Angel Investing Strategies, Part III: Diversification in Early-Stage Investing

Introduction

No matter how you slice the data from our previous article about the practicalities of a large portfolio, and regardless of whether you believe the winning characteristics of startup unicorns are worth following, the core of investing remains the same: invest in enough companies to give yourself (1) enough data to improve upon your investment strategies, and (2) enough shots on goal to hit a winner.

When looking at advice for early-stage investing, we often find another argument that investing in a large number of early stage companies will make an investor “well-diversified,” thereby reducing risk and increasing the chances of achieving market-rate venture returns.

While this advice is sound for other asset classes, we question its effectiveness in the private early stage asset class, and again think angel investors should reconsider this advice around portfolio construction.

What is Diversification Anyways?

Interestingly, diversification as a financial concept has been around since 500AD!

If you look carefully at the above definition, while a diversified portfolio has multiple investments, the strategies themselves do not depend on portfolio size. In theory, a portfolio comprising two investments in totally different sectors technically meets the definition of “diversified.”

Ultimately, the goal of diversification is to lower the risk of the portfolio without decreasing the potential returns.

When did diversification get conflated with “large portfolio theory”?

This misconception probably has its roots in Modern Portfolio Theory:

This was all made possible with a data-driven approach that quantified the risk/reward ratio of different assets. By mixing assets with different risk and return profiles (diversification), one can reduce the overall risk of a portfolio without necessarily sacrificing returns.

If this still doesn’t sound familiar, the most well-known applications of MPT are mutual funds and ETFs, which seek to invest in all companies of significance (typically measured through market cap) in the public market. Since the number of companies in ETFs (e.g., 500 companies in SPY) is so large, this likely has led to the thought that a large portfolio equates to minimized risk.

So why doesn’t the same large portfolio approach doesn’t always confer diversification in early stage investing?

A large portfolio alone doesn’t take into account correlation of individual assets

While a large portfolio contains a high number of startups, many of them might operate in similar industries or be subject to the same market trends. This lack of consideration for correlation can lead to a portfolio that is not truly diversified. In contrast, true diversification involves selecting investments that do not all react in the same way to market changes.

Given the inherent challenges of understanding whether a company can make it through 0 to 1, it’s unlikely an angel investor can invest in many different sectors efficiently to really achieve diversification through lots of investments alone.

There is a distinct lack of data for early stage investing

Modern portfolio theory relies on accurate financial data to mix and match multiple assets. to reach a certain risk threshold. But robust, quantifiable data is rarely available in early stage startups and would impede data-driven processes that constructing the modern portfolio theory requires.

One important distinction to make is that Dave Mcclure of 500 startups, who was one of the earliest proponents of the large portfolio theory, was likely driven by his initial observations around investing in internet consumer startups, which have dramatically reduced R&D cycles and can generate revenue quickly, allowing for a more financial data driven approach at the early stage.

For other sectors where revenue doesn’t come quickly and preseed/seed rounds are typically investments into R&D, investment approaches would more likely resemble the early days of the stock market, where information was not updated immediately like in modern day public markets, and the prevailing wisdom given the investment environment was to find a good stock and buy it at a great price.

And what defines a “good stock” can be quite a bit of a judgement call.

Is it really possible to diversify a portfolio of early stage assets anyways?

ETFs such as SPY are widely accepted as “well-diversified” for two main reasons:

1. Portfolio construction starts with a comprehensive view of all companies in the public market, and the ability to invest in any company that move the financial needle (typically judged by market cap), and

2. All companies in the index, regardless of industry, can be measured and compared based on standardized (ex: GAAP accounting) and publicly available financial information.

In this way, ETFs can objectively achieve diversification by investing into the whole universe of investment possibilities, and not be affected by sector-specific influences by measuring all companies through the lens of financial performance, thereby ensuring market rate returns at lower risk.

In early-stage investing, no matter how prestigious the investor is, there’s not a complete view of all startups available on the market, and there is a clear lack of standardized, quantifiable information to compare all startups with each other. As such, even for the earliest of early investors there’s always an element of serendipity (the next unicorn decides to accept your investment) and active selection (even the most active startups accelerators who also invest in graduates have a 2-3% acceptance rate), and ultimately, how the manager selects the companies to invest in becomes a critical factor in the outcome of the investment portfolio.

Conclusion

While diversification is a proven strategy in traditional investing, its application in early-stage investing is more complex and nuanced. In the world of early-stage startups, where data is scarce and investment decisions need to be made with an incomplete information, the sheer number of early stage investments alone does not guarantee reduced risk or increased chances of success, and some element of active investing and risk taking is required to be successful in early stage investing.

What are some practical advice for angel investors developing their own investment strategy? Join us next week as we continue exploring strategies and concepts to help investors enhance their early stage investing experience.

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