Biotech investments aren't right for everyone, and even for those who are ready to take the plunge, it pays to be prepared. How should one prepare for the crucible of investing in biotech stocks, you may ask? Taking these three steps should dramatically increase your odds.
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1. Meditate on your chosen stock's chances of success
Biotech stocks are incredibly risky. The smaller and more early-stage a company is, the higher the risks. For reference, the chance of a single pipeline project moving from pre-clinical testing through the clinical trials process to survive and get approved by regulators is roughly 13.8%.
Success rates tend to increase the closer a program gets to being submitted to regulators for consideration, and they also vary significantly depending on the target indication of the program in question. So whereas oncology programs in phase 1 trials face grim odds, with only a 3.4% chance of success, an investment in a company with a phase 3 ophthalmology program is significantly less dicey as such programs have, on average, a 74.9% chance of getting commercialized.
Furthermore, the fewer pipeline programs a biotech company is working on, the fewer chances it has to hit a home run and commercialize a best-selling drug. The reverse is also true. More mature biotechs, especially those that have medicines on the market, have a much greater ability to swing and miss and still have enough money left over to survive and even eventually thrive.
That doesn't mean you should limit your biotech investments to the most mature competitors, only that you need to understand the way the risk profile changes accordingly.
2. Make sure your portfolio is diversified with safer investments
While biotechs often offer a significant level of exposure to upside, their failure rates are so high that it behooves you to invest in safer stocks first. Therefore, the first thing to do if you're thinking of investing in a biotech stock is to ensure that your portfolio is diversified enough that you won't be breaking the bank by making a somewhat speculative investment in a biotech company.
Being diversified means limiting the risk to the overall value of your portfolio by picking investments that aren't exposed to the exact same set of risks to the extent that you can do so. For example, if you're eyeing a purchase of something like CRISPR Therapeutics (CRSP -1.35%), don't even think about putting a big chunk of your money into it if you're already heavily invested in a company like Editas (EDIT -2.02%), which is both a direct competitor and just as risky by virtue of being a pre-revenue biotech.
Instead, opt for a larger and significantly more mature company like AbbVie or perhaps a business like Johnson & Johnson that competes in product markets. Then, if your investment in Editas blows up because of sub-par clinical trial results, and it might, you won't need to kiss your whole portfolio goodbye -- just a small piece of it.
3. Think about the ideal size of your biotech position -- and act accordingly
On the topic of biotechs blowing up, you really shouldn't be investing more than you can afford to lose when it comes to biotechs. While that's also true with any stock, it's particularly true with biotech investments because the risks of failure are incredibly high.
So, if you're trying to size your position, think hard about how much money you would be willing to bet, given the odds. Of course, most of the businesses you're going to be interested in investing in will have more than one program, and in many cases, there will be multiple programs in the clinic.
A good rule of thumb is not to allocate more than 1% of your portfolio's total value to early-stage biotechs with very few programs and no more than 5% to late-stage companies. If you stick to those guidelines, a stumble in clinical trials that shaves 30% off your investment's share price won't leave a huge dent in your portfolio, which will also make it easier to think about whether mediocre clinical data warrants selling the stock.
