Want to Buy Marijuana Stocks? Ask Yourself 3 Questions First

Whenever a sector of the stock market does well, investors pay attention. Nowhere is that clearer than with the current marijuana stock craze, as everyone's looking at the increasingly high-profile stocks that have exploded onto the scene. With the opportunity that October's legalization of recreational marijuana in Canada will bring, many people can't wait to pile into the stocks they think can benefit the most.

Cannabis presents an interesting investment opportunity, and it's certain that some companies will take full advantage of this budding market to prosper. Yet before you just throw your money willy nilly into the cannabis space, you should ask yourself three questions in order to measure your resolve and commitment toward making a well-reasoned investment in marijuana stocks that will leave you satisfied no matter what the outcome is.

1. Can I afford to lose my entire investment?

Investing in cannabis stocks right now involves an above-average amount of risk. Valuations of some of the first-moving marijuana stocks, such as Canopy Growth (NYSE: CGC), Aurora Cannabis (NASDAQOTH: ACBFF), and Tilray (NASDAQ: TLRY), have climbed well into the billions, long before they'll be able to establish how successful they'll be at generating sales growth from the coming boom in sales of marijuana and cannabis-related products.

I'm not saying all marijuana stocks are going to go to zero. Some will inevitably be successful. But it's almost certain that some cannabis-related companies won't be able to match up to their competitors and will end up failing as businesses, and their shareholders are likely to be wiped out. You can hedge against that risk by investing in multiple companies in the sector, or by using exchange-traded funds, but only you can decide what level of risk you're comfortable taking on.

2. Am I ready for big swings in both directions?

In nearly every high-growth industry, even stocks that eventually prove successful and highly profitable for long-term investors go through periods of massive declines. Whether you look at internet stocks in the early 2000s or the high-flying e-commerce plays of the early 2010s, you'll be able to see big pullbacks that tested the resolve of investors. The same thing is already happening with marijuana stocks. Tilray is the obvious example, exploding higher by 15-fold before suffering a 65% loss in a matter of days.

Many shareholders sell out when those uncertainties strike, and although they can claim profits on their initial investment, the amount of money they make is far less than what they would have made if they'd stuck with the stock through the downturn. Only those who have the resolve to stick with their initial decision will be able to reap the full rewards from their commitment.

3. Do I understand my company's overall strategy and business plan?

Smart investors know that buying shares of any stock really means you're taking an ownership stake in the underlying business. In order to be a good part-business owner, you have to have confidence in the plan the company has to be successful.

Many cannabis-related companies have made compelling cases supporting their business plans. Canopy Growth already has substantial sales from the medical marijuana side of the business, including more than 85,000 registered medical patients, and it hopes to use its partnership with beer and spirits giant Constellation Brands to enter into new markets. Aurora Cannabis has demonstrated a huge ability to produce marijuana at capacity, as expansion is expected to make it the leading producer in the market. Tilray has made inroads toward making its cannabis products attractive to pharmaceutical companies looking at potential new medical uses for marijuana, including a partnership with Sandoz Canada.

If you're comfortable with those business models, then you can evaluate your marijuana stocks by seeing if their businesses are able to make the most of their strategic plans. If they do, then you can feel confident weathering temporary setbacks when they come. If they don't, then even a soaring stock price shouldn't necessarily make you comfortable that the company's on the right track.

Be smart

Investing in marijuana stocks is risky, but it doesn't have to be irrational. As with any investing decision, just make sure you've defined in advance exactly what your reasoning is behind your investment, and then pre-plan how you'll respond to future news about the company and the stock. That way, you'll be as comfortable as possible as you prepare to take the roller-coaster ride that marijuana stocks will inevitably take their shareholders on over the months and years to come.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.