Risk and Reward Biotech Style
Posted by Doug Rice on Wed, Mar 03, 2010 @ 11:00 AM
Potentially large rewards come with significant risks.
There is no better example than developing new drugs.
Medivation, a biotech company. set an all time high on it's stock price on Tuesday of $40.49 due to it's new hopeful Alzheimer's treatment. But when results were announced today that it failed to be effective in a large scale study, Wednesday the stock plunged almost 70%.
In this example, you can clearly see how the market works in a classic case of buy on the rumor, sell on the news.
In anticipation of the success of the drug, the stock ran up to an all time high. The market buys on the rumor, or hope, that the drug will be successful.
As the release date of the trial study approaches, the market moves up in anticipation of good news. Then when the news is bad, especially this bad, the stock sells on the news.
It can, as it did here, fall off a cliff. (Biotech is especially susceptible to this as their trial results are typically binary, either they pass or they fail.)
But even if the trail had been successful, the stock may have sold off as the success of the trial may have already been priced in. Stocks fall on good news quite often because the market is anticipating it.
Of course in this case, we will never know how much it could have moved up if it was successful, if at all.The point is that there's no guarantee it would skyrocket further. It typically too late to buy after the news is released.
What can we learn from this?
At least two things.
1. Don't measure decisions by results. The investors in this company took a risk based on information on the potential of significant profits if the drug has been successful.
It's not useful to think of this as a bad decision because the risk didn't pay off. It's far more useful to measure the decision by how well they did their analysis. Did they consider all the information correctly and were the the probabilities actually in their favor?
If so, the decision was correct, regardless of the result.
Think of it this way. If they odds on the success of the drug were 100 to 1, but the payoff if was successful was 1,000,000 to 1, then the correct decision is to make the bet and buy the stock. But if the odds were reversed, then they made a bad decision.
It's all about the analysis of the probability of success because the outcome isn't certain.
So the goal is to analyze the potential for success correctly and choose those investments that put the odds in your favor. If you find you aren't doing well, it's because you aren't analyzing the chances of success correctly.
Focus on the risk and keep putting the odds in your favor.
2. The market is forward looking. Those that bought this stock did so in anticipation of a successful drug trial, not because it was already successful.
They were looking out the foggy windshield and saw what they thought was a pot of gold. But when the fog cleared, the gold turned out to be a mirage and they drove off a cliff.
However, if they didn't didn't drive toward the pot of goal in the first place, they never would have had the opportunity to profit if it was real. Others would have beat them to it.
No risk, no reward, but take smart risks.