Bigot says, “It’s a technique by which investors invest their capital across a number of different asset classes, geographies and industry sectors in order to minimise their risk. Rather than making one investment, they create a portfolio of multiple smaller investments in assets that have different price and risk characteristics, so that on average the investment portfolio will yield a higher return on investment and pose a lower risk than any individual investment.
“Its role is well understood by investors in the public markets but may not be in the private markets, particularly in the early stage segment, where it is arguably most crucial. In the public markets it may mean investing in a balanced portfolio of ETF trackers, bonds and cash, but how can diversification be applied to early stage investments?
Investment portfolio management
“For early stage investing, it’s important to understand the most likely risk to an investor and how it affects a portfolio when looking at companies to invest in: company failure. This is generally not something an investor thinks about in the public markets, or even in much of the private market when choosing investment options. It is generally accepted by most professional Venture Capital investors that venture backed startups follow a power law. That is, most early stage companies will fail, some will return a little bit and a small few will return an oversized amount. For an early stage portfolio with a relatively small mix of investments it’s more likely that they will all fail than all succeed, but if one company does succeed then you can expect its return to be magnitudes greater than anything else in the portfolio. This is how most professional venture capital funds think about their investments and portfolios.
“As startups are so risky, an early stage investment portfolio requires a small number of investments to be highly successful, to provide the returns necessary to compensate for the investments that have failed as well as provide a satisfactory return for the risk taken. For its success, this means it’s important the portfolio has exposure to potentially hugely successful companies, but as the probability an investor will be able to choose the winning company every time is very low, investing across a number of companies becomes paramount.
“Of course, we all hope that we have the foresight to tell which industries are going to shape the future and which companies within them will be the key drivers, but the reality is that is unlikely. Instead, an investor should spread their investable capital across a large number of businesses that have the potential to return large amounts. This is why many investors look at the potential size of the market when deciding whether to invest. The question is; if this company does succeed, how big can the company go, and could it return enough to provide a positive return to my overall portfolio if the others don’t succeed?
“Unfortunately, the high fixed costs and risks associated with investment portfolio management in the private market, particularly at the earlier stage, has historically meant that its use as an asset class within a wider diversified portfolio has been reserved for a small, generally very wealthy segment of the population who can afford to make the deal economics work. This means a large portion of the population who otherwise hold well diversified, well balanced, financial investment portfolios nevertheless miss out on an important asset class. While very risky, early stage investments can have an important impact on a portfolio as returns generally don’t follow the returns of the public market and there is the potential of high returns in an otherwise low rate environment.
“However, the cost of participating in the private markets and in early stage businesses in particular is dropping drastically. The roles of equity crowdfunding platforms like Seedrs and peer-to-peer debt platforms allow everyday investors to invest in the equity or debt of small and early stage businesses for very small minimum investment sizes, democratising the asset class for all. For a very low cost, an investor can diversify their portfolio and optimise its risk-return level using exposure to companies at an early stage of growth, rather than only in the public markets.
“Harry Markowitz, the pioneer of modern portfolio theory, said that diversification is the only free lunch in finance. With a well diversified portfolio, an investor can expect to reduce the risk of their portfolio for the same level of return. As long as the risks are well understood and portfolios are structured accordingly, investments in the private market, in particular high growth startups, can play a crucial role in achieving this.”
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