How the Scientific Method Can Make You a Better Investor

Most individual investors fail to beat the market because they let emotion and intuition take the wheel. But with a good framework for navigating their decisions, individuals can learn to identify and ignore their emotional biases to make calmer, more rational choices with their money.

On this week's Industry Focus: Healthcare, Kristine Harjes and Todd Campbell share how, for more science-minded investors, the scientific method can help take the emotion out of decisions. And, they illustrate how with two examples from this week's news -- Illumina's (ILMN 0.63%) 22% crash after they reduced their 2016 growth estimates, and UnitedHealth Group's (UNH 1.61%) decision to leave the Obamacare exchanges.

A full transcript follows the video.

This podcast was recorded on April 20, 2016. 

Kristine Harjes: Why thinking like a scientist can make you a better investor on this healthcare episode of Industry Focus.

It is April 19th, welcome to Healthcare Industry Focus! I'm your host, Kristine Harjes, and I've got Todd Campbell on the line. Todd, how's it going?

Todd Campbell: It's going very well. Glad to be here.

Harjes: Good, glad to have you as always. Gaby Lapera and John Maxfield did a show on Industry Focus last Monday, April 11th about writing and how learning to be a good writer helps you with your investing. We got a lot of really great feedback about that episode. It is a great one, so make sure to give it a listen if you haven't already.

I have to say I have always been more of a math nerd than an English nerd. I had this idea. Fortunately, Todd was onboard with me here. We want to make the argument for thinking like a scientist in your investing and how it can help you make better financial decisions.

We'll start out by talking a little bit about the overlap between science and investing. Then we'll do some more healthcare specific stuff. Sound like a plan, Todd?

Campbell: I think that's a great way to approach it. Listeners, don't get too nervous here. You're not going to need to be a scientist to be able to invest in healthcare. We're just going to walk you through some thoughts, things that we think that could help you in your process.

Harjes: Yeah, this is definitely more of a high-level episode as opposed to, "Well, if you're looking at this clinical trial data and you see a p-value that doesn't correlate with you ...." We're not going to bog you down with that, so, no worries.

Todd, when we were chatting earlier, you mentioned Adam Grant, who, I was really excited when I saw your note about him because I actually just read his book, Originals. He has a lot of really great thoughts about thinking like a scientist and how to best use a really empirical framework in making decisions. Did you want to talk a little bit on him?

Campbell: Yeah, he was just at Motley Fool HQ wasn't he?

Harjes: Yeah, he gave a really, really fascinating talk.

Campbell: Yeah, what struck me about him, or what reminded me was we were doing the work leading up to this episode. I was listening to the podcast that he had recorded when he was there. It was a fascinating discussion, because it talked a lot about how we come to make our decisions.

Harjes: Yeah, we get emotional, as humans, about a lot of things and we know, in investing, that time and time again individual investors often lose to the broader market because they let their emotions get tied up in their decision making. As Adam Grant points out, trusting your gut only really works when you're an expert working in your field of expertise. Outside of that, you're better off following more of a structured, methodical way of thinking.

Campbell: Right, it's all about process. If you have a process that's repeatable, something that you can put into place and continually refer back to and then use time and time again, eventually maybe you'll get that experience level where you can rely on your gut, but yeah, investing with your gut, especially in healthcare where there's a lot of nuances, especially in biopharma, yeah, it's good to have a process that you can spell out and walk your way through.

Harjes: Right, so that process, of course, and we're talking about science, is the scientific method. It's just a very elementary concept. I think I probably learned it first in elementary school, but it is so robust and so useful that it's something I still use to this day in my investing and outside of that.

I'll just start walking us through what this scientific method is. There are some very clear steps to it. Then, maybe we can talk about how it relates, particularly, to investing.

First things first. When you're looking at the scientific method, you need to ask a question. If you are an observant person, which hopefully you are, you're going to be picking up new ideas all the time, learning things from the world around you and you're going to hear these ideas about new industries, and new companies. Maybe you see something in the news, or on a podcast and as an investor, you're asking, "Is this a good place for my money?" There's your question, "Do I want to invest in X?"

Campbell: Right, and you know the other thing to add to that, too, Kristine, is if you can be more specific when you're asking your question, even better.

Harjes: That's a great point.

Campbell: Asking the question, "Is Celgene likely to go higher?" Maybe you're not going to be able to narrow that down quite as easily as maybe if you could say, "Will Otezla, their autoimmune disease drug, see their sales grow over the course of the next 52 weeks?"

Harjes: Once you have that question in mind and I really like your commentary there that the more specific, the better, you need to do some research. You need to understand what are some of the competitors in this space, or what is the industry all about to begin with? You want to make sure that you have that solid understanding before you get to your next step, which is to construct a hypothesis. This is absolutely the essential point in the scientific method. If you remember one step out of this, remember to construct a hypothesis.

Campbell: It's like trying to figure out where you're going without a map.

Harjes: Exactly, yeah, and this actually really ties back into what Gaby and John were talking about on Monday, because you should write it down. You should have a solid thesis statement hypothesis and write it down and be able to carry it with you as you go through the rest of the scientific method.

Next step, in the official scientific method, is to test your hypothesis via an experiment. The way that I would think about that for us, for investors, is that people running these companies are running experiments. You're running a business. You don't quite know what the outcome is going to be, but you're putting in all these variables and you're testing things.

Even though it's not you, the investor, necessarily conducting this experiment, it is still your job to keep an eye on the company leadership and what exactly they're doing so that you can hit ....

Campbell: There are other ways to, not as deep diving as that, but if you have a hypothesis, you think the stock may be going up because of a certain drug and the sales may be increasing, then track the sales of that drug. See whether or not they truly are increasing quarter after quarter, after quarter. Put the stock on a watch list if you haven't invested in it yet. See whether or not the stock is acting well, if it's trading up on greater volume, if people are embracing the story.

Harjes: Exactly. Yeah, that brings us right to the next step, which is to analyze this data. Say you can find data about new prescription volumes of this drug that you're interested in, and you want to correlate that to the stock price, you can do that. You can make a regression and try to draw a conclusion from it.

Once you have that conclusion, the very last step in the method is to communicate your results. We're so fortunate to be part of this Motley Fool community where there are other people that are really, really interested in talking about this kind of stuff. You can go to Motley Fool Caps. You can go to our boards. There's this whole community of people out there that want to review your work. They want to look at your hypothesis and your research and see if your analysis is correct.

Campbell: What's great about that too, is it provides ... You and I talked about this previously, but you have to be a little bit nervous when you're an investor about confirmation bias. You come up with a conclusion; you've determined what you think will happen. From then on out, you run the risk of excluding any kind of information that may call that into question and just simply reinforcing that same conclusion over and over again with what you read.

By opening yourself up to a broader community, you're challenging that. You're allowing people to be able to say, "No, I disagree with you. Maybe you didn't think of this."

Harjes: Yeah, I think that really gets at the most important part of thinking like a scientist in this entire thing, which is that when you're presented with new evidence, you need to be able to look at it critically. You got to take your emotions out of it, even if you have to admit that you were initially wrong in light of this new fact, or this new piece of information. That happens. You don't want to be overrun by this confirmation bias as you mentioned. You need to be able to take in new evidence and say, "Okay, is my hypothesis still correct?"

Campbell: That's one of the biggest, most difficult and most challenging things facing investors. It's very hard when you've invested your time, your effort, and your money into a certain idea to say, "You know what? I was wrong."

Harjes: It is extremely hard. Hopefully I help you guys see a little bit more how this works with some specific applications and particularly in the healthcare field, we're going to dive into a couple of examples.

First, I want to point our listeners to podcasts.fool.com where you can explore the entire suite of Motley Fool podcasts. Did you know that we have 5 different ones? In fact, Chris Hill's Market Foolery is having its 1,000th episode tomorrow, which is very, very exciting. It's going to be a great show. Definitely check that out and also check out podcasts.fool.com to see what other podcasts we have to offer.

As promised, we are going to take some of this framework of thinking like a scientist and apply it to healthcare stocks. Where should we begin?

Campbell: We have a few different topics there probably fresh on the minds of listeners here. We can start with Illumina if you like.

Harjes: Yeah, we talked about Illumina last week on the show.

Campbell: We sure did. We talked about the future of healthcare. We discussed how gene sequencing and the use of gene sequencing could revolutionize the innovation of personalized medicine.

Harjes: If you had listened to our podcast last week and bought shares of Illumina after, of course, doing your own research on top of ours, you might have had a pretty strong emotional reaction to the news on Monday night of Illumina releasing their preliminary financial results, which ended up causing the stock to shed over 20% of its value on Tuesday.

Campbell: It was a big drop. Basically, their sales in the first quarter are lighter than what industry watchers were hoping for. They thought that sales would continue to grow by a higher percentage than they're actually going to grow. As a result, people got very nervous and the knee jerk reaction was to press the sell button.

Harjes: When we were looking at Illumina, to go back to our scientific method, what is the hypothesis there? If you were an Illumina shareholder how would you have communicated the buy thesis?

Campbell: I think that the reason to own a company like Illumina and, spoiler alert, that reason hasn't changed just because of what we found out on Monday. I think that what we're trying to communicate here is, where is medicine heading?

Is medicine getting more and more specific to the genetic makeup of everyone that's suffering from disease, be it cancer, or be it some sort of a rare disease, an orphan disease? The use of gene sequencing is going to allow us to transition from these small molecule drugs that just treats a whole lot of stuff and hopefully treats what's ailing you too, to these very specialized medications.

Harjes: Illumina is, by far, the leader in this space. If that's your buy thesis, and you look at these results and you say, "Oh well, it looks like Europe was a little bit weak." which, by the way, even with your having a little bit of weakness, we're still seeing double digit growth projections for this company. It seems like that doesn't really modify the thesis.

Campbell: No, it doesn't. There's a few things that we have to do. You have to do your background. You look at it and you say, "Okay. They're saying that Europe was slower than the rest of the world." You've got Asia and the United States growing at mid-teens growth rates. You've got Europe growing at what they think is going to be low to mid-single digit growth rates. Growth, not a retrenchment, a growth still, but slower growth than the rest of the world.

Then you ask yourself, "Well, why is that? What are the things that could be going into the reasoning behind Europe growing more slowly than the other parts of the world?" Once you've asked that question, then you can start to seek out the answer if you will.

Harjes: I think if you dig in and one of the things that you find is that it was competitive threat-related, which, to me, it doesn't seem like that was, but I do think that in my own personal thesis on this company, I'm not a shareholder, but if I were, That's a huge element to the thesis. Is this company going to remain the dominant player?

Campbell: Surely, you've got a lot of companies out there who are trying to get involved in this space before, theoretically, it blows up and gets a lot bigger. You've got Thermo Fisher, which bought a company called Life Technologies a few years ago. They do a lot of work in the clinical space, in basically developing systems that can be used for targeted gene sequencing. You've got an upstart out of the UK called Oxford Nanopore. It's a brand new approach to gene sequencing. They actually market a handheld gene sequencing device and have plans for a much larger device that could theoretically compete some day with Illumina.

Yeah, there are competitors out there in the marketplace that we have to be aware of. If you look at the reasons and they didn't go into a lot of depth, but if you listen to the conference call and you listen to the reasons, one of the things that they said as far as why Europe is slowing is because of sharing of devices.

Maybe in Europe, you get more research teams sharing the devices than maybe you would get in other markets like the United States. That's not new. It's hard for me to understand why they didn't model for that appropriately. You still do have to consider the competitive aspect here. It's obvious that that, from their perspective, is having an impact.

Harjes: It'll definitely be something to look out for in May when they release their official results; listening in on that conference call and gather more evidence to test against the original hypothesis.

Let's take one more example. This is something that is even more recent than the Illumina news. United Health Group announced that it was going to leave the Obamacare exchanges all but entirely. What does this mean?

Campbell: Yeah, it's not a complete and utter surprise because they communicated that they were going to have discussions surrounding exiting Obamacare.

Harjes: They're anticipating a billion dollars of losses between 2015 and 2016 because of these exchanges.

Campbell: Yeah, they lost, I think it was over $400 million last year. They came into the year thinking they were going to lose $500 million this year. Then in their conference call last night, they said, "We think we may lose $650 million." It may not sound like a lot when you're talking about a company with $44 billion in revenue, but this is a very low margin industry. If you look at their premium revenue of 34 or $36 billion, their earnings from operations on that business was only, I think, $1.6 billion or something like that, very thin margin business. $650 million, I can understand why they want to rein in their exposure to that.

Harjes: If you're somebody that's interested as an investor in United, does this change your thesis? Is Obamacare ....

Campbell: I don't think so. Do you?

Harjes: Is Obamacare even a big enough ...

Campbell: Do you think the people aren't going to buy that stock now because of Obamacare?

Harjes: No, I actually think it's a good thing. You're exiting something that was clearly not profitable for you. That's the example of the scientific method right there, is saying, "You know what? We tried this and it didn't work."

Campbell: Keep yourself open to opportunity. Other competitors in the space, they're not coming to the same conclusion "Yet". We don't know if they will eventually come to that same conclusion. Obamacare exchanges are expensive because you've got people who weren't previously insured. They're now starting to go out and get care. That care is expensive. If you don't model for that correctly and you don't price your premiums correctly in the marketplace, you're going to lose money.

It's going to be very interesting to see how this plays out. I think that from a shorter term perspective this is the right move for shareholders because it allows United Healthcare to retrench, reevaluate, and then slowly, but surely begin to increase their exposure. You have to remember, too, that this company, they went from operating in just four states the first year, so three years ago, to 34 states last year. They expanded this extremely rapidly. It's hard for me to understand how they scaled it up this quickly without expecting there to be some problems.

Harjes: That's a good point too. It was a quick ramp-up and it looks like a pretty quick ramp-down, too. I actually do perceive that as a good thing where the company can look at its decisions and say, "Okay, realistically, maybe that wasn't so smart. Let's backtrack a little bit here."

Campbell: There are going to be parts of the country that are going to be more profitable for insurers, based on how they design their patient pools. I think that once UNH digests all the information it's got now, it's going to have a much better chance of figuring out where those parts of the market are most profitable for it to participate, and those are the ones it'll stay in. As we go forward, maybe they'll start to fold in other areas in the coming years. Yeah, I think it's smart to retrench, think about where you're going and then roll it out from there.

Harjes: Exactly. We got lucky here doing this episode this week that we had two really good examples come though the news for us.

Campbell: Yeah, it didn't take us long to figure out what to talk about today did it?

Harjes: Exactly. Thank you, Todd so much for your excellent analysis, as always, and for your time. Folks, thanks for listening. One housekeeping note before we totally sign off. I have been instructed to mention that the Thursday and the Friday shows of Industry Focus are going to be swapped this week. You'll see the tech show coming through on Thursday and the energy show on Friday. Huge shake up, I know, catastrophic. If you want to complain about it, or maybe celebrate it, I don't know. You can email us at [email protected]. Thanks for listening, folks!

As always, people on the program may have interest in the stocks that they talk about and The Motley Fool may have formal recommendations for or against these stocks, so don't buy or sell based solely on what you hear.