When contemplating an investment in a new business venture, investors typically do not consider a private investment in a technology startup as a risk-minimizing activity. However, within a given portfolio, an investor can maximize return for a given level of risk by diversifying among several uncorrelated asset classes. Taken in this context, venture capital investing, while in isolation a risky investment style, can provide enhanced returns at a given level of risk. While a well-diversified portfolio can reduce risk, it does not ensure a profit nor does it guarantee against a loss.
Illustrated graphically, Harry Markowitz, a pioneer of modern portfolio theory, introduced the efficient frontier in 1952 as the representation of the relationship between risk and return in the context of a portfolio of assets. Shown below, the efficient frontier is a set of optimal investment portfolios that offer the highest level of return for a given level of risk.
The distinguishing feature of the efficient frontier is its non-linearity. The degree of curvature of the efficient frontier is due to the covariance, or lack thereof, of the assets within a portfolio. As long as the returns of the assets within the portfolio are not perfectly correlated, the standard deviation of the portfolio must be less than the average standard deviation of the assets. Meaning, as new assets whose returns are uncorrelated to that of the portfolio are added, the relative risk of the portfolio is minimized for a given level of desired return.
Based on modern portfolio theory and the efficient frontier, return is maximized for a given level of risk through asset class diversification. Therefore, adding alternative investments, like private equity or hedge funds, to a traditional portfolio can provide enhanced returns for the same level of risk. The chart below illustrates how alternative investments can impact the efficient frontier. What results is an upward shift in the efficient frontier, providing an enhanced return for a given level of risk, or conversely, a similar return at a lower risk profile.
The principles of modern portfolio theory are not unique to aggregate portfolio management. Diversification is equally important among assets within the same class and especially important when investing in technology startups. When contemplating a venture capital investment, it’s important to consider multiple investment opportunities in an effort to reduce risk across the portfolio. Ultimately, the goal for any investor is to maximize return at a desired level of risk. Diversification of and within asset classes, particularly alternative assets, can enhance portfolio returns while reducing portfolio concentration and risk.
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To learn more about diversification read our related blog posts:
Mitigating Risk Through Diversification
Building Wealth Through Pre-IPO Investing
5 Guidelines for First-Time Startup Investors