Risk, Reward, and Rocket Lab
Just because a company has a high chance of going to zero does not mean an investor is wrong to own it.
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We had a fun discussion for this week’s Wednesday episode with Simon Erickson, founder of 7investing.
Simon came on to discuss Rocket Lab, the second most successful commercial space company after SpaceX.
The company is unprofitable, burns cash, has a good amount of debt, and carries a literal “our product may blow up” risk.
Excited to buy shares?
Well, what if I told you the stock has 10x or more upside potential? As we go through the episode, Rocket Lab clearly has a lot of upside. There is just a wide skew, it also realistically can go to zero.
This is where the Kelly Criterion can come in, a calculator where you put in the odds of “winning” a bet (i.e. your thesis is correct) vs. the upside that will occur if it does happen.
For Rocket Lab, I believe a 10% chance of 10x upside is a reasonable assumption. Under these parameters, the Kelly Criterion says you should make it 1% of your portfolio.
This feels reasonable to me. If you can find 10 Rocket Lab-esque investments, you can then make them cumulatively 10% of your portfolio at cost. Some will win, and some will lose, but it won’t blow up your portfolio if a lot of them end up duds.
I wouldn’t fault anyone for owning Rocket Lab. But I would fault them for making it a huge position in their portfolio at cost. That is just asking for trouble.
Not a strategy for everyone, but don’t scoff at someone for buying a high-risk stock like Rocket Lab. It is how the Motley Fool likely outperformed you in the last 25 years.
-Brett
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