For investors looking to mitigate overall risk in their investment portfolio, investing in startups can be a potential diversification strategy. With such a high rate of failure, investing in startups may seem counterintuitive; however, when balanced with a portfolio of traditional assets, a modest amount of startup investments may reduce overall portfolio risk by moderating the potential for higher correlation between certain asset classes within a given portfolio.
So, investing in startups can be a viable diversification strategy. But now much of your investment portfolio should actually go toward startups?
Finding the Sweet Spot
To help mitigate risk, investors should aim to balance their portfolio by spreading risk across multiple investments; i.e. avoiding putting all your eggs in one basket. By spreading your startup investments across many different startups, you’re ensuring that the startup allocation within your portfolio isn’t reliant on just a few investments to turn a profit. Further, while you can’t completely remove risk from the picture, taking this approach can reduce intra-portfolio correlation and help to mitigate overall portfolio risk.
Of course, the individual investments you make are crucial to the success of your portfolio, but the way you allocate your investments across different assets also plays a major role in the success of your investment portfolio.
Asset allocation is a strategy that involves adjusting the percentage of each type of asset in your portfolio based on factors such as your age, risk tolerance, investment time horizon, current financial situation, and investment goals. The aim of employing an asset allocation strategy is to balance the potential for risk and reward by recognizing that different asset classes have varying levels of each.
Although venture capital investing is considered to be a high-risk strategy, the performance of pre-IPO companies is usually uncorrelated with that of traditional assets like stocks or bonds. So, although they are riskier assets in general, they can help to mitigate overall portfolio risk when added to a portfolio that is already heavy in traditional asset classes like stocks and bonds.
Now, it’s easier than ever to diversify your portfolio with an array of asset classes. The key is finding the right mix of how much you want to devote to stocks, bonds, and real estate, or others like VC and crypto.
How Many, How Much?
The percentage of your portfolio that should be allocated toward startup investments to achieve optimal asset allocation depends on multiple factors, including your personal risk tolerance and investment time horizon.
Theoretically, we wouldn’t recommend allocating more than 2% to 10% of your investment portfolio to startup investments and the actual amount depends on how much risk you are willing to take. Within that portion, many investors try to build a startup portfolio where they balance it our between early and later stage companies.
Choosing Your Investments
When selecting your investments, it’s important to assess and manage your risk and investment time horizon. Aside from investing in companies that have high growth projections, are scalable, and are turning a profit, you can mitigate risk by:
- Diversifying within your startup investments
- Investing in startups that have been pre-vetted
- Investing in startups in industries you understand
It’s important to note that startup and pre-IPO investing is a long-term commitment. Such investments are considered illiquid, meaning they have immediate restrictions on resale and/or transfer. Even after those restrictions have expired, it may be difficult, or even impossible, to find a market in which to sell these securities. You should plan to hold them in your portfolio for years as the company works towards a potentially successful exit.
Risk & Reward
Again, something to keep in mind when it comes to divvying up your portfolio assets is your personal risk tolerance. For risk-averse investors, portioning a more modest 1-3% of your assets to startup investments may be more prudent. For investors with a more aggressive risk tolerance, 5-15% may be suitable. As always, the higher the risk, the higher the potential reward.
When it comes to investing, especially when investing in startups, there is no guarantee of success. But when implemented as a part of an overall investment strategy, investing in early-stage ventures can help to reduce your overall portfolio risk with the potential for high reward in the long-term.
The information provided is for general informational purposes only, and should not be considered a solicitation to effect transactions in securities or personalized investment advice. Each investor needs to review an investment strategy and their asset allocation for his or her own particular situation before making any investment decisions.