A key component to mastering portfolio diversification is understanding asset classes. In episode 5, Dave gives an overview of asset classes and explains where startups exist as an asset class. We consider how alternative asset classes, like startups, may act as a hedge to more traditional asset classes in their lack of correlation to them. Enjoy this short, but mighty episode.
We’re back. It’s SeedFunders podcast, episode five. Going out to SeedFunders Nation. Do we have a nation yet Dave?
I think we do.
Today we’re going to talk about asset classes, and startup investing as an asset class. Let’s set the stage by defining, what exactly is an asset class?
Well, first let me say, I’m not an investment advisor. I’m not making any investment recommendations here, simply providing information. Any investment decisions obviously should be cleared with your investment advisor or your spouse, whoever comes first. That said, if you and your advisor’s goals are to be 100% sure to preserve capital, then startup investing is not for you. Because there is – as I said in previous podcasts, about half of these investments will fail. But on the other hand, some will typically provide huge returns, bringing an overall decent portfolio return. They’re high-risk, high return, high reward as an asset class. So, in answer to your question, an asset class is a group of financial instruments which have similar financial characteristics and behave similarly in the marketplace.
And what are a few typical asset classes?
Well, it depends on who you talk to, but it’s either three, five, or seven. I’m in the five range. Pretty much everybody agrees on the first three: cash, fixed assets which are things like money market, investments, bonds. Things that pay a set rate over time and then return your capital. So, they’re fixed. They’re low-risk typically. And then you have stocks. Stocks are equity, ownership in a public company. The principal can fluctuate on stocks. So, those three pretty much everybody agrees are basic typical asset class is cash, fixed assets, and stocks. I would add two to those. And some people add two more to those. Real estate basically invests in properties, invest in a fund. They’d invest in commercial property, so real estate. And then commodities such as gold, copper, silver, oil and gas, things like that. A lot of people add those two into the basic typical asset classes.
So, those all seem pretty traditional. I also see alternative asset classes mentioned a lot. What are alternative asset classes?
Sure, there are a number of those. And that can include hedge funds, insurance products, collectibles, foreign currency, cryptocurrency, structured products such as credit default swaps or collateralized debt obligations. And of course, the one that we’re talking about today is private equity. Basically, private equity is investing in private companies. That typically can come in three sub-sets. One is buyouts where a private equity firm completely buys a company, owns the company. Another is growth capital where companies are expanding and they’re looking for growth capital. And people will invest in those companies, supply that growth capital. The other one is the one that – my favorite of course is startups. These are early-stage – very early-stage companies that are not yet making a profit, and looking for capital to proceed with their business plan.
With startups, how do they stack up typically against all those other asset classes?
There was a publication called ‘Startups are the Asset Class your Portfolio is Missing’, a recent publication by Peter Amico of NewGate Capital Partners out of Winter Park, Florida, ‘Startups are the Asset Class your Portfolio is Missing’. In that, he analyzed a 2016 Angel Resource Institute report that 245 early-stage startups analyzed. He determined that 70% of those failed. So, much higher than I had previously quoted about half of them are going to fail. But he found in that study, 70% failed. But over a period of four and a half years, $100,000 in diversified investment returned at 2.7x. And what that means is the annualized return that was just under 25%. Now, that is on par with what I said last week when studies show that between 22 and 27% in previous studies return on startups. So, if you have a broad investment in startups, the asset-class could return from 22 to 27%. And this study, in particular, said 25%. Compare that to real estate. You go into a real estate deal. You have an expected internal rate of return under 20% for that asset class. This could be a decent asset class for investing. The point is though if you diversify your asset classes across all asset classes, startup investing is likely to be highly uncorrelated with other investments. So, again by diversifying into the startup asset class, you can actually minimize your risk across your entire portfolio. This provides additional safety for your overall portfolio. Now, Doctor Amico concluded that “Startups are,” and I’ll quote, “An important asset class that is often overlooked by traditional investors.”
So, when there I heard a lack of correlation which can access a hedge, diversification. Can you summarize why investors should commit a part of their portfolio to startups?
Sure, and by part, we’re talking small, three to 5% is typically recommended. No more than 5% of your investment portfolio. And that’s because of the high risk. It’s a high risk, high return. So, you might invest three to 5% and get 22 to 27% return. If you don’t invest in the right companies, you’re not invested broadly enough, you could have zero return. So, you really don’t want to risk a lot of your portfolio. But if you do risk up to 5% of your portfolio, in this portfolio diversification, as I said there is a low correlation to traditional asset classes. So, by diversifying, you’re actually being safer with your investment money. By taking to three to 5% of your investment, and putting it into these higher risk but potentially higher return asset classes of startups. SeedInvest Company, out of California did a blog recently called ‘The Role of Startups in your overall Portfolio’. Their research shows that investing across asset classes, the way you spread your investment across different asset classes, has more impact on your overall performance than the actual individual investments that you make. So, that’s a pretty important statement by SeedInvest. They also recognized that the difference between asset classes each have unique levels of risk and return, and which I talked about. This is a high-risk, high return where some of the other asset classes are a much lower risk, but appropriately lower return. So, by allocating investments across asset classes, you can help balance your overall risk. And actually, your portfolio could actually perform better.
And that brings us back to something you said in the last episode, which is actually a diversification that comes with an Angel group because you’re now diversifying even within the startup space or the startup part of your portfolio.
Exactly, in an Angel group, the Angel group is helping you diversify your investments within the asset class. This is another level, by diversifying in an asset class over other asset classes of your investment.
So, in the end, all the numbers point to adding some level of startup investing to your portfolio adds to an overall better return.
That is correct. And there is no guarantee of course, that you’ll get an overall return. As I said, there’s a chance you could lose all your money, if you’re not diversified significantly enough across, within the asset class itself. But there’s a San Francisco called SharesPost published a report entitled, ‘Investing in Private Growth Companies’. They said that investors who allocate 5% of their portfolio to private growth companies can experience a 12% higher overall portfolio return.
Wonderful, another brain full of information. As usual, thank you. Any closing remarks.
Sure, I just want to quote Jason Calacanis, a very famous Silicon Valley investor. In May 2016 he said, “I would tell my mom and two brothers to put one to 5% of their savings into an Angel investing because heck, it’s probably the only and best shot they would get at having a breakout financial event in their lives.”