Next big investing idea

So you missed gold hitting $1,500 per ounce, Apple shares topping $350 each and never got around to shorting Greek bonds last summer. You probably didn't get rich from the housing bubble either.

So you missed gold hitting $1,500 per ounce, Apple shares topping $350 each and never got around to shorting Greek bonds last summer.

You probably didn’t get rich from the housing bubble either. At least, I don’t recall any Yukon News readers being mentioned in Michael Lewis’ book on how people made billions shorting mortgage-backed securities.

You may even have seen the post office strike as welcome relief from those sad letters you get from your RRSP manager, pointing out the $1,000 you invested in the Canadian stock market five years ago is currently worth a whopping $1,116.

So what to do now?

You’re not the only one casting around for the next big investing idea.

The big problem with big investing ideas is by the time most people have heard of them, the opportunity is gone. This is a trap a lot of retail investors fall into. They end up buying at the top of the cycle, enriching the well-informed and lucky who went before them.

Just ask the people who didn’t get around to buying Blackberry-maker Research in Motion (RIM) stock until it hit $145. It’s now trading around $30.

Some people like to say just because a stock is overvalued doesn’t mean it isn’t a smart investment. They believe in something called the “Greater Fool” theory.

It assumes while you may be doing something foolish, you’ll be saved by those who have even worse judgment than you do. Lots of people thought RIM was overvalued at $100 back in September 2007, but you could have made a lot of money buying it and then selling it for $120 just a few months later.

When looking for gobsmackingly big investment returns, some people do the stock market equivalent of ambulance chasing. They look for assets where the market has overreacted to bad news. Like buying uranium shares, many of which are down 30-50 per cent since the nuclear disaster in Japan.

Buying British Petroleum after the oil spill when it was down to $27 from $60 took guts, but produced a handsome return.

The company has lots of attractive oil-spewing assets outside the Gulf of Mexico and its shares bounced back to the mid-forties by late 2010. That’s a return of more than 50 per cent in six months.

Of course, that assumes that BP is a fundamentally profitable company. Buying Sino-Forest, which is at the centre of the latest Toronto Stock Exchange scandal, wouldn’t necessarily meet this test since there are (shall we say) certain differences of opinion in the market over whether the bulk of the company’s assets exist or not.

The reverse of this strategy is to look for where the market has overreacted to good news. The much-anticipated IPOs of the big social network companies, such as Facebook and Groupon, may fall into this category. Look for a trend that so many people are convinced is The Next Big Thing and short it aggressively.

The problem with this strategy is that it costs money to short a stock. And you can lose big bucks if the stock keeps going up, however irrationally. As a famous economist once said, the market can stay irrational longer than you can afford to stay short.

Another strategy is the so-called asymmetric bet. You look for an event that is extreme, but unlikely, and buy insurance against it. Since it’s so unlikely, the insurance will be cheap. And if the bad thing happens, you make out like a bandit.

This is what some of the housing bubble millionaires did. As Lewis recounts, some of them phoned up banks to buy insurance (credit default swaps or CDS in the lingo) on mortgage-backed securities. Everyone was so confident in these time bombs that bankers laughed, but sold the CDSs anyway.

A few months later the banks were frantically trying to buy back the contracts.

In Lewis’ original book, Liar’s Poker, he recounts a more alarming version of the strategy. This is where a Wall Street summer student is flying somewhere for a weekend, and a trader gives him a few bucks and tells him to buy travel insurance. But to make the trader the beneficiary.

The trader was making a simple asymmetric bet. He was investing less than $20 in the hope that his summer student would die in a fiery plane crash and the trader would get a big payout.

Nice place, Wall Street.

Anyway, some investors are now scouring China for these kinds of opportunities. Some are beginning to short the Yuan. Of course, everyone expects the Yuan to rise. China’s economy is booming, the Yuan is undervalued by many typical measures and its government is under pressure from the US and European Union to let the Yuan move higher to address China’s huge trade imbalance.

According to the Wall Street Journal, you can call your favourite banker and purchase a put contract with the option to sell $10 million worth of Yuan at 20 per cent below today’s price for just $15,000. If the Yuan goes up or just falls a bit, your contract is worthless. If it falls a lot, say 30 per cent, your original $15,000 investment turns into $850,000.

Picture yourself boasting about that to the gang at work.

This is the real message. You are only likely to hear from the small number of people who get lucky with these strategies. The larger number who end up losing money are much less likely to tell you about it.

Remember that when someone else’s watercooler investing story makes you think it’s time to sell your boring old blue-chip bank or pipeline company stock.

Keith Halliday is a Yukon economist and author of the Aurore of the Yukon series of historical children’s adventure novels.

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