The Diversification Paradox
Modern Portfolio Theory is an investing framework that paradoxically maximizes returns with correspondingly low risk. While counterintuitive, it is accomplished primarily by deploying a diversification strategy. Astute financial advisors build client portfolios that consist of a range of securities that at very least differ by type of instrument, industry, and geography in order to achieve optimal diversification.
As part of a prudent diversification strategy, conventional wisdom is that 5-20% of a total portfolio should consist of alternative investments - asset classes other than traditional stocks, bonds, REITS (real estate), and cash. They include precious metals, art, derivatives, private equity, and venture capital.
But let’s take this a step further. In addition to diversifying your overall portfolio by including alternative investments, the alternative investments themselves can (and should!) be diversified to further minimize risk and maximize returns. Early stage investing is an exciting alternative investment that warrants strong consideration as it is proven to be a top performing asset class when multiple investments are made to mitigate risk.
This type of investment also has the added bonus of not correlating with public stocks (correlation coefficient of .04% for those mathematically inclined, according to Chen, Baierl, Kaplan, 2002). So investing in early-stage companies actually helps de-risk your overall portfolio.
Don’t just take it from me:
“Diversification is a central strategy of many of the leading investors in private equity." Ryan Caldbeck, Contributor to Forbes, Feb 2014.
“Most investors opting into startup investing…should make at least 10 investments. Diversification can reduce the impact of negative events within your startup portfolio." Christopher Steiner and Alexander Mittal, May 2016,
David Rose wrote a book about angel investing where he counsels investing in 12 to 15 companies to generate the best return. Robert Wiltbank in a report entitled, “Siding with the Angels”, recommends investing in 10 early-stage companies.
I could go on quoting years of research that supports having a well-diversified early stage portfolio and you may want to take a look online yourself, as many academics and investment gurus offer their opinions on the subject.
Judging by their conclusions, it appears as though a portfolio of 10 or so early stage investments constitutes appropriate diversification. Therefore, it follows that you should only invest a maximum of 10% of your total early-stage asset allocation to any given deal. It may take you a couple of years to be fully invested; however, you are putting the chances of being rewarded with outsized returns on your side.
At Brightspark we invest in a fully diligenced deal every few months and invite our community of individual investors to co-invest with us. Currently, we are seeing greater opportunities than ever before in our 20-year history. And, in our opinion, there is no other asset class that can outperform prudent early-stage investing. Where else can you get a 500X return as early investors gained from Twitter?
To recap, by investing in multiple deals, you are paradoxically increasing your return potential and decreasing overall risk. While we hope that you will find Brightspark deals attractive for your alternative asset portfolio, you can certainly find early-stage opportunities from other sources as well. Either way, you should be rewarded with great returns with a diversified strategy.