Here is a happy problem: You have a large instant gain from one of your stocks. What should you do?
The topic comes from an actual question raised at Scutify.com, where participants exchange ideas and get a wide range of opinions. (I get to play the role of the straight man in a world of day traders, revolutionaries, Bitcoin and gold zealots, and bubble callers. It is usually fun and there are some good ideas if you can sort through it all). The stock in question was trading about $4.00 yesterday and doubled in early trading because of a favorable ruling by an FDA Advisory Committee. Since I have nothing to add about the specific company, I am not going to name it. I want to use it as an illustration of how to think about risk and reward. (You can probably guess the stock, but please remember that my upside and downside targets are only illustrative).
For the purpose of this analysis let's assume that the position size is appropriate for the trader or investor in question.
The Standard Answer
Most people would advise something like taking your original money off the table and playing with the "house's money." This gambling metaphor has broad psychological appeal. How would you feel if the stock dropped back nearly to zero?
We know from the behavioral finance literature that people are much more sensitive to losses than to potential gains. The psychology of this situation is powerful.
You could also add that the technical analysts might well be flashing warnings like the following:
- The stock is trading far above its 200-day (or 50-day or 200-week or X-day) moving average.
- The stock has a gap opening and the gap "needs to be filled."
- Or the rally was mostly short-covering with a volume spike.
- And similar arguments.
The Fundamental Answer
A fundamental analysis starts with a fair value for the stock. In the case of a binary event – the drug is approved or it is not – the calculation is straightforward. Let's do it both before and after the Advisory Committee decision.
I am making up numbers here to illustrate a point. Each case requires good homework. Let us suppose that in the case of success the stock goes to 20. In the case of failure it will go to 50 cents. Next we need to estimate the odds of success. My newest investor program involves many companies with such issues, so I am doing a lot of work on the method. (Examples include companies facing litigation, restating earnings, turnarounds, potential takeovers, as well as new drugs. You would not want a big position in any single name, but a basket can work if you have edge in each case).
Before the Advisory Committee, we might put the odds at 25%. That gives us a "fair value" of 25% times 20 plus 75% times 50 cents, or a value of 5 + 0.375 or 5.38. This was the price of the stock in the weeks before the decision, but it was a premium on the day before. This is what you might expect.
After the Advisory Committee, let us put the odds of final approval at 90%. (Advisory Committees are usually respected). This gives us a value of 20 * .9 plus .5 * .1 = 18.05. The result, which might seem surprising, is that the investment is even more attractive at the higher price, after the decision, than it was before the announcement.
The existing investor should not sell, since edge has increased. A new investor should be happy to join in, even at the higher price. The edge is greater. The fact that the price is higher is irrelevant to the current decision.
I realize that this will seem counter-intuitive to most, but it is exactly what big pharma does in looking for candidates to buy – paying a higher price when the odds of success are greater.
A Caveat on Risk
Remember my earlier comment? Every investor should start by analyzing risk!
If you take on excessive risk, you will make emotional decisions. The insightful investor does a dispassionate analysis of risk and reward – every time, every trade, every day. Find a good system that fits your personal risk profile and stick to it.
Thoughtful readers might consider how to apply this in other settings. How about the overall market? 2013 saw the removal of lots of risk, starting with the fiscal cliff and proceeding through lower recession chances and better earnings. If you did not buy stocks in 2009 because risk was too high, and you have not increased your holdings since then because you missed the rally, you need to analyze your approach. There must be some combination of risk and reward that is attractive.
If you have not found an appropriate balance of risk and reward to buy stocks in the last five years you are not an investor. You are either a permabear or a pundit!