For some investors, their favorite stocks or strategies are the riskiest. These satisfy the inner gambler, the dreamer, the lover of an underdog with revolutionary ideas. But these risky stocks -- and shorting or options, for example -- are combustible. They can turn your investable assets into smoke before you can say "wingardium leviosa." Not good for you, not good for your family.

The Foolish investor takes one of two paths. The first is to answer How Much Risk Do You Want? with a swift "None of that red hot stuff, thank you very much," and have a long, happy investing career without ever owning an unprofitable, development-stage company, shorting a stock, or buying a put or call option. You enjoy big scoops of that broad market, the low-expense stock index fund, every month.

Put risk in its place
The second is to put risk in its place. No, not to hug Treasury bills, because that's more risky. Despite the fears of deflation, many economists cite historic examples that policies to combat deflation eventually lead to more inflation. Rather, the second option is to more clearly evaluate risk and keep high-risk investing to a smaller part of your portfolio.

Personally, I like high risk when there's potential for high reward. I just want to control it, like chocolate or TV. Here's how I allocate my portfolio to do so:

  • Dividend-paying stocks, large, dominant companies still growing, a low-expense S&P 500 index fund, and cash waiting to be invested. This "sleep at night" section comprises about 40%-50% of my stock portfolio. (See Dividends Plus Growth.)

  • Value investments, mostly small caps. Bought at a discount to low estimate of intrinsic value, usually sold at some point at or above high estimate of intrinsic value. About 30% of portfolio. This week's subject. (See last week's column, Value Stocks in Your Portfolio.)

  • Informed speculations. Leaders in emerging industries (Rule Breakers, "aggressive growth"), unprofitable, development-stage companies, shorts, options. High risk, 20%-30% of portfolio. This column and at least one more will take a mid-year look at this section of the portfolio. (You can show up when you want, by checking my -- and any Motley Fool writer's -- archive. You can use the "Browse Stories by Author" drop-down menu on our home page. Here's my archive.)

Caveat: If stocks in any category outperform, I don't sell arbitrarily to maintain some percentage allocation in my portfolio. I continue to evaluate all businesses and valuations and only sell when an investment no longer provides a potential reward greater than available elsewhere.

What's high risk?
You see that the high risk category includes types of companies and strategies. I might buy a Rule Breaker company -- a company revolutionizing an existing business or creating a new one -- but do it with call options. I might short a stock, or buy put options to do so. (Jeff Fischer recently wrote about selling options, another business altogether. Enjoy his latest off-the-radar stock idea in the first issue of Tom Gardner's Motley Fool Hidden Gems.) No matter, each investment requires research, financial analysis, and valuation, but all involve much higher risk than the dividend-paying and large, dominant company, and small-cap value parts of my portfolio.

Don't forget that the highest investing risk comes from not doing your homework -- buying a company without reading its latest quarterly and annual reports, for example -- and that's really gambling.

Biotech risk
Take biotechnology, a particular passion of mine. The late 1970s saw recombinant DNA breakthroughs and the first biotech investing boom in companies with great promise but no current profits. Every now and then -- a year and a half, three years, and so on -- there have been other times when the stocks there have been many more. The 1999-2000 stratospheric rise in genomics stock prices was astonishing, but it wasn't the first time that investor capital moved not only to companies with products and profits, but to development-stage companies built on a story: a new technology or one drug candidate in the development pipeline.

Why would investors take a chance on a biotech drug maker, when it can take 10-15 years for a new drug to move from identification through animal testing, into human trials, and past the Food and Drug Administration's alligator-filled moat? And when even then there is no guarantee of marketing success, and competition may have superseded it or be hot on its tail?

Any success comes at astounding cost. The Tufts Center for the Study of Drug Development estimates that it costs $800 million, including the cost of failures, for each drug that successfully reaches the market in the U.S. Thus, the newer company has a teenager's ability to consume cash. For at least a decade and usually longer, it needs more and more cash fuel, which it tries to snare during the periodic investing booms through stock offerings and by enticing bigger, cash-rich drug companies into alliances. The first dilutes existing shareholders. The second is a game of how much ownership share of a drug's future revenue streams to relinquish.

Result? Their managers and PR staffs must be carnival barkers promising hope and riches, and they are masters of spin. They have to be. I like a lot of these folks personally -- they are smart, dedicated, and visionary -- but they have honey tongues. The opportunity cost of investing now for speculative riches many years from now proves too great in all but a few cases.

Three biotech holdings
Scared? We all should be. I keep my biotech investments in their place. The ones I own now are these three companies using biotechnology to create innovative drugs:

  • QLT (NASDAQ:QLTI), a pioneer in photodynamic (light-activated) drugs, with the Visudyne treatment for macular degeneration currently on the market. Profitable and free cash flow positive.

  • Ligand Pharmaceuticals (NASDAQ:LGND), a deep and rich pipeline. Unprofitable, but a very favorable marketing deal with Akzo Nobel's (NASDAQ:AKZOY) Organon unit for painkiller Avinza may finally be the tipping point. (For more, read A Painkilling Double.)

  • Isis Pharmaceuticals (NASDAQ:ISIS), the largest patent estate in antisense technology, with one small-selling drug on the market. As Jeff Fischer reported, the company recently released disappointing results from trials of its Affinitac lung cancer late-stage drug candidate developed in partnership with Eli Lilly (NYSE:LLY). Unprofitable, cash burning.

I own a fourth company that has recently entered the field of using biotechnology to facilitate the drug-making process. Meridian Bioscience (NASDAQ:VIVO) has extended beyond diagnostics to recombinant DNA manufacturing in support of biotech drug makers, but it's been profitable for years and pays a nice dividend. Not a speculation by any means, Meridian fits in both the dividend-paying and small-cap value parts of my portfolio.

Why are QLT, Ligand, and Isis risky?
QLT's Visudyne is a very successful first product, one for which it secured a terrific deal with drug giant Novartis (NYSE:NVS). It purchased from Xenova (NASDAQ:XNVA) an interest in lung cancer drug candidate tariquidar, but its Phase 3 trials have disappointed. The risk with QLT is its relatively thin pipeline against the fact of life that 80% to 90% of drug candidates that enter human trials fail to secure FDA approval. (Note: 90% used to be the conventional wisdom, but new research suggests that there's more success, at least with biologic drugs such as monoclonal antibodies like Genentech's (NYSE:DNA) Rituxan, Herceptin, and just-approved Xolair.) Visudyne alone may not a company make. For more on QLT, check out A Quick Double?

Here are the returns so far, using compound annual growth rate (computed using Internal Rate of Return) since purchase to account for periodic purchases, sales, and dividends (for the S&P 500):

            First Buy       CAGR* Company     Date    Company   S&P 500 (Divs. added) Isis       1/8/02    -39%     +27%               QLT        1/23/03  +187%     +34%  Ligand     7/8/02   + 85%     +27%*Compound annual growth rate, using Internal Rate
of Return (accounts for periodic purchases, sales, and dividends)

Selling is the same as for any other stock: The potential return (modelling estimated future revenues and free cash flow against current valuation) no longer justifies the risk or opportunity cost of not investing in another company with greater potential. For example, I sold my shares of Millennium Pharmaceuticals (NASDAQ:MLNM) to buy more Isis and two other stocks in this category I'll discuss next week, because I believed that they offered more potential return for the risk over the next three to five years at their valuations. But as you can see from the wide range of returns above, you need to be able to tolerate extreme volatility in high-risk investing.

You can enjoy all things biotech on our discussion board.

Next week
I'll continue with the high-risk part of the port, looking at the non-biotech side of "tech" -- companies producing or enabling computer hardware, software or networking; telecommunications equipment or services (including wireless); semiconductors; and alternative energy. (This definition also includes nanotechnology and nanobiotechnology, the application of small-scale manufacturing to "tech" and the life sciences.) Plus, Internet e-commerce. I'll also discuss current short positions and investments made through put and call options.

See ya then. In the meantime, have a most Foolish week!

Writer and Senior Analyst Tom Jacobs's (TMF Tom9) regularly writes on biotechnology for and pens the investing column for the journal Nature Biotechnology. He owns shares of all companies mentioned here, except Millennium Pharmaceuticals, as well as other companies listed in hisprofile. Motley Fool writers are investorswriting for investors.