LAKE GEORGE, N.Y. (TheStreet) -- The horses are back at Saratoga, and I've made my annual August trek up to the Adirondacks to spend time at my vacation house overlooking Lake George. It's the perfect place to enjoy some boating and take in the racing at the grand old thoroughbred race track in Saratoga.Last year, in " Five Investing Tips I Learned at the Track," I highlighted some lessons and strategies that are applicable to both investing and horse-betting:
There are people at the race track called bridge-jumpers who will bet huge sums of money on prohibitive favorites to show. Show bets will pay off if the horse runs in first (win), second (place) or third (show) positions. A typical bridge jumper bet will return $2.10 for every $2 wagered. Certainly a quick 5% return in short order sounds terrific. How often can you make 5% in two minutes? However, the downside risk is extreme. If the horse runs out of the money, then you lose the entire $2. That equates to an instantaneous 100% loss. For every loss, you have to hit a bridge-jumping bet 21 times to break even. Jim Cramer likes to look at investments in terms of upside vs. downside. When I seek out investments, I place a minimum of 20% expected return on an individual stock. Furthermore, I will stop myself out on a 20% decline just in case my investment thesis on an individual pick is incorrect. When you successfully pick more expected return winners than actual losers, your actual returns should outpace the market. 3. Diversify You know the old adage "Don't put all of your eggs in one basket"? In investing, we call that diversification. At the race track, we diversify by picking several horses that could win a single race or consecutive races and bet them in combinations and permutations, called "boxing," in exotic (or derivative) bets such as exactas (first two horses in order), trifectas (first three horses in order), daily doubles (winner of two consecutive races) or Pick 3 wagers (winner of three consecutive races).
As an individual investor, it is sometimes hard to pick the best stock in a sector. Let's say, for example, you want to play the biotech sector. Should you invest in Amgen ( AMGN)? Gilead ( GILD)? Genzyme ( GENZ)? Or you could put together a portfolio of representative stocks or even buy an exchange-traded fund such as the Biotech HLDRs ( BBH). Buying one stock in a sector, you take on stock-specific risk. Should you pick the wrong stock, in an index that is trading bullishly, then you will have guessed right as to the sector but will still lose money because of the individual stock pick. Nor do you want to buy stocks exclusively in one sector. If your thesis is wrong about the biotech sector, for example, then you could find yourself taking a beating. That is why investors diversify across sectors and asset classes. So the final lesson from the race track: diversify. Because, as with all investing strategies, applying lessons from the race track to your stock-picking endeavors requires discipline and risk management. If you plan on being at the Saratoga race track, drop me an email and perhaps you can bet alongside the professor. -- Written by Scott Rothbort in Lake George, N.Y.