“Paradoxically, I believe the ability to make high-risk investments is a way for folks to break out of poverty […] I would tell my mom and two brothers to put 1-5% of their savings into angel investing because, heck, it’s probably the only and best shot they will get at having a break-out financial event in their lives.¹⁾1 – Investing in early-stage start-ups is very risky investors should expect to hold their investment for an average of 5-7 years before any potential liquidity event in the form of an acquisition, IPO, listing on a public exchange, or the development of another secondary market to trade your shares. However, it is also likely that the company may not succeed and fail before any such liquidity event. Investors should not invest in startups unless they are prepared to potentially lose the entire amount of their investment. ”

This is the first installment in our multi-part series on startup investing. You can read more in Part II – Due Diligence and Why Vetting Matters and in Part III – Diversification and the Potential for Outsized Returns.

There are many reasons investors choose to invest in venture capital. Some find it exciting to fund the future and help make the “next big thing” happen. Others got their start by simply supporting a friend or family member’s new startup. But thanks to recent changes in securities laws, for the first time everyone now has the option and ability to incorporate venture capital into their more traditional portfolios of stocks and bonds. But should they?

In part one of this series, we’ll share our thoughts about the role of startups and venture capital in your overall portfolio.

Asset Allocation: Your New Best Friend

Research has shown that the way in which an individual spreads his or her investments across asset classes (i.e. stocks, bonds, etc.) is actually more impactful than the individual investments themselves.²⁾2 – Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. “Determinants of portfolio performance.” Financial Analysts Journal 51.1 (1995): 133-138. In more formal settings, this concept is referred to as asset allocation. In a nutshell, this concept recognizes that different asset classes (like those just mentioned) each have relatively unique levels of risk and return. By mindfully allocating your investments across these asset classes you can help balance the risk and reward profile of your overall portfolio.

But is the impact of asset allocation important enough or great enough to even matter? Studies show that historically that has certainly been the case. In fact, studies have shown that asset allocation decisions have been responsible for up to 90% of the total variation in fund returns over time.³⁾3 – Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. “Determinants of portfolio performance.” Financial Analysts Journal 51.1 (1995): 133-138. ⁴⁾4 – Ibbotson, Roger G., and Paul D. Kaplan. “Does asset allocation policy explain 40, 90, or 100 percent of performance.” Financial Analysts Journal 56.1 (2000): 26-33. ⁵⁾5 – Will a more diversified portfolio guarantee success? While a more diversified asset allocation in one’s portfolio has historically correlated with increased likelihood of higher returns, past performance is no guarantee of future results. Startups raising capital on SeedInvest are not necessarily representative of those which have generated positive historical returns. In addition, early-stage startup investing has a higher rate of failure, volatility, and less liquidity. 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. In short, asset allocation decisions have historically mattered more than what individual stocks a given investor actually picks.

Venture Capital as Part of Your Overall Investment Strategy

It’s important to note that venture capital as an asset class has historically not been highly correlated with public stocks.⁶⁾6 – Chen, Peng, Gary T. Baierl, and Paul D. Kaplan. “Venture capital and its role in strategic asset allocation.” The Journal of Portfolio Management 28.2 (2002): 83-89. This implies that, although startup investing is inherently risky, adding startup investments and other alternatives to your existing portfolio of publicly-traded stocks and bonds may actually de-risk your overall portfolio as a whole.⁷⁾7 – Will a more diversified portfolio guarantee success? While a more diversified asset allocation in one’s portfolio has historically correlated with increased likelihood of higher returns, past performance is no guarantee of future results. Startups raising capital on SeedInvest are not necessarily representative of those which have generated positive historical returns. In addition, early-stage startup investing has a higher rate of failure, volatility, and less liquidity. 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.

Diversify, Diversify, Diversify

It is easier than ever for investors to expand their portfolios above and beyond the traditional mix of stocks and bonds. But instead of maintaining a laser focus on each individual investment, one should consider focusing more on how much you want to deploy in aggregate across stocks, bonds, real estate, venture capital, and other alternatives.

Once you’ve figured that out, you can turn your attention to the way in which you are investing and diversifying within each asset class (more on that soon).

Yale’s Approach

Let’s look at a real-life example of what we’ve been discussing:

The Yale Endowment is diversified across numerous asset classes. In mid-2015, a little over 16% of their portfolio was allocated to venture capital.⁸⁾8 – https://investments.yale.edu/endowment-update/ ⁹⁾9 – How much of my portfolio should I allocate to alternative assets? SeedInvest does not recommended that the average investor allocate more than 10% of their overall portfolio to alternative assets.

Yale’s strategy of moving away from a more conventional portfolio dominated by stocks and bonds to a more diversified strategy resulted in 13.9% returns per year over the last 30 years and enabled the endowment to generate higher returns than its peers.¹⁰⁾10 – http://investments.yale.edu/endowment-update/ ¹¹⁾11 – Should I expect similar future returns? Past performance is no guarantee of future results. Startups raising capital on SeedInvest are not necessarily representative of those which have generated positive historical returns. 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.

To put this into dollar terms, a hypothetical $10,000 portfolio managed by The Yale Endowment over the last 30 years would now be worth over $496,000.¹²⁾12 – 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. In comparison, during this same period domestic equities returned 10.7%, foreign equities 8.7%, and domestic bonds 7.1% per annum.¹³⁾13 – Should I expect similar future returns? While early-stage venture capital has historically generated larger returns than domestic equities, foreign equities, and domestic bonds over the last 30 years, past performance is no guarantee of future returns. Startups raising capital on SeedInvest are not necessarily representative of those which have generated positive historical returns. In addition, early-stage venture capital investing has a higher rate of failure, volatility, and less liquidity. Only those prepared for the potential of extreme volatility, a lack of liquidity, and to lose the entire amount of their investment should invest in early-stage venture capital. Our hypothetical $10,000 portfolio would only be worth $211,000, $122,000, and $78,000, respectively, if invested in just these asset classes.¹⁴⁾14 – 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.

You Are Not Yale

Individuals should not allocate as large a percentage to venture capital as Yale does but it is worth noting that the most sophisticated investment managers typically do not simply rely on stocks and bonds to maximize risk-adjusted returns.

For the first time, you now have access to investment opportunities in early-stage startups. So step one is to decide what portion of your overall savings you’d like to allocate to startup investments.

If you decide to add startups to your portfolio, you will need to consider the importance of building a diversified portfolio of multiple startups and also determine how to vet the startup investment opportunities themselves.

Be on the lookout over the coming weeks as we continue this multi-part series by sharing our thoughts on the role of due diligence and how diversification affects venture investment returns.

Till next time…