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Diversification and the Potential for Outsized Returns - Part III

US Venture Returns

“[…] Our target batting average is ’1/3, 1/3, 1/3‘ which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.”

         – Fred Wilson, co-founder of Union Square Ventures, 2009 [1]


This is the third installment in our multi-part series on startup investing. If you haven’t had a chance to read the previous pieces on asset allocation and due diligence you can do so on the SeedInvest Blog.

Right now though we’re only looking to answer one question: is diversification really that important?


10% of Exits Generate 85% of Returns [2]

We’ll start with a simple premise that is widely agreed upon: some startups will make it big while most will fail. If we were to borrow concepts from the world of statistics, startup investments are not “normally distributed.“ That is, instead of following the type of bell curve depicted below to the left, startups appear to follow more of a “Power Law” distribution as depicted on the right.


startup investing returns distribution


There is real-world evidence to support this notion. In 2014, for example, Correlation Ventures released a study that showed the distribution of outcomes across over 21,000 financings spanning 2004-2013.[3] The results (depicted below) clearly show a return profile matching that of the above-mentioned Power Law Distribution.[4]


US Venture Returns


While not everyone agrees on the nuances per se, it’s commonly accepted that the majority of your returns will be concentrated in just a select few startups while the majority of your startup portfolio investments will return at best what you invested (and more often than not even less than that).

This is a critical concept for those who have or are looking to add venture capital to their existing portfolios. If you invest in too few startups, you are statistically less likely to be invested in one of the few “winners” whose outsized returns are crucial to offsetting the myriad losses you are almost guaranteed to experience.[5]


Investment Minima Are No Longer a Gatekeeper to Diversification

One of the major hurdles to proper diversification are investment minima. Even in traditional angel investing where investment minima can hover around $10,000, most accredited investors cannot afford to easily invest across dozens of startups. Through SeedInvest, investors have the ability to invest as little as $1,000 per offering.


[4] Past performance is no guarantee of future results. The following is a hypothetical illustration of mathematical principles, based on historical results and in no way is meant to predict or project the performance of an investment or investment strategy.
[5] Should I expect similar future results? Past performance is no guarantee of future results. In addition, early-stage startup investing has a higher rate of failure, volatility, and less liquidity than other investments alternatives. Only those prepared for extreme volatility, a lack of liquidity, and the risk of losing their entire investment should invest in early-stage startup investments. While it is important to diversify amongst multiple startup opportunities, we do not recommend you allocate more than 10% of your entire investment portfolio to alternative assets in order to ensure you maintain a well-diversified portfolio across multiple asset classes.
[6] Diversification is only across multiple early-stage investment opportunities within the asset class. There is no guarantee that this program will lead to a well-balanced portfolio of companies across industry types or stages across the asset class. In addition, enrolling in this program will not lead to diversification across your entire investment portfolio. In order to achieve diversification, we do not recommend you allocate more than 10% of your entire investment portfolio to alternative assets.


This post was written by aaronkellner on August 9, 2019

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