It is extremely hard for even the most skilled investor to predict which start-ups will succeed and which will fail. For every incredible start-up success, there are many more companies which lost their entire investment even though they looked like clear winners at the time.
Therefore, similar to index investing in public stocks, the safest way to invest in start-up companies is to hold a large and highly diversified portfolio of companies across a range of industries and development stages.
Larger Portfolios Improve Expected Returns
Studies using Monte Carlo simulations, suggest that larger portfolios of well chosen companies can increase the expectation of positive returns.
Venture Capital has Low Correlation to Stocks
“The correlation between Venture-Capital investments and large-Cap stocks is very low, consistent with the notion that the risk of venture capital investments is almost entirely from unsystematic risk (or investment specific risk).
Because of their low correlation with public equity, venture capital investments can be a good diversification tool for an all-equity portfolio.”
Source: Peng Chen, Gary Baierl, Paul Kaplan “Frontiers of Modern Asset Allocation” Wiley and Sons 2012
Venture Capital vs. S&P 500
Correlation Ventures created this study of S&P 500 returns compared to Venture Capital returns from 2003 to 2012.
Combining Venture Investments with the S&P 500
Since start-ups have a low covariance with other asset classes, an “efficient frontier” of possible risk-return outcomes can be created by mixing varying percentages of Venture Capital and stocks (e.g. the S&P 500 Index).
The Rise of Alternative Investments
The ability to potentially increase returns has fueled the global interest in increasing the percentage of alternative investments in both institutional and retail portfolios.
A recent study by the global consulting firm McKinsey reports that alternative investments now represent 16% of global institutional portfolios and 9% of global retail portfolios.
Source: McKinsey “The Mainstreaming of Alternative Assets” June 2012