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What is the "Portfolio Effect?"

Posted by Erica Duignan Minnihan on Jul 6, 2016 12:33:57 PM

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The “portfolio effect” is the decrease in overall risk in a portfolio of high-risk, but relatively uncorrelated assets. In venture investing, it typically refers to the strategy taken by experienced investors of investing smaller amounts of capital into a fairly large number of startups, rather than putting all of their capital into one or two companies.

It is often very hard to predict exactly which of a group of high growth potential startups will end up as the “winner-that-takes-all”, so better risk-adjusted returns can be achieved by investing in a portfolio of 30 high quality companies over time. Even 5 small investments per year is enough to make a significant difference in the expected returns.

Many startups fail, and the returns to investors are often binary, meaning you tend to either get a high multiple return at an exit, or you don’t get much of anything back at all. The portfolio effect gives you a better chance of mitigating the losses generated by the relatively high percentage of failures, with the outsized gains generated by your successful investments, which can reasonably produce up to 10-100x returns on investment over time.

The portfolio effect can help improve the performance of your overall portfolio when you add uncorrelated assets to your holdings. So if you already have significant investments in assets like, cash and equivalents, fixed income, bonds, real estate, and public equities, adding a small amount of venture investments to this mix could help enhance overall expected returns.

However, as with most investments, make sure that you can afford to withstand the loss of whatever capital you allocate to higher risk investments in your portfolio. Experts suggest no more than 5-10% of your portfolio should be allocated to high-risk, illiquid, alternative assets. But if you can afford to allocate a reasonable amount of your overall investments to this asset class, the “portfolio effect” can help you meaningfully increase your expected risk-adjusted return.

Topics: Invest in Startups