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One simple, overlooked way to improve your investing returns

One thing that new and even intermediate investors are at risk of is getting sucked into high-octane speculative stocks with ‘billion-dollar’ markets which can often end up being little more than a dream with heavy cash outflows.

We all recognise the companies – which might come and go – with names like Prima BioMed Limited (ASX: PRR)  or SPOOKFISH FPO (ASX: SFI) that have floated through the spotlight over the past few years.

Many investors, including myself, have lost money in these types of companies. Yet these four simple questions, which draw on probability and game theory, could potentially save you stacks of cash as well as improve your investing decisions. First ask yourself:

What is the likelihood of the eventual outcome occurring?

How likely is it that Cynata Therapeutics Ltd (ASX: CYP) will successfully develop its regenerative medicine therapy and go on to become a billion-dollar business?

I don’t know – and I mean that in the sense that the outcome is literally unknowable. First look at the company’s stated goal, then ask how likely it is to achieve it eventually. You must qualify your ‘eventually’ by using your investing timeframe. If you want to invest for 3-5 years, then you must ask how likely the company is to achieve the desired outcome in the next 3-5 years.

Next, you must work backwards and ask yourself:

What hurdles would the company need to leap along the way?

It’s easy to beat up on biotechs like Cynata here, as biotechs must successfully make it through Phases 1, 2, and 3 with their research (a quick Google search will show you how long this can take), then achieve regulatory approval, then start selling their treatment.

What pitfalls must it avoid?

Most of the more speculative companies that novice investors are vulnerable to are characterised by heavy cash expenditure and limited revenues. Let’s look at another, better established company – iCar Asia Ltd (ASX: ICQ).

iCar must hit certain milestones in terms of numbers of vehicle buyers and sellers using its website. It must then be able to convert these into revenue, and then it must be able to use them to generate enough revenue to cover its costs and start generating profits and cash flow – and it needs to do that three times over, in Thailand, Malaysia, and Indonesia.

While it’s doing that, it must avoid making poor investment decisions, being outdone by competitors, and spending too much or having to raise too much capital, or issue too many new shares. You can come up with as many risks as the day is long, but it’s best to stick to the biggest ones.

What is the likelihood of leaping those hurdles while avoiding the pitfalls?

Let’s look at an even more established company – Woolworths Limited (ASX: WOW). Although Woolies is out of favour with investors, what’s the chance it that it won’t be a multi-billion dollar supplier of groceries Australia-wide in the future? Actually, virtually nil. Woolworths must avoid making poor investments, being outdone by competitors, and continue to make money. In this sense, Woolies requires only half as many things to go right, compared to something like iCar Asia.

I’m not saying that any of the companies in this article are a good or bad investment per se. Nor will these questions identify great investment opportunities – but I bet it’ll help you dodge the bad ones.

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Motley Fool contributor Sean O'Neill owns shares of iCarAsia Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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