Importance of Diversification in Vc Investing

📊LP Strategy – Index Approach to Startup Investing → 6 Takeaways Months ago, Zachary and I wrote about the Index Approach to startup investing for LPs. According to a Harvard University study of 2,000 venture backed startups, it's estimated that: - 75% failed to produce any returns to investors.  - Only 1% - 2.5% of venture backed companies ever become unicorns (worth over $1B). According to a study by CB Insights: - only 0.07% of venture-backed startups have reached decacorn status - i.e. only 1 out of every 1,400 venture-backed startups will become a $10B business. The most obvious takeaway is that picking unicorns and decacorns is extremely hard, and odds are that any single startup investment will return you near zero capital backed. By creating a diversified portfolio of high risk investments, early stage VCs more or less accept that the majority of their portfolio companies will fail or return 0-1x capital back, but the few that make it will become massive winners, providing outlier returns of 100-500x+ invested capital and return the fund, potentially many times over. This is crucial to understand as an LP when you think about allocating into early-stage startups. You can check out our full post (link in comments) but our 6 takeaways to conclude are as follows: 1) While investing in startups can be lucrative, your diversification strategy will play a meaningful role in your returns. 2) While a fund GP may take a different (or more concentrated strategy) because of their access to management, data, perceived competitive advantages, etc. the data suggests as a whole LPs are not served best with this approach, and we agree. 3) If you decide to create a concentrated portfolio, you can create an outlier portfolio, but this strategy for most LPs will result to below market returns. 4) Create a financial plan to determine exactly how much you can afford to invest in startups (using 1-5% of worth as a guideline, but ask your financial advisor). Divide your pooled capital by a very large number (well over 50) to drive you closer to market returns, as it will increase your chance of getting that portfolio outlier that can return your entire invested capital multiple times over. 5) Alternatively, if you want exposure to the asset class in a diversified way but don’t want to put in the effort, a good option is to invest in Rolling Fund from a GP you trust. 6) As a whole, getting small exposure to this asset class has the ability to provide LPs with strong return, but it is a high-risk/high-reward asset class with returns uncorrelated to returns from other asset classes. Return potential for venture is among the highest of all asset classes. -- I write about VC Syndicates. Powered by Sydecar, Last Money In Media is the most actionable venture capital newsletter.

Investment Magic with Uncorrelated Assets. Harry Markowitz shared the 1990 Nobel Prize in Economics for discovering Modern Portfolio Theory. He showed that holding many securities – portfolio diversification -- offers a proverbial free lunch, a reduction in risk without necessarily sacrificing expected return. Markowitz published this magical result in 1952, but investors today still try to pick a few stocks that will outperform the market. This is a mistake. Here is a simple coin-flipping example showing how diversification works. Suppose stock returns are very risky and pay off annually like the flip of a fair coin: Heads gives 100% and tails gives 0%. An investor putting $1,000 into one stock will earn either $1,000 or zero each year, for an expected return of $500 or 50% on the $1,000 investment. Not a bad return, but half the time the investor earns zero – which is disappointing. Now imagine there are 1,000 very risky stocks whose outcomes each year follow the flip of their own fair coins. An investor who diversifies a $1,000 portfolio by putting $1 in each stock would expect to earn about 50% in EVERY year because about half of the flips will be heads and half will be tails. For example, suppose 480 flips are heads and 520 are tails, the portfolio earns $480 or 48%. If 520 are heads and 480 are tails the portfolio earns $520 or 52%. There is virtually zero chance of earning nothing. So, an investor who diversifies gets about 50% each year with much reduced variability, precisely the gain from diversification.  An apparent problem is that all stocks tend to move together in response to economy-wide factors, such as interest rates, so their returns are not uncorrelated like the flip of a coin, and hence are not diversifiable. But Modern Portfolio Theory teaches that stock returns depend only partly on such systematic forces. They also depend on firm-specific characteristics, such as good advertising (the Gecko), great inventions (ChatGPT), or bad CEOs (Musk). The outcomes unique to each company are uncorrelated, some positive and some negative, so they tend to cancel like with the flip of a coin, leaving only the smaller systematic risk. Venture capital firms spread their money around for the same reason, banking on the idiosyncratic outcomes of mad scientists (the crazier the better) to diversify their returns. Good Luck, Bill Silber, December 3, 2023, 4pm. #investing #diversification #venturecapital #VC  

Happy Thanksgiving! Love this perspective on fund diversity and deployment strategy. "For early stage investing, large portfolios (~100 investments) outperform small portfolios (~30 investments). The goal for pre-seed or seed GPs is to invest in a large enough number of companies to maximise the chance of finding outliers (about 2% for ~50x, 5% for ~15x according to data from Dave McClure). From that point, once you have built a sufficiently diversified portfolio, you can consider a strategy to deploy remaining funds into follow-on rounds for best looking companies as "call options". This only makes sense if you think these follow-ons are the best opportunity available for that capital. Evaluate them as you would any other investment. A lot of VCs (and LPs, for that matter) understand the logic of concentrating into winners, but not the first step of building an appropriately sized portfolio. Why? Probably because the former amplifies risk, while the latter reduces it — playing into the principal-agent problem in VC and the "power law" smokescreen. It also happens to be a lot easier to manage a small portfolio. I've spoken to LPs that say they prefer small portfolio strategies because concentrating into winners is more likely to produce >10x returns. In a world where only the top 5% return >3x, it makes ZERO sense to optimise for that level of risk. Especially when you are allocating other people's capital (pension funds, MFOs, sovereigns, etc). "Few investors demand diversified funds, so GPs don’t offer them. A slow and steady 'venture is a numbers game' pitch is much less emotionally compelling than 'I am a rock star who can consistently beat the odds.' And GPs need an emotionally appealing pitch to get funded." - The Pervasive, Head-Scratching, Risk-Exploding Problem With Venture Capital" This is how we built our fund's strategy -- to invest early in a diverse portfolio. Our current partially deployed fund already has 42 bets, averaging a deal every 1.8 weeks. Dave McClure taught us that investing in 50 companies on a 10x lower cost basis leads to close to the same ownership in each one as investing the same capital in just 5 companies. This approach seems advantageous for startups too as it allows us to give an easier yes to diverse and early companies. We are still finding our sweet spot around valuations and portfolio construction, and we are passionate about these core principles. Jamie Rhode, CFA has done many podcasts on this for those who want to hear more about the data. I look forward to fund 2 when we will have enough capital to both make diverse bets (60+) as well as have follow-on capacity for winners when they are, as Dan says, the best available opportunity for that capital. For investors and startups, what do you think about this strategy? https://lnkd.in/gizefUYC Benjamin Rolnik Julia C. Manu Satyavolu Aman Verjee, CFA Sophia Platt