3 Reasons You Shouldn't Buy Stocks in Biotech

How can you double your investment literally overnight? Buy stocks of the right biotech companies. However, you can also cut your investment by half overnight by buying the wrong biotech stocks. The reality is that not everyone is cut out for the sometimes crazy world of biotech investing. If any of the following criteria apply to you, you probably shouldn't buy stocks in biotech.

1. You don't know what you don't know.
You don't have to know everything to be a successful biotech investor. However, you do have to realize that you don't know everything -- and make decisions accordingly.

Let's look at an example of a hypothetical investor we'll call Joe. In April 2010, Joe saw that the Food and Drug Administration approved a new prostate cancer vaccine, Provenge, which was developed by Dendreon . Provenge looked very promising, with one prominent analyst forecasting peak annual sales as high as $4 billion.

Joe noted that Dendreon's stock was up more than 30% for the year and had more than quintupled in the last 12 months. He thought to himself, "Great stock! Great potential! This is a sure thing!" So, Joe loaded up on shares of Dendreon. Unfortunately, Joe didn't know what he didn't know.

He had no idea that doctors would be hesitant to prescribe Provenge due to concerns about reimbursement. Joe didn't realize that analysts are frequently overly optimistic when making sales projections for new treatments. It was an expensive lesson for him. Dendreon's stock sold for more than $40 per share in early April 2010. The stock's current price is around $4 per share.

2. You can't afford to lose.
Too many people invest money that they can't afford to lose -- and then proceed to lose. As with any other sector in the market, you're going to have some biotech stocks that perform well and others that perform horribly. The key is to not risk more than you're prepared to lose.

Biotech stocks are highly volatile. A good example of this is Spectrum Pharmaceuticals . Spectrum rode a wave of generic leucovorin shortages in late 2010 and early 2011 to stock gains of more than 170%. Shares then plunged more than 30% from July through September 2011. But the ride wasn't over yet.

Spectrum's stock price nearly doubled over the next three months. And then it fell 37% before climbing back to hit new all-time highs. However, shares now stand at nearly half of where the stock traded in July 2012.

At several points along the way, you could have been a big winner if you held Spectrum shares. Unfortunately, you could also have been a big loser depending on when you bought the stock. If you're not prepared to lose money with the volatile nature of biotech stocks, it's probably best to stay away.

3. You aren't willing to wait.
This crazy volatility can shake out many investors. However, some biotechs take years to achieve their potential. If you aren't willing to wait for success, biotech investing probably isn't for you.

MannKind presents a textbook case for the importance of waiting. The company first attempted to gain regulatory approval for its inhalable insulin product, Afrezza, back in 2010. Then in 2011, MannKind received another thumbs down from the FDA. Shares have risen and fallen more than 40% multiple times in the meantime.

However, MannKind is now near its third attempt at approval. The stock has more than tripled so far in 2013. Investors who waited patiently could finally see Afrezza gain approval within the next year. Those who didn't wait likely experienced significant percentage losses.

On the other hand
The good news is that biotech investors who don't meet the above criteria can often see solid returns. I think Sarepta Therapeutics offers a nice opportunity right now.

First, investors should know what they don't know concerning Sarepta. For example, no one knows for sure yet whether the company's Duchenne musculary dystrophy drug, eteplirsen, will gain accelerated approval by the FDA.

Second, investors should limit how many shares are bought. Sarepta's stock could take a beating if accelerated approval doesn't happen. There are plenty of other risks that also make it a prudent decision to control the size of any stock purchase.

Finally, be willing to wait even if accelerated approval isn't granted. Eteplirsen has shown tremendous promise thus far in clinical studies. The long-term prospects for the drug and for Sarepta should be strong.

As you have probably surmised, these reasons to not buy stocks in biotech also apply to any other area of investing. They all boil down to appropriate risk management. If you manage risk effectively, the rewards are much more likely to come.

While you can certainly make huge gains in biotech and pharmaceuticals, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

The article 3 Reasons You Shouldn't Buy Stocks in Biotech originally appeared on Fool.com.

Fool contributor Keith Speights has no position in any stocks mentioned. The Motley Fool owns shares of Dendreon. Try any of our Foolish newsletter services free for 30 days. 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.

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