Investing in biotech penny stocks holds the promise of big gains—but they are much more likely to end up costing you money

If you decide to start investing in penny stocks, including biotech, understand that you could make money, but you will likely lose more often than you win.

Penny stocks suffer from large price fluctuations, so any bit of news will cause a penny stock’s price to rise or fall. This includes biotech penny stocks. As well, in general, penny stocks have lower trading volumes or liquidity, and this lack of liquidity means it may be more difficult to sell a stock when you want to.

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Biotech penny stocks are more speculative than many investors realize

We see an increasingly bright outlook for some top established pharma leaders—and we recommend the best of them in our newsletters such as Power Growth Investor. Still, even major biotech and pharmaceutical companies can be riskier than most investors realize. They need a continuing flow of successful new products to maintain their earnings. They face increasing litigation and aggressive competition from generics as drugs come off patent. Unlike tech stocks, they have formidable regulatory burdens, and unlike other manufacturing stocks such as, say, auto companies, they do not benefit from customer loyalty.

But biotech or pharmaceutical penny stocks are even more speculative and come with a greater variety of problems than many other penny stocks. Successful investors should be aware of the risks.

As mentioned, drug stocks are riskier than investors realize. The cost of developing a new drug is huge, and the payoff, if any, is uncertain. And that’s even more so with pharmaceutical or biotech penny stocks, which typically have just one or two drugs in the early stages of development and with lots of work ahead to get to commercialization. Commercialization is more often than not unattainable.

Here are three risks with pharmaceutical and biotech penny stocks you need to know about

Even though the aging of baby boomers will further increase demand for pharmaceutical drugs, there are drawbacks to drug company stocks, and in particular pharmaceutical penny stocks. Here are three major hurdles most drug stocks face:

• High research and regulatory costs: Drug firms need to spend heavily to create new drugs and spend even more to gain regulatory approval. Even then, they only get to profit for a limited time before patents run out and generic products appear. Also, their research spending usually leads to dead ends, rather than new drugs that fill a need and can earn the approval of regulators. Failed research may add to the general body of knowledge, of course. But for the company that spent the money, it’s a writeoff.
• Aggressive competition: Drug companies must deal with increasing litigation and aggressive competition from generics as patents on their drugs expire.
• No brand loyalty: Demand for effective drugs can evaporate overnight, long before the patent expires, if more effective drugs come along. Unlike many other manufacturers, drug stocks don’t benefit from brand loyalty. What’s more, if investors come around to the common-sense view that the best treatment for diabetes is a combination of improved diet, more exercise and fewer calories, they may lose their appetite for the high risks of drug stocks.

Use these 6 tips to reduce your risk when investing in penny stocks

If you are going to invest in these penny stocks, here are 5 essential tips to minimize your risk:

1. Apply Our Sell-Half Rule: Selling half your holdings after you double your investment is a good strategy for any high-risk investment, but especially so for penny stocks. This can give you a clearer perspective on what to do with the other half of your investment. After all, if you are too slow to sell speculative stuff, your profits and even your principal can evaporate all too quickly.
2. Be Wary of Broker Hype: Avoid penny stocks that trade at unsustainably high prices because of broker hype or investor mania about the underlying commodity.
3. Analyze the Right Metrics: Look for earnings or at least positive cash flow. A perpetual money loser will eventually go broke, no matter how impressive its technology. But if it makes even a little money, it can stay in business and perhaps reap the bonanza of a new product.
4. Watch Out For Acquisitions: Acquisitions can bring “time-bomb” risk. Companies sometimes grow quickly by buying other companies. But it may also be the case that those selling the companies may simply want to bail out of a losing situation.
5. Diversify The Right Way: Spread your penny stocks out across different market segments, not just biotech. When making a list of penny stocks, we recommend investing in a range of markets. This includes software, biotech, technology, mineral exploration and so on.

• Limit Your Penny Stock Buying: Keep speculative penny stocks to a smaller part of your portfolio, and only invest money you can afford to lose–if you choose to invest in them at all

Use our three-part Successful Investor approach to build your portfolio—and limit your exposure to biotech penny stocks and other highly speculative investments

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What would convince you to invest in biotech penny stocks?