How to lose a lot of money in the market

Are all of your stock picks winners? Sick and tired of making money hand over fist? Then look no further because I’ve got a couple of ways you can reconnect with the rest of us mere mortals by learning to spot losing propositions. If losing money is not your goal, that’s even more of a reason to read on because even seasoned investors can find themselves being lured into these money traps.

Losing proposition #1: The one-trick pony company
Although I’ve railed against this type of investment before, it bears repeating because apparently many people are still being taken in by this type of risky scenario. A one-trick pony company is one that makes only one product or offers only one niche service. Small biotechs that will be relying on FDA approval to market their lone drug or medical device is the most dangerous example of this breed. While product approval could translate into a lucrative payday for investors, the consequences of denial could be dire. The company’s stock most certainly will plummet and the company itself could very well go out of business.

You think this doesn’t happen? It financially ruined two personal acquaintances and inflicted so much psychological trauma on one that he suffered a nervous breakdown. Both were heavily invested in one-trick pony biotechs that were relying on FDA approval. Obviously, neither company received it causing their respective stocks to be flushed down the toilet. (The companies were Xoma (XOMA) whose stock plummeted from $30 to around $1 in the early ’90s and the other was Northfield Labs (NFLD) which went out of business last year.)

The latest addition to this list of biotech losers is Xenoport (XNPT). Citing pancreatic cancer concerns, the FDA yesterday put the kibosh on the company’s restless-leg syndrome drug that the company was developing with GlaxoSmithKline (GSK). Xenoport stock immediately shed two-thirds of its value while pharmaceutical giant Glaxo lost a mere 1% on the news.

XNPT Chart 2-19-10

Losing proposition #2: Unsolicited takeover bids
On January 7th, medical and scientific equipment maker II-VI (IIVI) made an unsolicited offer of $10 per outstanding share of Zygo (ZIGO). Zygo stock rose over 30% on the news, closing the next day well over the $10 offering price on hopes of a bidding war.

What followed were several lawsuits but no other offers. Facing an uncertain future and angry shareholders, the company appointed a new CEO, Chris L. Koliopoulos, on January 19th and made him board chairman on February 12th. Several days later, the company’s board rejected II-VIs offer causing the stock to drop over 9%.

ZIGO Chart 2-19-10

Comparatively speaking, this loss wasn’t nearly as bad as it might have been as stocks typically drop back to pre-announcement prices or even lower following a merger rejection. Might shareholders still be hoping for a better offer? That’s something I certainly wouldn’t bet on!

You’re probably wondering why someone would even want to get mixed up in these types of situations in the first place. The answer is simple: If the drug gets approved or the unsolicited offer spurs higher bids, you stand to make a lot of money. If you’re playing with some mad money then by all means enjoy yourself, but if a potentially large loss will deprive you of a good night’s sleep, then it’s your fiduciary duty to yourself to put your funds into a more conservative investment strategy. ‘Nuff said.

2 Responses to “How to lose a lot of money in the market”

  1. Let’s carry the one-trick pony a step further….

    What if the investor owned 10 one-trick ponies—a ‘stable’ of stocks? In essence, what’s accomplished is creating one diversified company with 10 divisions. In this case, you have dedicated and focused managements committed to their specialized high-potential product areas—but diversified in areas of business to mitigate risk.

    For example, say someone has a $100,000 stock portfolio made up of normally about 10% in each holding. Well, I would argue that the owning ten 1% holdings, each in one-trick ponies, might be far better than owning just one stock of modest potential. In your example, would it be better to own 10 specialized tech nano-caps than 10% in Pfizer?

    However, your admonition on one-trick ponies is generally true because those clinging, ga-ga holders tend to concentrate their investments on just one big bet—sort of risk squared.

    I like one-trick ponies. One should expect that some will fall by the wayside, but some will earn staggering returns. One element necessary with a stable of one-trickers is an ability to hold stocks even after major gains have accrued. Having some rule like “taking out your cost” after a ___% return, helps you stay in. After all, sometimes a “pony” less than 58″ high at the withers tricks people and turns out to actually be a colt after all.

  2. admin says:

    Hi Miles,

    I did mention at the end of the article that these types of risky stocks are best played with funds you can afford to lose, as you noted. Play as many as you want. If you buy a bunch of small biotechs, you do not have a diversified portfolio–you just have a large portfolio of potential losers. While the risk is now spread among many companies, that doesn’t necessarily mean that it’s any lower than by buying just one.

    I can’t say whether it’s better to own the same dollar amount of a basket of risky bets rather than one blue chip such as Pfizer. Pfizer has lost stock value over the past 10 years but the loss has been somewhat mitigated by its dividend, something which speculative stocks don’t pay. (Also, if you had used a stop/loss you would have been out of Pfizer a long time ago.)

    Let’s say you’re playing this scenario with ten stocks in your junk basket and by some lucky chance one of your ponies actually does turn into a beautiful colt. In that case, its stock is going to have to appreciate 1000% just to make up for the other nine losses (assuming an equal $ amount).

    I have no idea what is the actual percentage of success for these types of speculative stocks (it would take a lot of research to find that out) and I’m not going to go on the record touting a basket of high-risk plays versus a low-risk one without knowing the actual numbers. My goal in writing this blog was to show how by wearing rose-colored glasses when looking at the market could be highly detrimental to one’s financial health.

    Thanks again, Miles, for the great comment!

    Dr. K

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