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Scientific breakthroughs in genetic research and rising demand resulting from a longer living and increasingly insured population have made biotech stocks among the market's best performers. However, the industry is prone to eye-popping pops and drops, and that makes biotech stocks among the riskiest industries to invest in.

Because biotech stocks can move dramatically on clinical trial whims and whispers, people often make mistakes when investing in them, including these common missteps.

Mistake No. 1: Ignoring clinical trial risks
It's tempting to get excited about the potential of a so-called revolutionary drug that can cure a tough-to-treat disease, but investors often forget just how hard it is to usher along a drug through clinical trials and across a regulator's desk.

Historically, 90% of drugs that enter phase 1 human trials -- the first stage of clinical testing -- end up in a laboratory dustbin rather than on a pharmacy's shelf.

And before you think most of those failed drugs fell short in that first phase of human trials, know that failures are common throughout all of the clinical trial stages, including the final phase 3 stage, in which up to 40% of drugs are unsuccessful.

Because of biotech's incredibly high failure rates, it's incredibly important to keep the value of innovative medicine working its way through biotech pipelines in the proper perspective -- after all, that great drug that just aced its recent phase 2 trial may never see the light of day.

Mistake No. 2: Eggs and baskets
Concentrating your portfolio in a hit-and-miss industry like biotech can be a big recipe for disaster.

Because the odds are stacked against a drug's chances of making it to market, many biotech stocks never end up producing the sales and profit necessary to reward investors with higher stock prices.

Obviously, the best way to minimize the risk of owning a portfolio made up entirely of profitless biotech companies is to diversify across other areas of the market, such as into consumer goods, financials, and technology stocks.

Another best practice is to avoid concentrating the biotech portion of your portfolio in high-risk clinical-stage companies.

Instead, consider focusing on a core group of top-tier companies such as Gilead Sciences and Celgene Corp. and then sprinkling in a few clinical-stage companies alongside them, depending on your risk tolerance.

Mistake No. 3: Ignoring the numbers
Identifying a breakthrough needle-moving drug is only one step to finding a winning biotech stock, yet many investors stop their research there and, as a result, end up investing in a company that's on shaky financial ground.

Dendreon, a now bankrupt cancer immunotherapy biotech company, is a great example.

The company's Provenge, a therapy for prostate cancer, posted solid efficacy and safety data in trials and after winning FDA approval, Provenge went on to generate hundreds of millions of dollars in sales annually. Yet Dendreon still went belly-up, in large part because of its ever-worsening balance sheet.

Because bankruptcy is a real risk that must be considered, always look beyond the drugs that are in a biotech company's pipeline and at a minimum consider:

  • How much cash a company has on the books.
  • How quickly a company is going through that cash.
  • And whether or not a company is weighed down by debt.

Tying it together
Biotech stock investing can be very profitable, but there are a lot of risks that are associated with buying biotech companies that need to be considered. Invariably, all investors are bound to make mistakes. However, doing as much research and due diligence as possible beforehand can reduce how many are made and how big of a negative impact they have on your portfolio. 

 

Todd Campbell owns shares of Celgene and Gilead Sciences. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may have positions in the companies mentioned. The Motley Fool recommends Celgene and Gilead Sciences. The Motley Fool owns shares of Celgene and Gilead Sciences. 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.