What is diversification?

Are you a future investor looking for the best way to start? Here are the key points you should inform yourself about before starting.

No sane investor buys just one or two stocks and hopes for the best. If there is one generally accepted investment principle in the financial world, it is diversification, which means spreading one’s investment over a lot of different stocks (and asset classes). This tried and tested method reduces the risk of individual investments and is bound to increase long-term returns. It also applies to startup investments, even more so.

The reason why diversification is quintessential in the startup world has to do with the return distribution of venture investments, which follows a power law curve. It is very much skewed to one side. According to a study of more than 20’000 venture returns in the US (see below), almost two-thirds of the investments failed to pay back even the initial investment (which means a complete loss in most cases). A fourth made a return of 1 to 5 times and around 6% brought back 5-10 times the invested capital. Very few have achieved spectacular returns of much more than this (only 4%). This clearly shows how seldom such “home runs” are. But still, 0.4 of the observed investments achieved a multiple of above 50x, a massive return on investment. With such a wide discrepancy between multiples, what can be said about the total distribution of returns?

It is important to mention that both these studies included only startups that actually managed to obtain funding from venture capital funds. This means these are companies that passed the diligent vetting process of professional investors that look at hundreds of startups to make a handful of investments each year. Furthermore, these are usually companies that have passed the seed stage and have sufficient traction (sales or product development) in order to convince VCs of their potential. Countless more companies attracted money from business angels but eventually failed to raise more money in later financing rounds from VC funds. Taking the survivorship bias of these studies into account, the final picture becomes even more skewed.

There are many roadblocks to success

Now, these are historical figures for just one geography, but the substance of it is universally applicable: a few fortunate investments make up the bulk of the returns this asset class delivers. This is because venture capital consists of early investments in companies that push the boundaries of technology and try to establish new ideas and business models. Many of them will fail because there are many roadblocks to success – the technology might not work as expected, the market might be slow to adopt it, or the startups get overrun by competitors. But sometimes, those who succeed do so in a spectacular way because they invented a huge market that wasn’t there before and came to dominate it.

In contrast to this, established listed companies are much more mature and generate more or less predictable revenue streams. Public companies are not supposed to go bankrupt, whereas accepting failures in a startup portfolio is necessary to begin with. In order to have the potential to generate returns of 10x or more, the uncertainty of a company’s success needs to be sufficiently large.

How many investments represent a meaningful diversification?

With startups, everyone is trying to pick the rare deals on the right side of the return distribution (those with high multiples) and avoid the ones on the far left, and still two-thirds of ventures fail (even the ones that are backed by VCs). It is also evident that the more investments you make, the higher the probability that your startup portfolio will include some of the great successes. How many investments represent a meaningful diversification in the startup world? A simulation run by the magazine “Institutional Investor” shows an interesting result with 500 investments versus “only” 15 deals:

As the picture shows, broad diversification significantly reduces the breadth of the return distribution, eliminating the money-losing strategies and positively affects the median return. It also makes achieving a very impressive result impossible, though. But this strategy still compares well to returns from global equities, and to many other asset classes for that matter.

Diversification is your friend

But there are some lessons to be learned from these observations. The first one is generally applicable: As with listed equities, diversification is your friend. One should do several smaller investments instead of just a few larger ones. This principle can guide investors even when making the first investment because, in reality, most people will have a finite amount of money that they can invest in startups over their lifetime. Consequently, it seems prudent to start investing with small amounts. What this means in terms of numbers varies according to one’s total assets and an investor’s risk appetite, which in turn determines the percentage of wealth earmarked for startup investments.

Take, as an illustration, an investor with a net worth of EUR 2 million that is comfortable with investing 10% of that sum in startups. This person can do, say, 4 tickets of EUR 50’000 each or back 20 different startups with EUR 10’000. From a diversification perspective, the latter approach makes more sense than the first one. There is also a third strategy that could prove to be successful, which consists of a staggered approach. Only half of the money is invested at first (say, in 10 startups with a EUR 10’000 ticket each), while the other half is kept in reserve. The investor then waits and sees how the startups develop. It will become clearer over time which companies are on an impressive growth trajectory. Those merit follow-on investments in later financing rounds. This leads to a lower diversification than spreading investments across 20 startups, but it increases the amount invested in those that turn out to be successful over time.

A cognitive bias that leads to suboptimal results while investing is the tendency to invest only in what is very close to you (geographically or from a topical perspective), termed familiarity bias. Now, in the context of startup investments, this is a more tricky one, because especially for active investors, it does make sense to invest close to what you know best. If you’re an industry expert, you can help startups from this industry with your network and your advice. With your specific knowledge, you also should have the necessary insight to judge if a startup has a good chance to do well. If some industries or topics really don’t interest you at all, forcing yourself to look at them isn’t fun. And investing close to where you live and where your network is based seems like a good start.