Always Invest In What You Understand
As an investor, it can be tempting to focus on the front-page headline. We saw this just a few weeks ago when oil futures collapsed. Suddenly, everyone wanted to invest in oil companies.
Of course, current events can present opportunities for the nimble investor. However, there are two massive disclaimers to keep in mind. Firstly, if it’s headline news, chances are the real opportunity has already passed.
Arbitrage is an important concept to understand in finance. Arbitrage occurs when a security is bought in one market and simultaneously sold in another market for a higher price. It takes advantage of inefficiencies in certain markets to create a risk-free profit for investors. Let’s say a stock is trading on both the Canadian and U.S. exchanges. Given currency fluctuations, the stock may at one point be available at a slightly cheaper price on one exchange. An investor could, therefore, buy it on one exchange, and sell it for a higher price on the other. When these opportunities do occur, the difference is typically minimal and only high-volume traders can benefit. For individual investors, it’s not a strategy that you should dedicate any significant energy to.
Information arbitrage is trickier still. Investing in Apple because you know they are releasing a new iPhone later this year isn’t a solid strategy. Everyone knows that Apple is releasing a new iPhone later this year. That’s already been priced into the stock. The only advantage you would have is if you knew something that others didn’t. For example, if a friend who worked at Apple had told you that there was some new feature that was bound to cause a spike in demand for iPhones. That’s information that you could use to have an advantage over other investors. However, trading on it would likely get you into serious trouble with the Feds. So… don’t do that.
The headline news is, therefore, not much good to investors looking to make a quick buck. That’s not to say we shouldn’t absorb the news. It can and should inform investing decisions. But there’s no rush.
The second big disclaimer is that you still need to know what you’re doing. The oil crisis may have presented some opportunities for those who know the industry well — it may have helped them formulate a broader investment strategy. However, the average investor doesn’t know much about the energy industry. They certainly don’t know much about commodity trading. They don’t know what “backwardation” means. Or what “contango” means. So, once again, there’s no advantage to be had.
Let’s apply this thinking to last week. The headline news is, of course, COVID-19. Gilead Sciences is a company that has been getting a lot of attention during the outbreak, as one of their drugs, remdesivir, has shown to have a positive impact on patients. This has led to a flood of inquiries on how people can invest in Gilead.
This poses very similar issues to the drop in oil prices last month.
Firstly, the information is already out there. It’s been digested by the thousands of well-trained analysts who cover the pharmaceutical industry. There’s no information arbitrage.
Secondly, pharmaceuticals are, like energy, highly specialized. To effectively invest in the industry, you should have some knowledge of how drugs are developed, of FDA regulation, and of patent law. And that’s just for starters.
Gilead is a multi-billion dollar company with hundreds of products on the market and many more in the pipeline. Investing in the business based on remdesivir alone would be akin to investing in Apple because of a hit new show on Apple TV. It could turn out that remdesivir turns into a major profit engine for the business over the next few years, but there are so many variables to consider. Far too many for the average investor with little knowledge of the industry.
As usual, my advice is to invest in what you understand and don’t waste your time looking for a quick buck. You’re not going to beat the experts at their own game.