7 Ways to Invest in Biotech Without Getting Burned

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Investors looking for large returns may be tempted to check out the biotech sector, in hopes that the next big cancer drug will also mean big revenue potential. It's easy to be lured by the possibility of fast dollars, but there is also a high level of risk.

But it's also quite possible a company will never develop products that will reach the market. It often takes years to learn if a biotech company's investments pay off, and there are many obstacles to turning research and development into a marketable, revenue-producing product. On the flipside, an investor can see massive returns very quickly if a biotech firm is successful.

Here are some strategies for investing in the biotech sector without losing your shirt.

1. The Bigger, the Better

One of the risky things about investing in biotech companies is that many of them are quite small, and their fortunes can depend heavily on the success of one or two products. A bigger company will be able to withstand the blow of poor results from one clinical trial. Look to large biotech players such as Gilead [GILD], Amgen [AMGN], or Celgene [CELG], which each have market capitalizations of $100 billion or more.

2. Go With a Fund or ETF

Rather than place a bet on a single company, consider putting your money in the broader biotech market. There are several well-performing mutual funds and exchange-traded funds that give you biotech exposure but across a diverse set of players in the healthcare industry. The Vanguard Health Care Index Fund [VHT] is a solid fund offering a consistent track record of growth with relatively low fees. Also consider the SPDR S&P BioTech ETF [XBI] and the iShares U.S. Healthcare ETF [IYH]

3. Invest in Pharma, Rather Than Pure Biotech

In many cases, there is not much difference between biotech companies and pharmaceutical firms. Both types of companies engage in research and development, but pharmaceutical firms also get involved in manufacturing and marketing drugs themselves. Thus, pharmaceutical firms tend to be larger and their stock performance will be less volatile. Johnson & Johnson, GlaxoSmithKline, and Pfizer have been consistently solid performers for decades.

4. Look for FDA Approval

Every biotech company will claim that it's on the verge of a breakthrough, but only those with government approvals have something that's truly worth investing in. If a company recently got approval from the Food and Drug Administration for a drug, then it has something tangible that could bring in revenue. Without an approval, you're only investing in possibilities.

5. Seek the Rarest and Worst Diseases

This may seem macabre, but the biotech companies that will reap the largest returns are those developing drugs to tackle the most deadly medical conditions. And if the company is testing drugs for something rare, there's a chance the drug could be developed without a competitor. In these cases, seek companies that have at least put a drug through Clinical Phase II or III.

6. Find an Acquisition Target

Rather than try to guess which companies might get approval for a drug, consider looking for those that could be bought by bigger players. Bloomberg News reported in January that biotech firms could be hot targets for larger pharma companies this year. For big pharmaceutical companies, buying young biotech companies is a way for them to spark growth.

7. Be Diversified

It always makes sense for your investment portfolio to have a wide array of stocks and other investments from different industries and asset classes. This is especially important when investing in biotech stocks, because they are so volatile. If biotech stocks or funds are a relatively small part of a large and diverse set of investments, then you need not worry too much if some investments don't work out.

Do you invest in biotech? Why or why not?