Biotech can be a scary industry to invest in, but it gets a lot less intimidating if you understand what's going on; reading this guide to biotech investing for beginners is a good start.

Lesson 1: Binary events rule.
I think this is what attracts beginners to invest in biotechs. Or rather the result of positive binary events, which can result in an overnight doubling or tripling of the share price.

Binary events come in three flavors.


First, a drugmaker will have clinical trial results that can drive a stock higher. Depending on the indication, phase 2 or phase 3 trials usually produce the largest gains. Exceptional data in a phase 1 trial can create an increase in value, but most investors aren't expecting much, either way, from the early trials.

Amarin , for example, nearly doubled after announcing data for a phase 3 trial testing its lipid-lowering drug, Vascepa. While investors expected the drug to lower triglyceride levels, they got a nice surprise when the drug also lowered bad LDL cholesterol, especially since its direct competitor, GlaxoSmithKline's Lovaza, increases bad cholesterol.

After positive results, drugmakers submit their marketing application to the Food and Drug Administration, and the agency sometimes schedules an advisory committee meeting to consult outside experts. The FDA's preliminary review of the drug for the committee members is typically posted on the agency's website two days before meeting.

Beginning investors need to remember that the FDA has the final say -- the committee's vote is just a recommendation -- so the briefing documents are often more telling of the FDA's decision than the committee's vote. The FDA can, and often does, go against a positive recommendation.

The most famous example of these reversals comes from Provenge, the first time that Dendreon applied for approval. The FDA went against the positive committee recommendation and sent Dendreon back to the drawing board. Investors who read the briefing documents weren't all that surprised.

Finally, the FDA makes a decision on whether the drug is approved. Depending on how the earlier binary events went, the FDA decision is often fairly obvious.

Lesson 2: Valuation matters.
Beginning investors often assume if a trial is positive or the FDA approves a drug, the stock is guaranteed to go up. Unfortunately, it doesn't work that way.

Investing is a game of expectations. If positive results are widely expected, investors will have priced the expectation into the stock, which can actually fall on the news.

ARIAD Pharmaceutical , for example, fell by double digits last year on the day it gained FDA approval for its leukemia drug Iclusig. Six months later, shares still haven't recovered to their preapproval highs.

Lesson 3: Study, study, study.
Sorry to say, but one basic article on biotech investing for beginners isn't going to cut it. Before you hit the buy button, you're going to have to learn more. A lot more.

Fortunately, you don't have to learn everything there is to know about the entire industry. Start small. Learn about one disease -- pro tip: Start with a disease that runs in your family, and then if you never make an investment, it won't be a complete waste of your time. Figure out the drugs currently available to treat the disease and what's upcoming in the pipeline. Most importantly, figure out the expectations for those pipeline drugs.

The way for beginners and experts alike to make money in biotech is to find drugs where investors' expectations don't match reality. Look for drugs that have a reasonable chance of success, but investors haven't priced the potential sales in already.

And, of course, diversify!
While biotech stocks can offer monster returns, but the best investment strategy is to pick great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" not only shares stocks that could help you build long-term wealth, but also winning strategies that every investor should know. Click here to grab your free copy today.

The article Biotech Investing for Beginners originally appeared on Fool.com.

Fool contributor Brian Orelli has no position in any stocks mentioned. The Motley Fool owns shares of Dendreon. 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.

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