Some of the biggest companies in the world have utilized Venture Capital (VC) to support their growth, including household names like Facebook, Google, Tesla, Oculus, Airbnb, Alibaba, Spotify, WhatsApp, Snapchat, Twitter, Zoom, Dropbox, Uber, Desktop Metal, and many other success stories.
Venture Capital provides investors with the opportunity to access the high growth potential of startups to build a diversified portfolio.
Understanding Portfolio Diversification
The concept of diversification is relatively simple and is related strongly to the principle of spreading risk. The idea is that an investor shouldn’t be too exposed to a single investment or indeed a single asset class. Preservation of capital is an important objective in any investment portfolio but on the flipside, an investment strategy that is too defensive or conservative can limit growth potential. This can in turn lead to erosion of capital if returns do not keep pace with inflation.
Balance is important in portfolio diversification, which requires careful management of the risk vs. return equation. Allocating funds across a range of carefully selected low risk / low return and high risk / high return investments provides portfolio diversification. The challenge is to reach an appropriate balance that suits the particular needs of an investor, depending on their own personal circumstances such as age, risk profile, parenting status, insurance cover, health, income-earning capacity, capital reserves, and more.
Correlation in financial performance between different asset classes is an important consideration when it comes to diversification. Purchasing assets that are not highly correlated with each other means that if one asset moves down, another asset may hold its value or even increase in value, potentially providing some protection for the overall portfolio.
Why Portfolio Diversification Matters
If you asked somebody who had their entire wealth invested in the US stock market in 2007 why portfolio diversification matters, they might answer, “So you don’t lose your shirt when the stock market crashes”.
Diversification matters because it can reduce the risk of heavy losses if a particular sector of the economy faces a sharp downturn and can increase the potential for returns in a low-growth environment.
However, it is vital to understand that diversification is not a silver bullet to solve all problems; it does not guarantee profits, nor does it protect against all losses.
What is an Example of a Diversified Portfolio?
An investor might think that having all their wealth invested in 10 different tech stocks means they’re diversified. On the positive side, they don’t have all their money invested in one company but it’s relevant to note the following negatives of this hypothetical portfolio structure:
- They don’t have any funds in defensive assets such as cash or bonds.
- They are exposed if the entire stock market falls sharply.
- They are overly weighted in the tech sector, so if something happens that affects many tech companies, they are exposed to potential losses.
It’s important to understand that a diversified portfolio doesn’t just mean owning a range of public stocks. An example of a hypothetical diversified portfolio might be:
- 40% in a variety of domestic stocks.
- 20% in a variety of international stocks.
- 20% in a variety of government bonds.
- 10% in cash.
- 10% in alternative investments.
How to Diversify Your Investment Portfolio
Many investors and financial advisors adopt a traditional approach to structuring an investment portfolio based on a typical 60 / 40 or 70 / 30 allocation, with 60-70% of funds allocated to equities and 30-40% to bonds. The thinking behind this approach is that the stocks provide moderate growth opportunity, while the bonds provide potential safety that can reduce risk and preserve capital.
Investment portfolio diversification is multi-layered and can range from simple to advanced. The simple approach could be as basic as buying a broad-based Mutual Fund or Exchange Traded Fund (ETF) such as the S&P 500 index fund, combined with a broad-based diversified Bond Fund. This simple strategy provides exposure to a range of different stocks and bonds, thereby reducing the risk associated with a single stock, sector, or bond. The advanced approach could involve specific stocks, specific bonds, and alternative investments such as real estate or Venture Capital.
Venture Capital provides a potential opportunity for investors to diversify their portfolios to access the high-growth opportunity of startup companies. Investing in a number of startups as part of a carefully considered strategy of structuring an investment portfolio can potentially help balance risk and opportunity. However, start-ups are high risk and are not suitable for all investors. Investors risk the total loss of their investment if the company does not succeed.
Diversification Can Reduce Your Risk
When it comes to investing, two main risks to be considered include Market risk and Sector risk.
Market risk refers to the broader economy, which could impact all types of investments, e.g. if the economy is flat or declining, this could impact on capital value and returns from cash, bonds, and the entire stock market.
Sector risk refers to specific sectors, such as the property market, or tech stocks, or the retail sector.
While risk cannot be eliminated, diversification can potentially reduce your risk. A wide view is required when it comes to diversification, considering markets, sectors, geography, and investment types.
What is the Advantage of a Diversified Portfolio?
As noted above, one advantage of a diversified portfolio is that it can potentially reduce risk. Another advantage is that an appropriately diversified portfolio can potentially achieve higher returns than a non-diversified portfolio. Particularly in a low interest rate environment, portfolio performance can be impacted by the limited returns available from cash and bonds. Incorporating some investments with the potential for high returns can make a positive contribution to overall portfolio performance.
Five Tips for Diversifying Your Portfolio
The following list provides five tips for diversifying your portfolio:
1. Spread your risk:
Take a close look at the weighting of the investments in your portfolio and think about what might happen to your total wealth if one or more of those investments were to suffer a sharp fall. If that potential outcome is unfavorable, consider increasing your diversity and spreading your risk among a wider range of investments.
2. Keep investing:
Managing your investments is not a set-and-forget task. It’s important to monitor the risk and returns of your portfolio over time to be confident that the structure is appropriate for your personal circumstances at that stage in your life.
3. Consider stock index funds or bond funds:
Index funds or fixed-income bond funds can be a simple way to add diversity to your portfolio. An appropriately selected fund could add a range of different stocks or bonds to your portfolio held in a single investment rather than having to go through the process of picking individual stocks or bonds.
4. Know when to hold them and know when to fold them:
Please excuse the reference to the famous Kenny Rogers song, but it seems appropriate in this context. Keeping an eye on your investments and understanding when it’s time to sell is an essential part of managing your investment portfolio and keeping it on track.
5. Consider alternative investments:
Alternative investments provide an opportunity to gain exposure to different market sectors and potentially achieve higher returns than traditional investments. But it is important to note they generally come with greater risk and increased complexity, so doing your due diligence and educating yourself is vital to increase your knowledge and ensure you understand what you’re getting into and that you are comfortable with the risk.
How to Diversify Your Investment Portfolio with Alternative Investments
The term Alternative Investments broadly refers to any investment that is not publicly traded, meaning they sit outside of the traditional markets of stocks, bonds, and cash.
One objective of alternative investments is to be invested in an asset class that may not be highly correlated with the traditional market. The idea is that if for example the stock market goes down, then your alternative investment does not necessarily follow that downward trend.
There are many different types of alternative investments, each with their own pros and cons as well as risk levels. Deciding on which one is right for you will depend on a range of factors and your own personal circumstances, so it is important that you do your research to discover what is a good fit for you. The range of alternative investments is broad and includes private equity (such as Venture Capital), private debt, real estate, precious metals, cryptocurrencies, commodities, hedge funds, collectibles, and more. You can find out more in our article What are Alternative Investments, and should I have some in my portfolio.
Build a Diversified Portfolio with Venture Capital on the Propel(x) Platform
The Propel(x) angel investing platform provides opportunities for accredited investors to invest in quality startups from as little as $5,000. As with any investment, there is a high level risk involved in startup funding and there is no guarantee these companies will take off in the long term. In fact, there is a risk of complete capital loss. And, while several companies are working to build a secondary market to improve liquidity in private equity investments, Alternatives typically require a longer holding period which may not be suitable for all investors.
The new opportunity of adding Alternatives to your portfolio by investing in startups requires caution. Now is not the time to “spray and pray”, where you throw money at every new startup that comes your way in the hope that something sticks, and you make out like Babe Ruth in a feast of home runs.
There are advantages to using a trusted angel investing platform. It is important to choose a platform created by innovators familiar with the startup ecosystem who have the ability and experience to identify and curate companies with some potential to “make it big”. Also vitally important is the assurance that comes with the rigorous due diligence that goes into a typical startup investment being handled by experienced practitioners who have made a career out of these kinds of deals.
It is important to understand that the extent of due diligence varies with different platforms. At Propel(x), we pride ourselves on our curation, our due diligence, and the level of care for investors who use our platform.
Venture Capital has the potential to outperform returns available from public markets. As an example, industry analyst Cambridge Associates reported in their First-half 2021 Insights Commentary, that for the three years prior to June 30 2021, the return for the CA US Venture Capital Index was 36.1% per annum, which exceeded the public market S&P 500 Average Annual Compounded Return of 18.7% per annum.
“Don’t put all your eggs in one basket” and “Don’t bet the farm” are clichés for a reason. These old sayings ring true when it comes to Venture Capital, where the concept of spreading your risk among various investments is an important concept. The high-risk nature of Venture Capital requires conscious, deliberate strategies to mitigate the risk associated with the high failure rate of startups. And that means investing in more than just one or two startups. A broad view is appropriate when developing a VC risk mitigation strategy. Investing not just in multiple companies but also across multiple sectors can help protect downside risk for an investor.
An important consideration in the VC world is the “Power Law”, which refers to the potential for a small number of investments to generate the majority of returns. This is related to the high failure rate of startups as well as the potential for a startup to generate returns for its investors that could be 10x or more of the original investment, which is often described as a “home run” or an investment that could “return the fund”. Accessing the potential of the Power Law requires investments in a number of different startups.
The opportunities available today for accredited investors and advisors to diversify their portfolios out of straight stocks and bonds have never been greater. A new approach is now accessible and available to investors to reinvent the old-fashioned portfolio structure. At Propel(x) we like to call this approach the EBA Portfolio, because it includes the key components of Equities, Bonds, and Alternatives.
Instead of the traditional 60 / 40 portfolio structure, this modern strategy is more like 60 / 30 / 10, which in broad terms means allocating 60% to Equities, 30% to Bonds, and 10% to Alternatives. The percentages may vary by portfolio, but the key idea is that Alternatives could be an integral part of a portfolio, in some percentage. The reason for doing this is to access the high-growth opportunity of quality Alternatives.
Propel(x) does the hard work of sourcing and screening deals, which involves hundreds of hours of work to find potential quality startup investment opportunities. We provide investors with an angel investing platform that is simple to use, and we perform due diligence on all the startups that are listed on the platform. We negotiate terms and deal allocations with reputable co-investors.
A key advantage of angel investing with Propel(x) is that we allow small investments, starting from as low as $5,000. The majority of startups will not accept small investments, with many requiring $25,000 or even $100,000 as a minimum investment. Propel(x) aggregates investment funds from a number of small investors into a syndicate investment via a Special Purpose Vehicle, thus providing individual investors with the opportunity for Venture Capital investments that may otherwise be out of reach.
Example of a Diversified Portfolio with Venture Capital (hypothetical)
Following on from the discussion above, it’s important that a diversification strategy be adopted when getting involved in Venture Capital investing. Investing in a number of companies over an extended period is advisable to spread risk and increase the potential for returns. It is also important that a portfolio view be taken with any VC investments, i.e. that VC should form only a small component of “high-risk” investments in an overall portfolio.
The following provides an example of a hypothetical diversified portfolio incorporating Venture Capital:
An accredited investor with $2million in their portfolio decides to utilize the EBA Portfolio approach and add alternative investments into the mix by investing in startups. They recognize that quality investments and returns take time and that diversification is important, so they decide to allocate 10% of their investment funds to 20 startups over a 5-year period, with the intention to hold the investments for up to 10 years. This approach means a total Venture Capital investment of $200k across 20 companies.
Without going into too much detail here (we’ve got lots more information on our blog), depending on an investor’s particular requirements, it can be a good idea to allocate some investment funds to an initial investment, and retain some funds for follow-on investments (follow-on investments can become available in subsequent funding rounds if a company does well in its initial stages). So, this hypothetical strategy might involve splitting the funds into 50% for initial investments and 50% for follow-on investments, i.e. $100k each in this example.
Based on the above, this strategy would involve deploying initial investments of $5k each across 20 startups over 5 years, supplemented by another 20 follow-on investments of $5k each. Provided the startup investments are across a range of sectors and stages of company operation, this would represent a diversified portfolio with Venture Capital.
As noted above, it’s important to remember the power law and that some of the startups will fail, but others may be a home run that could provide strong returns.
Portfolio diversification is an important concept that has the potential to reduce risk and improve returns for investors. The Propel(x) Venture Capital platform provides accredited investors with the opportunity to diversify their portfolio with quality alternative investments.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.
This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.
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