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August 20, 2014

Solar, Internet, Biotech? Avoid lottery stocks

The upside potential from investing in exciting stocks in sectors like solar, internet or biotech is enormous. Investors often fall in love with these stocks because they see new technologies and revolutionary stories. These stocks offer high revenue growth potential, something that the staid blue-chips simply cannot deliver. Behind all the excitement clearly lies the hope that these stocks can make us very rich quickly.

However, the sad truth is that although some individual stocks may very well turn out to be home-runs, taken together as a group, they underperform the broad market badly. Speculating on some hot stocks clearly has some entertainment value, but it has nothing to do with long-term investing. Individual investors should stay away from trying to pick stocks in these sectors.

O’Shaughnessy Asset Management (OSAM) has done an interesting analysis on what they call „lottery stocks“. OSAM defines lottery stocks as the 10% of stocks with the highest prices relative to their sales, earnings, cash flows. In other words, these are the stocks for which the market has the highest expectations. Interestingly, nearly half of the stocks from that list come from only 3 sectors: Biotech, tech hardware and software.

The result is quite depressing though. An initial investment of $1 would have turned only into $2 after 50 years, i.e. it would have grown at 1.5% or below the rate of inflation. On the other hand, the more mundane broad equity index S&P 500 would have grown into $114 or approx 10% return p.a.

Lottery stocks chart 50 y

Summary: while it is certainly possible that some of these lottery stocks do phantastically well, it is not very probable. There will always be exciting stories of stocks like Tesla where investors have done well, but you should not be seduced by this. The historical record over the last 50 years is very clear: stay away from the lottery stocks! An investment into any of the riskier sectors of the market can make sense, but private investors should only do this via actively managed funds – however, they should not try to pick high-risk stocks themselves.

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