do not endorse any particular resource and have no conflict of interest. Subscription sites I have used in the past include BioRunUp and Chimera Research Group. An excellent free resource is Bio Pharm Catalyst. The resource I use most heavily is the FDA AdComm Calendar. This is difficult to navigate (it is the Federal government, after all), but if you put in thirty minutes or so you will start to realize that it has a great deal of information. This is where AdComm briefing documents are released. You can also subscribe to receive update e-mails whenever new information or events are posted.
My personal approach involves correlating medical data with market sentiment around binary events. I use several different trading strategies to profit from the common patterns that surround these events. There are a few main timeframes that I trade. First is the run-up. Typically, there is a run-up to the event starting 3-4 months prior to the binary event. In some cases, there is an AdComm prior to the approval date, and this can be treated as a binary event in and of itself. Next is the actual approval event. Last is the sell off, as traders sell the stock after approval. This is important because typically companies lack the ability to immediately monetize their new approval. Cash flow may be months or years away, and could require partnership deals and/or raising a sales force. This is highly tradable and predictable. It is also an opportunity to pick up shares of these companies with promising approved drugs at a discount. Trading is just trading, but as a physician with insight and foresight you can use traders’ frivolity to value invest.
There are no hard and fast rules, and not all companies fit these patterns. It is important to never put all your proverbial eggs in one basket. These trends have proven to be true for a majority of trades over the past two years, but there are always exceptions. Pigs turn into bacon. Don’t get fried on one trade. Make rules for yourself and limit risk in any one idea to an amount that stings if you lose it but doesn’t make you wretch or file Chapter 11. Options are an excellent way to have a fixed, tolerable downside with an unlimited upside. They can also be used to hedge.
Without further adieu, I will present my general framework for evaluating small- and medium-cap biotech stocks with near- and medium-term catalysts. I do not take all these steps for every company.
General Approach to Biotech Investing
- Catalyst Date
- For this I typically rely on the FDA calendars at subscribed sites. I look a few months ahead and then research the companies and pipelines.
- Summary of disease
- As a physician, this is obvious. Incidence, prevalence, impact, chronicity, severity are all factors to consider.
- Competitive landscape
- What other drugs are on the market? Do they work? Is this a new formulation of an existing drug (frequently the case)? Are there generics?
- Most important question – is this a disruptive technology (i.e. an oral formulation of a therapy previously only available as injectable)?
- Downside (Market cap – net cash)
- Use your brokerage site or Google finance to look at the company’s financials. How much cash do they have? How much cash do they spend? What is the market valuing them at (market cap = share price x number of outstanding shares)? This is typically the downside potential.
- Upside (industry comps)
- Difficult to gauge, but you can look at the prevalence of disease, competition, and predicted drug cost and make a reasonable guess as to the revenue expected from the drug or device. Once you have this figure, you can predict a new market cap based on commonly used Price/Earnings multiples (average for biotech is 10X), but you can look at direct competitors of your company for more accurate analysis.
- Obligations/Partnerships
- Many companies have partnerships and debt obligations. These should be disclosed in shelf filings, financial statements, annual reports, and general news. Know the deals they have, know the associated milestones, and adjust accordingly. I find comfort in small companies who have multiple deals with Big Pharma, it means that these major players have done due diligence.
- Projected market valuation
- Multiply the projected earnings per share by the average P/E and compare to the current market cap. The difference can be extrapolated to suggest upside on approval.
- Projected Market Cap (favorable/unfavorable)
- Just to reiterate, it is best to model the upside and downside. This is especially useful when creating an options strategy. My favorite options strategy is the ‘strangle’ or ‘modified strangle’. This operates on the premise that the stock price will move up or down based on the binary event.
- News
- Google news or brokerage site should be used to have news on your watchlist forwarded directly to you.
- FDA Comparisons/AdComms
- Look at how similar drugs (by class or mechanism) have fared with the FDA in the past. Pay attention to the AdComms – these are highly tradable and the briefing documents have a great deal of information.
- Twitter sentiment
- Twitter has a tight group of biotech investors who I have followed for some time. There is a lot of information and news that can be gleaned in this fashion. I do not post often, but typically use Twitter to ‘listen’. News travels fast on Twitter, and I have made several profitable quick trades as a result. Log in to Twitter and look at who I follow. (Follow me at @MFMDMBA.)
Con: Buying Individual Stocks is a Loser's Game, Even Biotech Stocks
Dr. Fishman's initial email to me said he tangentially followed my blog. I figured it must be REALLY tangential for him to send me a post suggesting that picking individual stocks was a good idea. His follow-up emails noted that he invests 20% of his portfolio in biotech stocks and 80% in dividend stocks. While I will readily admit there are dozens and dozens of reasonable portfolios, I don't see his as one of them. It is a bit difficult to know exactly where to start with this one, but I was able to come up with a five point list about why investing as Dr. Fishman has suggested isn't a great idea.
1) Uncompensated Risk
According to well-known investing theory, any time you can diversify away a risk, that risk is uncompensated, meaning you will not, on average, receive additional return for running that risk. By its very nature, investing in individual stocks, which are easily diversified by purchasing a very low cost index fund, is uncompensated. The data is very clear that thousands of professional mutual fund managers can't beat the index funds despite their best efforts. What makes you think you're so special? If you're really that smart, why are you practicing medicine for chump change instead of running your own mutual fund or hedge fund? Going to medical school does not give you enough of a leg-up that you're going to beat the pros at picking biotech stocks, much less beating a passive fund.
2) Competing with Experts
But I'm a doctor! Surely I know more about biotech companies than the analysts some mutual fund has hired. Guess what? Those mutual funds can hire doctors, and MBAs, and CFAs and MD/MBA/CFAs. These guys spend all day, every day analyzing these health care companies. Every time you buy and sell, guess who the guy on the other end of the trade is? It's not Joe the Plumber.
3) The Value of Your Time
Dr. Fishman has listed out an 11 step process to aid you in knowing when to buy and sell biotech stocks. How much time do you suppose those 11 steps will eat up? All of a sudden I have to read all kinds of financial news and follow a bunch of people on Twitter? I have to learn how to analyze earnings statements? I have to read shelf findings? I have to know what an AdComm is? I have to spend time on the FDA website? To make matters worse, many of these companies are making products that aren't even used in my specialty. That means more research for me. So, let's be conservative and say you're going to spend 5 hours a week doing this stuff. That's 260 hours a year. Let's say your time is worth, pre-tax, $200 an hour. That's $52,000 per year if you spent that time at work instead of researching biotech companies. Now, I have no idea how large Dr. Fishman's portfolio is as a fellow, but I suspect it is not very many multiples of $52,000. But even with my presumably larger portfolio, I would need to be able to beat the market by about 10% a year in order to be worth spending 260 hours on it, and that's assuming my entire equity allocation is invested in these individual stocks. Call me skeptical, but I don't see that happening. If I could do that, I'd be running a hedge fund. Far better for me to be contributing an extra $52K into my portfolio each year than spending 260 hours a year on Twitter and the FDA website.
4) Vanguard Health Care Fund
If I really thought biotech and other healthcare stocks were a smart sector to overweight, there are far better ways to do that than trying to purchase individual stocks. Vanguard's health care fund has an excellent long-term record, almost 18% per year since 1984, all for just 30 basis points. There are dozens of other passively managed ETFs as well. Otherwise, I'll content myself with knowing that I already own every single stock Dr. Fishman has bought in the last 10 years.
5) Invest, Don't Trade
Dr. Fishman also suggests that you “trade” these stocks. In case the meaning of that is unclear to you, he is saying you should not necessarily hold them very long. You buy them before they go up, and sell them before they go down. The problem with this strategy is that it is extremely difficult to predict the future accurately enough to overcome the costs of the strategy. Every time you buy and sell there are bid/ask spreads, commissions, and tax consequences. If you've held it less than a year, you pay your full marginal tax rate on your gains. I don't know about you, but my crystal ball always seems to be cloudy. Predicting the future always seems so hard to me, even when things seem obvious in retrospect.
The other issue I see traders run into all the time is they don't accurately track their returns and compare them to a reasonable benchmark. I say, “XIRR?” and they say, “Huh?” Or perhaps they don't include the commissions or the extra taxes. Or perhaps they're comparing their returns to the S&P 500 while investing in stocks that aren't in the S&P 500. At any rate, Dr. Fishman didn't reveal his returns to us, and even if he did we don't have an independent audit of them and so would probably be skeptical anyway. But none of that really matters. What matters to you is YOUR returns, not those of Dr. Fishman. So if you're going to trade individual stocks, track your returns meticulously, include all expenses including taxes, subtract out an appropriate value for your time, and compare them to an appropriate benchmark. If you're like most who do this, you will quickly disabuse yourself of the notion that you are any good at picking stocks. While you're at it, write down all your other predictions about the future- currency changes, interest rate changes, which way the indices are going etc. You'll likely be surprised how cloudy your crystal ball is.
Busy physicians don't need to pick individual stocks, much less options, in order to successfully reach their financial goals. Coupling an adequate savings rate with a reasonable, low-cost indexing strategy has worked for thousands of physicians and it will work for you. If you wish to engage in stock-picking as a hobby, limit yourself to a small slice of your portfolio and meticulously track your returns.
Rebuttal – Dr. Fishman
Michael Fishman, MD, MBA
I use the above strategy as a component of a balanced stock portfolio. I have mutual fund positions in my retirement accounts, but did not disclose them as I tend to think of my active and passive portfolios as distinct entities. The investing strategy I use in my trading account is to generate gains using the aforementioned trading strategy, which are then used to purchase dividend-paying stocks, REITs, and ETFs.
I enjoy the process of being informed on emerging companies, technologies, and drugs. I tend to select companies in areas within my specialty, but also enjoy learning about others. Investing and learning and research are fun. The savvy physician investor can use my strategy to identify opportunities where the traders have taken their profits and left a company with an approved drug in an oversold state. Value investing beats the market consistently over time.
Is this riskier than passive strategies? Yes. Have I consistently matched or beaten the S&P for the past several years? Yes. Have I considered leaving clinical medicine to pursue this full-time? Yes, but I enjoy medicine (at least for now).
Rebuttal – White Coat Investor
I've said many times it doesn't matter all that much what you do with a tiny portion of your portfolio. If you enjoy picking stocks, and it is a relatively small portion of your portfolio, then have at it. But I find it interesting that someone who enjoys investing, spends a great deal of time doing it, and apparently can beat the market with his stock picks still invests his serious money in mutual funds. There are two lessons to take from that. First, that informed investors invest their serious money in mutual funds. Second, that even an investor who has (reportedly) beaten the market is humble enough to realize there is a reasonable probability that he beat it by luck rather than skill and smart enough not to bet the farm on that skill. Chances are that readers neither have an MBA nor are willing to spend countless hours researching biotechnology stocks rather than spending time with their kids, mountain biking, or seeing patients.
Dr. Fishman makes a couple of other points in his rebuttal that should be addressed. The first is that value investing beats the market. That is true, as evidenced by Fama and French. However, picking value stocks doesn't beat a passive value investing strategy for most investors, most of the time.
Second, Dr. Fishman compares his returns to the S&P 500, an inappropriate index for someone picking biotech stocks. He should be comparing his returns to a biotech index, such as the Nasdaq Biotechnology Index. This index sat at 791 5 years ago. As I write this (and that is a few months before the post runs) it is at 3583. That represents an annualized return of over 35% per year, not including dividends, whereas the S&P 500 had a 5 year annualized return of just 16%. If Dr. Fishman's annualized after-expense returns are between 16% and 35%, he has made the classic error of mistaking a bull market for brilliance, while actually underperforming the market he is investing in. A 2010 investment in the ETF IBB, which invests in that Nasdaq index, has quadrupled in value over the last 5 years.
Hopefully, Dr. Fishman has a profitable hobby, but even if his stock picking is underperforming an appropriate index, that's okay too as long as he's enjoying it. Readers know that not only do I invest in some weird stuff, but I waste lots of money on hobbies I enjoy too.
What do you think readers? Do you think physicians have an edge over the pros (or even average stock pickers) when it comes to biotech stocks? Why or why not? Comment below!
THANK YOU, for this awesome post! It makes me feel so much better about my indexing. I have it bookmarked and will refer to it every time some trading strategy starts to tempt me.
We set aside 10% of our portfolio for individual stocks. My husband is good or lucky at picking them. I am neither but am willing to sell quickly if he is wrong and sell out our initial position as we make profits. He has done well with biotech but by investing not trading. I think it’s a big waste of time but not worth arguing over.
I think the average physician has no edge on picking biotech stocks. I do believe a very select few people in the world are able to understand an industry better than others. If you add into it the ability to evaluate the value of the company today, and then be able to predict its value once the product is developed and FDA approved for retail. Those very few people may be able to outperform the index.
Warren Buffets and Benjamin Graham existed and people like them will continue to exist. Could Dr. Fishman be one of them? The only way to know is to do an XIRR calculation and see how he does over many years. Maybe a decade is enough to know for sure. After all, even a monkey can look like an investing genius in a bull market.
Dr. Fishman, I highly recommend you perform an XIRR function and compare yourself to the biotech index. Don’t do it for us. Do it for your own knowledge that indeed you are outperforming the market and decide for yourself if you should continue. I hope you fair well in your investing future. The world can use some more Warren Buffett.
If your investment has the following characteristic:
http://2.bp.blogspot.com/-n8iYmrARxyA/TntJjUSHR8I/AAAAAAAAAGw/W05Q7OpQzWE/s400/Taleb%2B-%2Bantifragile.png
you don’t have to be good at ‘picking’ stocks. Biotech has the potential for this type of returns (that is, a limited downside, and unlimited upside). For example, companies that are working on potential breakthrough drugs might be a good candidate.
I’m 100% behind the indexing strategy, but if you do have some ‘gambling’ money you want to play with, and you have some time, go find several cheap biotech start-up R/D stocks and try your luck. Chances are, a single one of them will more than offset any of your losses in the other ones, and you can build up your positions over time. Just don’t spread yourself too thin – when it comes to making profits from this strategy, you want to really narrow your field down, and only include new stocks if they have something extraordinary to offer. Too much diversification here is not a good idea (yes, I’ve said it).
As long as you understand that the strategy is not to bag capital gains once in a while, but to wait until the ‘black swan’ drug discovery (or FDA approval), which can be decades. Keep 90% of your money in index strategies, and you’ll be just fine.
AWESOME POST. Should do one of these a week. My good friend from highschool who is now a PhD and biotech researcher who contracts with multiple companies suggested almost this EXACT same investment strategy to me a year ago with the same resources (Bio Pharm Catalyst), Seeking Alpha, twitter accounts, and FDA calendar and postings. He ran me through an example of his method with a company CYTR. At the time I felt like he had cracked some kind of code to getting rich quick with his 18% returns through 2011. So I tried it for a month with 5% of my portfolio and quickly realized I hated it. Does anyone know how boring it is to look up these companies and read AdComm pubs, especially if you aren’t in the field? It’s a chore. I don’t like chores when it comes to investing. Also WCI’s final paragraph really hits home that while 18% looks really nice, compared to a biotech index during the same period my friend was seriously underperforming, while putting in all that extra time.
The phrase is “without further ado”, for the record. I admit reading this and thinking that this sounded like a plausible strategy, but WCI’s rebuttal of citing the correct comparison index blows that out of the water.
There’s also the point about trading: WCI notes that there are “tax consequences.” In particular, there’s the huge consequence of converting paper gains to short term capital gains. Just to belabor that point, STCG are taxed at normal marginal rates, not the lower LTCG rates. Even if he beat the health care index, this tax disadvantage would be formidable indeed to overcome.
Good for you for trying. Keep it a hobby. Keep retirement assets indexed. I fully agree with WCI, nailed it with all his counter arguments. I have a buddy that manages a $6 billion dollar portfolio. A few months ago we were talking about a pharm company that is very specialized in my fellowship trained specialty. My friend also follows the same company for his portfolio. I use the medications thousands of times a year and am very aware of the research, competition, risks/benefits, etc of the medications in this market. We started talking about the company and it became very apparent, very quickly that he knows much more about this company, its pipeline, revenue projections, early stage research, etc than I do. If Harvard MBAs spending 80 hours/week can’t beat the market then how can I expect to beat the market spending a few hours a week even with my medical background?
PS, if you can consistently beat the market, quit medicine and invest full time. You will become a billionaire very quickly.
Physicians do not have edge picking individual stocks biotech or otherwise. Individual stocks are a losers game.
Invest in low cost mutual funds which track whatever index you are interested in. This course will beat the actively managed “pros” 95% of the time over the long term.
To say you dont have an edge over an average investor is exceedingly untrue. I get that everyone believes in indexing and overall there are very very good reasons for this. However, you’re a doctor, you at least have a basic understanding of how drugs are approved and physiology. The average investor that isnt reads a press release as if its scientifically accurate and not marketing. You would be shocked to see the number of also rans, long shots, and makes no sense kind of drugs that people “believe” in.
If you combine that with basic stock picking rules like valuation, and having a real product it is not that hard. Was it difficult to see that Gilead was going to explode to the upside, or that with Abbvie’s recent bad press there will be a flight to them? Or for example, a company Im about to start watching Portola (ptla) supposedly has an antidote for current anticoagulant medications, this will be huge if it works. I have yet to look into them in a full due diligence and read the studies and such, but that kind of thing should be obvious.
Not at all. Now, no one has to pick stocks, and in the crazy binary world of drugs/biotech, this is an excellent argument for indexing as there are lots things to potentially pay attention to, etc…and you get the gains without the work. However, of course as a doctor you should be better than the average non doctor at discerning biotech. Medicine in general has excellent macro tailwinds demographically and politically, investing somehow in this space long term be it index or whatever is a smart move.
Be sure to track your returns and compare to something like Vanguard’s Health Care sector fund. Maybe you’re talented, but the smart move is always to bet against the stock picker, because the vast majority can’t beat an index. Stay humble and be ready to throw in the towel if it turns out you aren’t one of the select few.
And my edge over the average investor is my income. Not only can I afford to take on more risk, but I don’t need to in order to reach my goals.
My edge isn’t my investing skill. It’s that I don’t need to have investing skill to reach my goals.
Im not advising picking stocks in this area to anyone, just the notion a doctor does not have more knowledge in the area and isnt less prone to being fooled by marketing and sell side than the retail investors. For example, go read Daniel Wards title cautioning exuberance on Anavex and their Alzheimers drug. (http://seekingalpha.com/article/3582716-anavex-life-sciences-unbridled-exuberance-requires-a-reality-check-for-investors-in-this-biotech) Its pretty insane in there, I’d go immediately to comments and bring popcorn. A doctor should not be so easily fooled as that crowd…though who knows. I think its far easier to spot drugs/companies that are unlikely to deliver than those that will and outperform, however, unless you’re basically crazy and willing to short something there are no benefits to that.
We know a fields basic potential/need and in general the likelihood of some amazing breakthrough drugs ability (seems there is no shortage of people who believe x company is about to solve Alzheimers or spinal cord injury with a market cap of 5 million and a CPA running the R/D department, its scary) to actually succeed despite the hopes of the company. That was really all, the assumption that everyone is smarter than us is not always true, having this background does give you inside information and knowledge on doctor habits (likelihood to change rx behavior, motivators, etc..). Many hopeful investors believe doctors will prescribe the new uber expensive drug over the similarly efficacious yet cheaper just because. It doesnt guarantee investing success of course, but its good to know your advantages.
While I did single out a couple companies, maybe I did not make it clear that I think while biotech is a solid sector and should be invested in specifically, I think its about as perfect an argument for indexing as it gets. I prefer IBB/VHT over XBI, and there are others that are all decent, but I like IBB since they are weighted more heavily to mature, stronger companies with lots of approved drugs and deep pipelines whereas other are smaller, etc…Theres just so many moving parts in pharma/biotech and so many uncontrollable, unknowable details that it would be easy to do all the due diligence in the world and still be caught with your pants down often. So, yes to biotech, and yes to exposure by indexing over stock picking. The science, societal choices (choosing to spend on healthcare) , and demographics are tailwinds. Just because you see/recognize potential value doesnt mean you have to jump into single stocks.
100% agree with our edge, and this is something that isnt discussed often enough. Being more interested in investing/finance, I read a lot of these kinds of sites and see lots of comments that are basically accepted crowd wisdom that are likely more detrimental than helpful. One of the worst is the idea that if you’re younger you can be more risky since “you have longer to make up for it”…but that idea needs to be inverted and really they have lost an even larger sum due to the length of time they have to compound. It can also lead to poor behavior, chasing, a reactionary move into far less beneficial strategies or even opting out all together. Few people approach it from the aspect that is their greatest advantage, time. While I think the allocation should be more “risky” as few fixed income % say in your 20s, they should be aggressively allocated but avoid being risky since their true and giant advantage is such a long compounding period. Ours is different and lies in the principal we can expose every year. These are important aspects that arent discussed often enough, but thats probably due to the more specific targeted audience nature of that kind of thinking.
Sorry about the length. Just felt like everyone immediately went to negativity on stock picking (appropriate) and dismissed biotech in favoring of indexing (meaning major indexes) and totally glossed over the fact that there is a biotech index and that it may be something to look into and see if its something your personality can take. Since I somehow missed this post, I figured you’d be the only one reading anyway.
The question isn’t whether or not to invest in it. I invest in it. The question is whether or not to overweight it. Very different question and requires a crystal ball to answer. But if you want to put a 5 or 10% slice of your portfolio into a specific health care sector fund or ETF, I think that’s a reasonable thing to do.
Fair enough. Thats very reasonable. There is great data on sectors that have over prior decades made an outsized contribution to the SP overall. They were pharma, energy, and vice (tobacco, defense), and there are those that arent so great like industrials/finance/tech. Probably any reasonable percentage of a sector fund is over weighting in combo with your other holdings, as you have to be mindful of redundancy (which you see a lot in etf mixings with different names, same holdings.
I dont think long term macro trends are very difficult to see in the very broad/general sense though, outside of healthcare they are more difficult to invest in directly. Demographics are moving toward older individuals who use more health care, will need long term care (maybe health care REITs, etc..), energy/political/technological trends have been eating into the energy sectors returns for a long time, and I think that will continue (albeit over decades, but I dont think traditional energy will perform as well over the next 50 years as the previous). Now, I havent figured out how to specifically do anything about the latter yet besides avoiding them long term, but I am paying attention to it.
I do over weight health care, since the science is there, and the ACA basically guarantees this sector will have a baseline of business (but most big gains were made last 5 years in insurance). I think tech is probably another good sector in theory, but the nature of it is so volatile and there really isnt a mature/stable index like VHT in that regard at this time.
So i guess that means I am in favor of tilting/overweighting using healthcare/biotech indexes to give a reasonably safer boost to say just a total market index and avoiding thinks that arent like commodities. I think there are good opportunities to do so, but I am not saying its for most people.
The question isn’t what the long-term trends are (although it can be argued that requires a crystal ball), but whether or not those trends are already priced in. That’s the difficult thing about predicting the future.
WCI – how do you determine expected return for the purposes of deciding whether a risk is compensated or not? I’m not asking for a scientific answer here – but I just want to know from you own perspective how do you do this analysis?
If you can diversify against the risk, then it isn’t compensated, even if the expected return is the same for a diversified and an undiversified investment.
There are lots of ways to calculate expected returns for an asset class. None of them are particularly reliable.
any chance you can have a leave a reply button above the comments as well- so we dont have to scroll as the comments get larger.
I’m reading the ‘intelligent’ investor’ and everything in that book is contradicted by the guest.
I would strongly suggest the guest to read intelligent investor before he recommend this strategy to anyone else.
On a personal level, making money is not something fun for me. I dont enjoy sitting in front of a compute or reading papers to do research to make an extra buck. I think I may as well play the lottery.
Graham does suggest that no more than 10% of your investment be put into ‘gambling’ stocks. I agree with this- I suspect many of us, including said guest have that inherent thrill in investing. I think that thrill is an itch to be scratched. And many of us, as we push ourselves not to gamble will or may eventually give into it- or at least take more risk than healthy (as we see other more ‘succesful’ investors pass us by quickly and we feel left behind – even though in reality in the long term we will do as good or better)…
When I start to build my portfolio my goal is to save aside 10% and either chose to gamble in stock or splurge on a gift to myself. That way I can enjoy the benefits of my savings without the agony of wishing I invested in something I shouldnt and paying for it.
I would strongly urge everyone to consider this- as it takes the edge of our investment behavior.
For me, what keeps me most careful is the image burned in my head of preceptors repeatedly checking their funds every morning as they reach retirement age because they are worried about their cash flow. I will do my best to avoid that.
The reply can be put at the top or the bottom. It’s a nice problem to have-dozens of comments on each post. The forum incorporated into the new site design should be a little more useable for these sorts of issues, but I’m still not sure the reply button will be above the comments. At least if it is below you have to pretend you read some of them before replying.
I liked the post and I kind of do the same thing as the author. The vast majority of my net worth is in boring investments, but about 15% or so is invested in individual stocks. I have my own approach (not limited to one industry) and it requires a ton of research, but I actually enjoy it quite a bit.
My returns have been fantastic, but most of this happened during the bull market of the last 5+ years, so I’m sure there is a huge luck component here. But at the end of the day, I enjoy it, it’s not going to break me, and it’s profitable (thus far), so I’ll keep doing it. I just see it as a hobby that happens to make money and I think both the author and WCI would have no problem with that.
I will say one problem with this hobby is you have to be disciplined. There are several times that I feel like if I had just invested more in X instead of just shoving money into my index funds, I could have made a killing. So far I’ve stayed the course and kept my dabbling in these types of investments to a minimum. But I can totally imagine someone doing something like this, getting lucky for a few years, then trying to invest more in it, and ultimately losing a ton when something unexpected happens. So if you’re going to do this, just stick to the plan and don’t let success get to your head.
There is one argument WCI makes that bugs me because it’s mostly, but not completely correct. The issue is whole idea if you can beat the market on some small scale, then you should definitely go run a hedge fund or something and beat the market on a massive scale. Unfortunately, this doesn’t logically follow. It is entirely possible for someone to have a strategy that works on a small scale but when that strategy is applied to hedge fund sized portfolios it will fail. But when WCI says stuff like “If you’re really that smart, why are you practicing medicine for chump change instead of running your own mutual fund or hedge fund” it makes it seem like he is unaware of this.
The main reason why successful strategies are not always scalable is that when you manage a very large portfolio like a hedge or mutual fund, your trades will be large enough that they can have a significant impact on the market for a particular security. This is something that a small time investor who is investing only tens or hundreds of thousands of dollars generally doesn’t have to worry about.
Even Buffet is aware of this. I don’t have the citation handy but I believe even he said something like if he had only a million dollar portfolio he claimed he could easily make something like a 50% return, but with the amount of capital that he has to invest, such returns are impossible.
You can manage a great deal of money, far more than any individual physician will ever acquire, without your trades affecting the market. At any rate, the argument still holds. If your stock picking skill is such that you can beat the market reliably by any significant sum, your time would be much better served picking stocks for you, your family, and your friends than practicing medicine.
That’s a little different than “go run a mutual fund”, which is why I said your statement was mostly, but not completely correct.
Furthermore, the investments affecting the market is just one reason why a particular strategy may not be scalable. But further discussion of other reasons is really going way off on a tangent that isn’t particularly useful, since we are more or less in agreement on the general principle.
The trades of a small mutual fund don’t move the market much either.
What other reasons do you feel keep a strategy from being scalable?
The amount that the size of a particular trade matters will depend quite a bit on the particular strategy being discussed. For example, if someone had a profitable strategy involving OTC stocks, it may not scale up very much at all.
Here’s some other reasons why a particular strategy may not be scalable
1. Taxes – It possible that one could come up with a strategy that just barely beats the market, but wouldn’t after taxes (perhaps something that involves short term trades). Such a strategy could be implemented in a retirement account for example, but attempting to scale it up to something larger that would almost certainly expose it to taxes and thus failure.
2. If you come up with a very successful strategy and you run a traditional mutual fund, once it’s clear that you’re a winner, others will look at what you’ve done and attempt to reproduce it (and you’ll have to disclose too much to keep your strategy a secret). If suddenly everyone is doing it, then it’s very likely that your strategy will cease to be viable.
But like I said, you’re mostly right.
Do you really believe there are profitable strategies involving OTC stocks? 🙂
I suspect many of the strategies used by actively managed mutual funds fall into that category. They can beat the market, just not after expenses (including taxes.) But the overall record is very clear.
It’s a tough business beating a market, especially when it is so easy and cheap to match it.
I have an acquaintance who claims that he has such a strategy (involving OTC stocks). I really don’t know the details, so I suppose he could be lying/embellishing.
My true belief that such a strategy is possible but probably very difficult to discover and execute. And almost certainly not something that anyone on here should pursue.
In my experience, most stock pickers don’t even know how to calculate their return. Those who do often fail to compare their returns to a relevant index. And of course there is also the cocktail party phenomenon of only remembering the winners. Plus, there is the whole “lucky vs good” consideration.
At any rate, I agree with you that most investors should stay away from the OTC stock market.
Well, I’m quite certain this particular individual knows how to calculate his return, but that’s beside the point.
While we’re largely in agreement, remember the OTC stocks were just an example. The larger point is that there are markets out there (OTCs are just one, I’m sure certain derivative markets also apply) where the market is very small. Such markets may actually lend themselves to profitable strategies precisely because they are small and hence do not have armies of analysts covering them on a full-time basis. Of course in these small markets, large trades (even of the variety that a small fund would make) can move the market enough to kill the strategy.
I’ll grant that such markets and the associated opportunities for profitable strategies are uncommon, but I’m sure they exist. I’m also fairly sure (as are you) that no one around here should be pursuing these strategies and that just about everyone reading your blog would be much better served by following a more conventional, bogleheadish approach.
My friends who do invest individually in biotech do tend to report impressive returns, and I do suspect that there is a survivorship/cocktail bias in the matter. The truth is that despite these successes, none of us actually have enough invested in these equities to quit our day jobs.
No matter how much I’d enjoy reading white papers/prospectuses and applying my medical knowledge to pick a great biotech company, I’d rather spend my time hanging out in the back yard, hiking, and being with the family.
I should say that among all books to read about finance and stocks should be Thinking, fast and slow by Kanheman
He won the nobel prize for behavioral economics and showed over and over that vast majority of people in the financial sector were just wrong about their abilities and their picks. It doesnt matter what sector, biotech, finance, medicine bla bla.
The stock market individually is a money loser.
Also, based on your quote you misinterpreted buffet. his percentage return will invariably be small with large investments because of the amount of money needed to match such gains- 50% increase is manageable with small amounts, but to scale up as you said you cant have similar gains because to match that percentage you need so much more money in profit. Its simply a form of law of large numbers.
Its why corporations start to slow down in profits over time – their returns simply diminish as they get bigger and bigger since the amount of profit declines as a percentage of the company’s overall net worth. 1 billion is a lot for a 500 million dollar company but nothing compared to a 20 billion dollar company.
its the same here.
I assure you my interpretation of the quote is correct. All he is saying (and all I am saying) is that you can’t just simply scale up.
As far as reasons why, in his case a major reason is his investments are so large they will move the price. Another reason is that there are not enough of what he considers suitable opportunities for the massive amount of capital he has. There are others as well. Possibly the one you are trying to articulate is one, but to be honest I’m not exactly sure what it is. But it doesn’t matter.
The basic point is that there are many investment strategies that are not scalable.