In today’s Money Morning…a heartbreak story with lessons for every investor…the right and wrong ways to speculate in small-cap stocks…it’s cheaper to learn from other’s mistakes than repeat them yourself…and more…
This might seem like a very stock-specific story for Money Morning today. But bear with me, because it contains some very important lessons every investor should heed.
Hopefully you are doing most of these already. But if not, this piece could save you a bundle…
For those of you that don’t know, ResApp Health [ASX:RAP] closed 78% down yesterday, after coming out of a trading halt.
Today I want to use this as a test case for investing in speculative stocks.
First a bit of background…
ResApp is a company developing software that can analyse the sound of a person’s cough to diagnose certain diseases, like pneumonia and bronchitis.
And the massive selling point is that it can use any smartphone to do it.
Just think about that.
An app that can be deployed across the world easily and cost effectively.
It’s an idea that is especially important for emerging economies. Or remote communities that don’t have access to health services nearby.
For example, some villagers in Africa have to travel hundreds of kilometres to even see a doctor for a diagnosis.
ResApp promised Australian investors the chance to be part of the growing revolution in mobile health. A potential $100 billion per annum industry.
As you can see, it was definitely an exciting story.
And you can understand why a lot of ordinary investors got behind it in a big way.
Things started off well…
Initially the share price rocketed from 2 cents to a peak of 55 cents in little over a year. For the past eight months it’s been trading in a range between 28 cents and 38 cents.
Yesterday it dropped to 6.8 cents.
Lesson one: take profits in small-caps to reduce risk
If you were fortunate enough to have bought shares in ResApp at any price south of 20 cents, you should have used the surge above 40 cents to take some profits.
This is not simply hindsight speaking.
There are many modifications on the taking profits rule. But the concept is all about reducing risk. There is so much uncertainty in a new business or technology that smart investors reduce risk when they can.
An easy rule to use is this. If the share price doubles, sell half of your position. That way, only profits are invested in the stock, and you can follow the story without too much emotional strain.
Now ResApp was in the medical field, which has even more uncertainty than usual. It had no revenue, and was valued at about $200 million.
Such a high valuation increases the downside risk.
The fall yesterday was on the back of poor test results.
Which brings us to the next lesson…
Lesson two: never buy on the news
Now this is a rule that is more often right than wrong. Though there is the odd exception.
It’s especially true for mining and biotech stocks.
Companies love to put out announcements like ‘approval provided’ or ‘high grade deposit found’. But often these are just part of a longer process of project validation.
Unless you understand the statements to a high degree, don’t get fooled by the language.
If you look through the past announcements for ResApp, you can see lots of impressive sounding announcements about medical approval.
I know some people who thought this was an approved product already.
But clearly those earlier stages weren’t as important as yesterday’s.
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Lesson three: don’t forget position sizing
Any shares are risky.
Pre-revenue small caps are especially risky.
But if you’re like me, you enjoy the idea of discovering companies that could grow fast. You are willing to take on this risk for the opportunity for a high reward.
There’s one caveat though…
Spread your speculative investments across at least 10 stocks. More if you have more capital to invest. Professionals call this position sizing.
This way you will reduce stock specific risk. Though, be aware that in any broad economic decline all small-caps, indeed the entire market, would go down together.
A friend of mine knows a guy at his office, a young bloke, who had $30,000 invested in ResApp. It was his only shareholding.
Today that stake is worth $6,000.
That’s a $24,000 lesson in position sizing.
Lesson four: never bet the farm
This one speaks for itself. Investing is not a game. It’s real money and it has real psychological effects on you.
I still think it is the greatest job or pastime in the world. To pit your wits against the market.
So for that reason, your prime motivation should be to always stay in it.
That means conserving capital. And always having a fall-back.
If you had an investment in ResApp, I hope the company recovers for you. I’ve been there myself in the past. Most long term investors and traders have.
The important thing is to learn from it.
If you weren’t invested in ResApp, you can learn from this story anyway. I always find it’s cheaper to learn from the experiences of others, than repeat them yourself. Though human nature means it rarely happens that way.
For some reason we all have to touch the hot stove first!
Editor, Money Morning
PS: If you’re interested in an intelligent, informed way to speculate in the market, my colleague Jason Stevenson can provide you with cutting edge research in the resources sector. His resource stock picks can move just as fast as ResApp, with the same potential for gains. But Jason’s experience with speculating in risky resource plays can help you get out with your profits, if it all falls over. You won’t find this kind of independent research anywhere else. Click here to find out more…