Diversification: The Proven Strategy VCs Use to Win

Venture capital is one of the most lucrative (and competitive) pursuits on the planet.

Much like in the celebrity world, the most successful VCs live big, flashy lives, full of access and publicity. (In that same vein, Silicon Valley is a bit like Hollywood for startups and VCs.)

The difference is that today, anyone can invest in VC-quality startups—no VIP status required—thanks to the JOBS Act.

The next unicorn is out there, and you don’t have to be rich or well-connected to find it.

As angel investors, there’s a lot we can learn from the world’s most illustrious VCs. Over the next few weeks, we’ll be diving into one strategy in particular: diversification.

Diversification means mixing different types of investments into a single portfolio.

It’s one of the most important ways an angel investor can hedge against risk, which is why many experts advocate for splitting up the total amount you want to invest into as many opportunities as possible.

Before we get into that, though, let’s zoom out and explore diversification as it pertains to an investor’s overall strategy.

Why diversification matters

We’ve all heard the saying, “don’t put all your eggs in one basket” at one point or another. Translated: if you only invest in one or two related asset classes, you run a higher risk of losing everything.

Think about it… if all your money is in the stock market, and a crisis—like a global pandemic, supply chain disruption, or looming world war—sends stocks tumbling, you stand to lose a huge portion of your money.

The most tried and true method of diversification is simple: reduce the impact of market volatility by spreading your capital across different types of securities and asset classes—otherwise known as asset allocation.

A balanced portfolio: a bird's-eye view

A decade ago, most financial advisors would suggest splitting up your investment capital between stocks, bonds, and mutual funds.

Today, there are infinitely more opportunities you can invest in, including real estate funds, startups, crypto, local businesses, video games, and more.

By owning investments that react differently to various market conditions, the overall risk of your portfolio is significantly less than if you were invested in just one or two asset classes.

Everyone’s finances are different, so we don’t recommend basing your exact strategy on anything you read online. If you can, talk to a qualified financial advisor to find the right balance for you.

Diversification between asset classes is Step 1, but it’s just as important to diversify within asset classes, too.

Let’s talk about what that means for an angel investor.

Building a diverse startup portfolio

There are two main reasons why the most successful angel investors have such huge portfolios.

First, diversification is a way to hedge against volatility within certain markets. Think about it this way: if you’ve invested your money into 10 startups, but all of them build consumer gadgets that require computer chips to manufacture, a global, years-long chip shortage might just knock all 10 out of business.

Likewise, if you’re only backing restaurants and entertainment companies, you might take a serious beating if a global pandemic forces brick-and-mortar to shutter its doors.

There’s a flip side to this concept, too; many startups that made it easier to work remotely, get medical care online, and get necessities delivered to our doorsteps saw rapid growth as demand for their services spiked over the past two years.

It’s all about balance—because, let’s face it—we have no way of knowing what’s around the next corner.

Whether the markets are running smoothly or swinging wildly between extremes, any angel investor should still plan to spread out their capital across as many different opportunities as possible. That’s because…

Angel investing is a "hits business"

It’s the “hits” – the big wins that produce the lion’s share of an investor’s returns that make the game worth playing.

Investing in private companies can be risky. Early-stage startups typically don’t have the entrenched infrastructure, brand recognition, or decades of experience that keep many of the world’s biggest companies in business.

Yet the startups that do make it big—the Ubers, Airbnbs, and Palantirs of the world—can produce the types of ROIs that gigantic companies are highly unlikely to see. For many of those behemoths, most of that growth is already in the rearview.

In order to have the best chance at a “hit,” many angel investors divvy up the total amount they want to put into startups into multiple smaller portions.

Let’s play out the potential outcomes for a 10-startup portfolio. Over the course of five or ten years, we might see:

• Four of those investments go to zero, or return just a portion of your money

• Three of them break even and give you back what you put in

• Two of them have modest exits, returning 2-4X to investors

• And one explodes in value – returning 10X, 20X, or even more.

Of course, that’s just a hypothetical scenario. According to Christopher Mirabile of Launchpad Venture Group, it’s “anyone’s guess” how many investments is the magic number to own, because “every portfolio is a snowflake.” 

However, he says that new angels should shoot for an absolute minimum of 10 investments to achieve baseline diversification.

A study by the Kauffman Foundation shared similar findings, reasoning that out of ten angel investments, just one or two on average will provide most of the return for the portfolio, with a 10-30X return expected on these investments.

 “With a small fraction of investments providing the bulk of the reward, angels need a significant number of diversified investments to optimize ROI. Angels with only two or three investments are managing risky portfolios indeed!”

William H. Payne Entrepreneur-in-Residence Kauffman Foundation

In short, to hedge against risk and maximize your chances of success, make sure you have a plan to diversify – both between and within asset classes. 

You can find investment opportunities in many of them here, including real estate, startups, crypto, video games, and more.

When it comes to your startup portfolio, aim to spread out your risk across as many opportunities as you can. Ten is a great goal to start with; more is statistically better.

Right now, there are more than 75 offerings live on Republic, spanning a diverse array of industries and markets.