For Investors General

Why You Should Diversify Your Startup Portfolio

September 7, 2019 6 min read

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Why You Should Diversify Your Startup Portfolio

We’ve all heard that we should diversify our portfolios. It’s the most cliched piece of investment advice there is, and it’s also one of the best, whether you’re investing hundreds or millions of dollars. 

The basic principle is simple. The market, overall, has consistently trended upwards, despite peaks and valleys. However, individual assets fluctuate in value all the time. So, when you have a narrow selection of assets, you’re vulnerable to those fluctuations.

On the other hand, if you have a broader collection, you’re more likely to capture the gradual upwards motion of the market—the rising tide that lifts all boats. You’re closer to the average, and the average is quite good.

What’s less remarked on is that we believe you should diversify types of investment. In other words, put your eggs in a number of differently shaped baskets. Make some safe bets, but also make some more speculative, high-risk, high-reward, selections. This way, you can effectively make your investments reflect your attitude towards risk (and if you aren’t a risky sort, then there’s always the good old savings account). Empirical study has revealed that this is one of the most important elements of portfolio design.

This can be hard to conceptualize since securities aren’t tangible objects. So, imagine diversifying risk with physical investments. First, you buy a big chunk of gold, because gold has done fairly well over the long-term. Then, you buy a few Renaissance paintings, because classical art, while not a guaranteed good investment, is less risky than contemporary work.

Finally, you buy some interesting collectible cards.  Sure, most of them will be worth nothing in twenty years, but did you know that occasionally, collectible cards can yield some surprisingly large returns. Who knew that a single playing card could be worth $166,000?

In this way, you’ve selected a mix of conservative, less conservative, and more speculative options. The same can be done when designing an intangible investment portfolio.

The Allure of Startup Investing

Of course, perhaps the most interesting of the speculative options is the start-up investment. While start-ups have traditionally been reserved for big-time investors with a lot of capital to throw around, thanks to companies like, say, StartEngine, you can now moonlight as an angel investor.

The allure of start-ups is obvious: the returns can be, at times, quite impressive. For example, Sequoia Capital Investments netted a 50x return on its investment in WhatsApp. That’s the kind of return that sounds like a scam: if someone calls you and tells you they can increase your money by a factor of fifty, you should probably hang up immediately. And to be fair, WhatsApp is a rarity; most startups fail well before investors can see a return (more on that in a bit).

But back to the point at hand, normally, in the stock market, you’re content to earn 1.1x on your capital, since that would place you slightly above the average historical return of the S&P 500.

However, the appeal goes beyond money. There’s also something intellectually engaging about start-up investing, something that just feels compelling about getting behind emerging companies.

First of all, they’re not faceless organisms. The founders are people you can talk to on Twitter, and you’re there with them as their dreams become reality (or don’t.) 

As well, on a larger scale, when we put our money in start-ups, we can become part of the forces of innovation that change the world, whereas when we invest in big stalwart companies, we’re investing in the world as it is. There’s nothing wrong with that, of course, but it feels good to get behind innovators who are shaping the future.

The Argument for Diversification

But that’s where the drawback of start-up investing comes in. Unfortunately, it’s difficult to shape the future, and that’s why nine out of ten start-ups fail. So, we believe the intelligent way to back start-ups is—you may have seen this coming—making diverse investments. Rather than having a bunch of safe investments and then a big slice of one exciting start-up, it might be wise to have ten smaller, and still exciting, slices.

Here’s a simple example. Let’s say you invest equally in ten start-ups, and most of your choices are terrible. Eight of them fail catastrophically. The money you invested in them vanishes, and perhaps you start to feel like start-up investing isn’t for you.

One of them, Mediocrely, grows slightly and stalls out. You don’t lose your Mediocrely money, but you would’ve made more if you’d simply put it in index funds.

However, one of them, Examplefy, is different. It’s what they call a “unicorn” in venture capital circles: not just a winning horse, but a horse of another variety. It gives you a 15x return. Congratulations: you’re a successful venture capitalist. By picking mostly failed companies, you’ve made a profit.

Of course, it’s also just as likely that you pick all failed companies, but such is the risk and the allure of startup investing.

The VC Model

To experienced VCs, this goes without saying. As well, by VC standards, 10 is a tiny number of investments. The emblematic story is that of Ron Conway, who made a dazzlingly high number of investments in the 90s. It’s not known how prolific he is exactly, but he mentioned in 2012 that he’d invested in over 650 companies, which gives you a sense of the numbers at issue. One of those early investments happened to be Google, and now Ron Conway is quite financially comfortable.

Even relatively conservative VCs spread their cash around to many different companies. Star investor Peter Thiel, in his book Zero to One, suggests that he only invests in ultra-profitable firms that could become monopolies—firms that do things that are so distinctive that they won’t experience direct competition. “At Founders Fund,” he writes, “we focus on five to seven companies in a fund, each of which we think could become a multibillion-dollar business based on its unique fundamentals.”

This is not to say that you need to invest in 68 start-ups immediately, but that after you find one start-up that excites you, consider finding another. 

It’s difficult to embrace the idea that most start-up investments fail, and that even the best investors make a lot of bets that don’t work out. It requires being humble about how much we can know, which is a difficult thing to be humble about. 

However, there’s also an exciting side to this unpredictability: the realization that there’s no telling where the next big innovation is coming from. Some brand-new technology will always take us by surprise and shock us with its success. When you make diverse start-up investments, you’re really just keeping an open mind about what the future could be.

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