Diversity is a well trodden subject in investment content. Stocks and bonds, or bonds an stocks? The traditional answers explain diversity within these two classes. But what about our favorite asset class - the startup asset class? In this episode, Dave share his insight on how startups play an important role in a truly diversified portfolio.
Hey Joe. How are you doing?
I am living the dream. Diversification, you’ve talked about it here a lot when it comes to investing. I want to dig a little deeper into how we diversify our investments and why it’s important. Let’s start with explaining what is diversification.
Joe, the first thing I want to talk about is the differentiation between investing in asset classes or within an asset class. I talked previously about the different asset classes such as stocks, bonds, real estate. I talked also about alternative asset classes. That’s where startup investing comes in. It’s an alternative asset class. When we talk about diversity among asset classes. We’re talking about the fact that recommendations are typically to only put three to 5% of your investible net worth into startups when the high-risk high reward type of investments might fail.
The first thing really is the diversification between the asset or among the asset classes. How much do you put in stocks, bonds, real estate or high-risk investments or alternative investments such as startups? Typically – as I said – the recommendation is to put about three to 5% of your investible net worth into high-risk investment such as startups. That’s the first type of diversification.
Now that we’re here talking about startups, let’s dig in a little more to the startup asset class.
As I’ve said before, startup investing and angel investing, in general, is high-risk, high reward. It’s very chance that you’re going to lose all your money, but there’s a chance that you can make a lot of money on individual investments. Most studies show about 50% of the investments will produce no return at all. Fifty percent or so plus or minus a little bit, but 50% of your investments in startup asset class is going to produce no return at all. It would be great if you knew which ones those were, but obviously, you’re not investing in the ones that are going to fail, but you don’t know that to start with.
It’s like a Philadelphia department store owner John Wanamaker said, “Half the money I spend on advertising is wasted. The trouble is, I don’t know which half.” It’s the same thing with angel investing. Which half is going to produce the returns? You obviously don’t know when you make the investment. Accordingly, you need to make a lot of investments to give you more chance, higher chance of huge success that will balance out the losses and the ones that don’t return anything. That creates a decent return when you balance out a lot of high-risk investments against the ones that aren’t going to return versus the ones that will return a significant on investment. That means diversification.
Got it. That makes a lot of sense. Then how does an angel investor diversify within the startup asset class?
I’ve always been a big believer in diversification. That’s why I started Florida Funders. That’s why I started SeedFunders. To give people the chance to diversify investment with as little as $5000 versus having to put a lot of money into single investments. For this podcast, I did some research on it. Even though I’ve been experiencing it I thought, “What’s the latest thinking as far as diversification?” there’s lots of info online if you type in those key words. That’s good, but all of the research and all of the blogs and things that I’ve seen reach very similar conclusions.
What I’m going to do is just boil it all down, save our investors time that they don’t have to go and read a lot of things or listen to things and podcasts and blogs, because they really all have the same message. Let me summarize, the first recommendations on diversification are first of all talk about industries or sectors. Basically, across industry or sectors such as healthcare, education, finance. It’s not good to put all of your investible assets into one or two even of those. You need to diversify across industries or sectors.
The second thing is, diversify across time. If you invest three to 5% of your investible net worth into this high-risk, high reward asset class, don’t necessarily put it all in at once in 2021 if you’re starting. There might be better deals that come out next year or the year after. You need to diversify across time as well as across industries. The third thing I would say is, you need to diversify across geography. Some investors invest across countries, others across states.
Even within a state, if you look at SeedFunders, we only invest in Florida. But again, within Florida you have St. Pete, Tampa, Miami, Jacksonville, Orlando, the Panhandle. Even if you’re investing only in one state, you can still diversify geographically. That’s the first diversifications that people should consider.
That’s lots of classes times, lots of time times lots of areas carry the sevens. It sounds like about two million investments. How many actual investments do I need to make?
It’s not two million, but basically, again, I’m going to quote some studies and some of the literature and blogs that I’ve seen on this and they – as I said – pretty much all say about the same thing. The first thing I’ll talk about is an investor called Fabrice Grinda. He’s a French entrepreneur and blogger, considered a super angel. He’s made over 200 investments and had exits of over $300 million. Here’s what he says, “Most studies show angels with fewer than 10 investments lose money. While more than 10 make money. Moreover – and this is important – the more investments made, the higher the internal rate of return, as it increases the probability of a huge hit.”
What he’s saying here is the minimum is 10. You start to make money after 10, but the more you have, the higher your return can be. Again, the minimum is 10, but the internal rate of return increases past that.
Is that consistent with other information on angel investment?
Yes – as I said – pretty consistent across the board. Another investor Kevin Dick, a managing director of Right Side Capital Management did an analysis on startups that they invested in, he concluded that they got a 4.05x return in six years. That’s a 26% annual return. If you remember, some of the other podcasts we talked about, other studies showed about a 21% to 28% return if you’re significantly diversified. They calculated 26% annual return, but he also said, “The return is dependent upon the number of investments, and again increases with the more investments.” The more investing you do, the higher your return can be. Very similar to the statements made by Fabrice Grinda.
That’s a couple of folks, I need more, any more studies or analysis.
Yes, let’s talk about one more. The Kauffman Foundation, very well-known research work that they’ve done in startups. They released a Monte Carlo Simulation by a guy named Simeon Simonoff. Basically, what they concluded, “The likelihood of cash returns from different portfolio sizes is what they consider.” The likelihood of cash returns from different portfolio sizes is exactly what we’re talking about here. They found that a portfolio size of 50, to be the sweet spot by increasing the likelihood of a 4x return or higher. Fifty investments to get that 4x return or higher, as the previous study showed, which would be a 26% annual return.
This is a similar conclusion to the Right Side Capital Management study. Basically again, stated the return is higher with more investments. Although, the Right Side Capital Management didn’t say 50, this Monte Carlo Analysis came up with the number of 50. Taken all together, these studies in observations say, “The optimum portfolio size for angel investors is 10 to 50 companies.
Four-fifty is less than two million, but it still seems like a lot of companies to source. And a lot of companies to do due diligence on. How can an angel investor possibly invest in 50 deals?
I think you know my answer to that. You have to be involved in angel investment group. I don’t see any other way that you can find, vet, close and monitor that many as an individual. As I said before, angel groups pull their resources. They present significantly more opportunities to its members than an individual possibly can. By joining an angel group, it’s a lot easier to find 10, 20, 30, 40, 50 deals than an individual possibly ever could.
Speaking of angel groups, you mentioned part of the benefits of being part of an angel group was getting access to follow-on investments. How do follow-on investments play a role in diversification strategy?
Follow-on investment is very important to consider when diversifying. For example, again if you’re investing three to 5% of your total investible assets. And you include investments in follow-on companies that you’ve already invested in, that’s not a new investment. You’re basically adding money to a previous investment. If you double down on existing investment, it’s not a new investment. When you allocate funds, and say you’re going to invest X amount, you have to count for the fact that you might reserve some for follow-ons.
That will impact the number of companies an angel can invest in. By basically saying, “I can’t put all these three to 5% in 50 companies. I’m going to have to put some in re-investing in deals that I’ve already invested in. It is interesting though, because I did read one analysis that concluded that returns are higher if all deals are original. What I mean by that is, if no funds are committed to follow-ons.
Basically, it said – and it did a very highly statistical analysis that I couldn’t follow, but it said basically, that if you invest more – rather than putting $20,000 into a follow-on deal, put $10,000 into two new deals. And your overall return will be higher. It’s obviously a personal decision. It’s very tempting to put more money into follow-ons. Once you know the founders, you get very confident, and they’re looking pretty good, it’s pretty tempting to put additional money.
In fact, when I started SeedFunders basically, I really thought we would not do follow-on deals, but it’s pretty tempting when you have a good investment. And you want to help that company succeed to do follow-on deals. That definitely needs to be considered in allocating your overall investment size and portfolios.
Great information as usual, closing thoughts…
Yes, I think a quote from Angel list – the online investment firm. They basically said, “At the seed stage, investors would increase their expected return by broadly indexing into every credible deal. I think every credible deal is a bit much, but certainly, 10 is the minimum. As you heard from some of the studies, 10 is the minimum [11:03] return an angel investor, probably sufficiently diversified at 50. Somewhere between 10 and 50 really is the goal.