Reasons why you need to diversify when investing in startups

How to keep increasing your number of investees and your alpha growing

We already discussed the benefits of diversifying and controlling binomial profitability – a risk in investment. Anytime someone recommends investing, they advise investing in several companies, considering that each has an independent probability, which means that these investments could not be worth anything. However, how much should I diversify? Let’s take a look at some of the major factors behind the diversification of investments.

Keep in mind that seed-stage companies and high-growth potential companies do not follow a normal distribution of returns, as do companies in public markets. For this reason, when you ask an alternative investor why some companies become worth €1billion and others 0, they refer to the power law distribution of the alternative investment.

In a power law distribution, the probability of an outcome is inversely proportional to its size.

To support our analysis today, we rely on studies by Steve Crossan, Jerry Newman, and Seth Levine based on Monte Carlo simulations performed on Venture Capital Companies that invest in seed-stage companies with high growth potential – Venture capital.

As expected, the simulation has several assumptions to overcome the problems generated by the characteristics of these types of companies. I invite readers to visit the links to the articles above for more detail.

What is the optimal balanced portfolio size in alternative investing?

The probability of exceeding any benchmark increases as you grow your portfolio. However, it grows very slowly when we focus on early-stage companies.

If you believe, as I do, that actively engaging the companies you are investing in increases their chances of success, you need to balance the decreasing growth rate of the probability of reaching the benchmark with the number of companies you can actively support.

So, to optimize your portfolio, you should analyze the ability to generate a return by decreasing the number of defaults. Looking at Figure 1, with only five investees, the probability of losing money is more than 40%. However, this decreases when the number of investees tends to infinity, reaching almost 0 in portfolios between 100 and 150, i. e., in the 1,000 random portfolios simulated by Monte Carlo, none of them lost money.

It is worth noting that the possibility of 3x increases considerably as you increase the portfolio, albeit at a decreasing rate.

Figure 1:

Source. Modeling suggests rational venture investors should have more comprehensive portfolios.

In addition, Figure 2 analyses companies that have defaulted, been part of an M&A process, or made an IPO between 2004 and 2013.

Figure 2 shows how (probabilistically) increasing the portfolio significantly improves your chances of success.

Figure 2:

We can draw some conclusions, but I would like to highlight some of them:

The analyzed models indicate that the higher the number of investees in your portfolio, the more likely you are to be successful in your investments. Why? Because in power-law distributions, everything is based on having the outlier and, assuming the rest of the variables are constant, the probability of a big hit increases considerably.

Following up on this theory, we can comment on the success story of Jesús Alonso Gallo, a Spanish Business Angel and a shareholder of Orbyn, who uses our platform to build his portfolio.

Also, this fact disproves the famous theory about seed-stage and high-growth companies 1/3 of them fail, 1/3 of them return your capital, and 1/3 of them do well

We should keep in mind that models have many limitations and will likely need to continue to do iterations as the data improves.

Private investors and VCs may differ on the method but not on the objective: to access outlier deals that guarantee a return to the portfolio. Our equity crowdfunding platform has recently encountered Zunder (formerly Easy Charger). Zunder entered with a pre-money valuation of around $3 million. However, after receiving a $100 million investment from the Mirova group, they are now at a valuation of approximately $400 million.

Blas Simón, CFA
Head of Capital Markets

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