How to build a diversified portfolio

When investors build an investment portfolio, there are several important aspects to be considered, such as the correct adequacy of the portfolio to their objectives and needs or the analysis of the expected return vs. assumed risk. Among them, we at Fellow Funders believe that the adequate diversification policy for our investments is one of the most significant and determining factors. We consider this diversification as the essential basis of the strategy to achieve the best return-risk ratio of the portfolios. This diversification is even more relevant in the world of alternative investment in startups and micro-SMEs, given their peculiarities. However, how do we build a diversified portfolio?

To diversify our assets…

First of all, we should consider two fundamental aspects:

• All investors must adapt their total investment volume to their circumstances. Generally, we should not allocate more than 10/15% of our assets to alternative investments.
• According to all the available studies, we should distribute our total investment among a minimum of 13-15 different companies. Later, we will provide a detailed explanation of the reasons why this strategy involves risk mitigation.

… attending to the variables

Once we have established the two previous premises, it is time to set the diversification strategy for our portfolio. For this purpose, we must be aware of a series of critical variables in which our investees can and must be differentiated:

• Sector of activity/business model. We can invest in many different sectors, each of which has its characteristics and associated risks. For example, we offer investment opportunities in classic sectors, like craft brewing or catering, research-focused sectors like pharmaceuticals (larger return periods due to the research process), highly disruptive projects like clean energy, real estate (with significant returns and aiming to preserve the invested capital), or agricultural projects (with periodic returns based on the distribution of dividends).
• Technology level. Technology is assuming an increasingly prominent role in the economic landscape. To manage diversification properly, we must distinguish in our portfolio between companies in traditional sectors attempting to do things “differently” and those of pure tech (biotech, foodtech, fintech). Consequently, we should diversify our portfolio among companies with different degrees of dependence on technology.
• Maturity level. Not all companies are at the same stage of development. Our portfolio may include companies in the seed stage, the growth stage, and the scaleup stage. Likewise, part of our portfolio needs to be focused on more developed companies in the consolidation stage.
• Divestment terms. One crucial issue to consider as investors is the time horizon in which we focus our investment and in which we will need liquidity. Generally, divestment processes in startups and micro-SMEs take seven years, on average, in Europe. If we invest all our capital at once and not progressively, we will probably face liquidity problems at some point. It will take us 5-6 years to start disinvesting. For this reason, it is advisable to choose companies at different stages of maturity and times. One relevant aspect that could generate medium-term liquidity for investors, as one of the EC’s policy objectives, is the development of junior stock markets. In these markets, less established companies could be listed, and investors could buy and sell their shareholdings subject to the laws of supply and demand.

Let us take an example*

After defining some essential theoretical keys that, in our opinion, will allow us to build an efficient alternative investment portfolio, we will now apply them to a specific practical case of investment in startups: 

An investor with an investment capacity of €10,000 per year. Each year, this investor distributes this amount among five companies, carrying out this practice consecutively for five years. After this period, he/she will have invested €50,000 in 25 companies (€2,000 each). 

Based on annual studies on startups, we can estimate that five of these companies will multiply their profitability by a factor of ten. We assume that the rest will not report significant profits and, therefore, we do not reflect their value in the portfolio. If we add the tax incentive, i.e., the capital that the investor will not see reduced in taxes thanks to the deductions for investment in startups (in the specific Spanish case and with the new reform of this type of investment, a 50% incentive), our investor will save up to €25,000 in taxes.

Adding this tax benefit to the €100,000 generated by the divestment in the five previously mentioned companies, we obtain a total of €125,000 from an investment of €50,000, translating into a return on investment of… 150%!

To conclude, we should point out that the benefits of alternative investments vary considerably depending on the parameters applied in the construction of our investment portfolio. However, the greater the diversification, generally, the lower the oscillation and risk assumed, resulting in a sufficiently attractive risk-return ratio for our investment strategy.

*This is a theoretical case study based on studies on startups and the probability of startup Exit.