How does diversification apply to startup investing?
Diversification applies to startup investing because past results have shown that the majority of returns in angel investing come from a small subset of companies. Startup outcomes typically follow a Power Law curve where the winners are far larger in magnitude than the other startup investments in a portfolio combined.
In theory, the more you spread your investments out across many companies the more likely you are to hit on a homerun company which should more than offset the losses on companies in your portfolio that fail.
While there is no guarantee that diversifying your startup angel investments will work to make money, the general consensus is that diversifying your startup angel investments should lead to on average better returns when compared to not diversifying.
Fabrice Grinda writes about his investment philosophy with regards to diversification:
“We have a portfolio strategy. Most studies suggest that angels with fewer than 10 investments lose money, while those with more than 10 investments make money. Moreover, the more investments angels make, the higher their IRR as it increases their probability of a huge hit.”
Similarly, Alex LaPrade ran an analysis of potential startup angel investment returns using data from the Kauffman Foundation’s Angel Investor Performance Project (AIPP) and concluded that angel investors should invest in as many startups as possible to be properly diversified.
Of course if you invest in a large number of bad companies, diversification will not save you from having poor returns in your portfolio.
Also, ironically, the more you diversify, the lower your odds of having extreme outlier performance on the profitable side as well. As you diversify, you will tend to regress to the mean. FundersClub seeks to provide a curated investment environment where the mean is profitable (although we have no way of guaranteeing that will be the case), but just as diversification helps you to avoid extreme downside, you also cap extreme upside as well. For this reason, some investors explicitly choose not to diversify. They may still invest in many companies across their portfolio to gain exposure, but may also put substantially more capital into investments they have higher conviction on. This may or may not be a winning strategy (e.g. if your conviction is off from reality, this strategy will hurt returns), which is why most experts simply advise diversification.
For further reading, please see our Investor Guide to Diversification