How to Manage a Venture Portfolio
Exploring the math behind diversification and how it impacts investor returns. Plus, my theory on the ideal number of investments and check sizes.
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How to Manage A Venture Portfolio
Poker has taught me a lot about bankroll management. I’ve learned the hard way how important it is for one’s long-term success. As I now remind my clients, you can be the best poker player in the world, but you will (eventually) wind up broke if you don’t manage your capital correctly.
I can now lecture because I’ve made just about every mistake in the book. People told me this when I was first starting out, but of course, the brash 21-year-old who won $1,000,000 in a year didn’t listen.
Naturally, I learned the lesson only after losing most of that money back and having to rebuild my bankroll from scratch.
Poker and Angel Investing
When I got into angel investing, I was determined to avoid the mistakes I made in poker.
The game has taught me that no matter how confident I am, there are things beyond my control. That is why I believe it’s almost always correct to diversify your bets, hedge your risk, and only invest what you can afford to lose.
Notably, humans are risk-averse, and the pain of losing is almost always greater than the joy of winning. Therefore, protecting downside risk is particularly important as losing money has a negative compounding effect.
In addition to bringing unwanted stress, losing can make it harder to make objective decisions, leading people to chase, which only furthers the loss.
While it seemed intuitive that diversifying would entail less risk, what I didn’t know when getting into investing was that it also leads to higher returns.
The Unknown Power of Diversification
The following is a summary of a post by Kevin Dick of Right Side Capital.
Let’s play a game.
I give you two options:
You invest $10,000 today, and I guarantee to return you $30,000 in 4 years.
We roll a six-sided die. You wager $10,000 that you can pick the correct number. Guess right, and I pay you $200,000. Guess wrong, and you lose everything.
Although #2 has a slightly higher expected value (EV), most would choose Option #1 due to the risk aversion principle I outlined above.
What most don’t know is that through the power of diversification, you can transform the risk of Option #2 into the certainty of Option #1 without sacrificing expectation.
How Diversification Helps You Avoid Losing
If you roll the die once, your chance of total loss is (5/6) = or 83%. However, roll it ten times, and your chance of losing everything is a mere 16%. The more you roll, the lower your risk of loss.
The following graph shows how the chance of total loss rapidly approaches zero as the number of rolls increases.
At 50 rolls, the chance of total loss is ~10,000:1. By 100 rolls, it’s ~100,000,000:1.Â
How Diversification Earns You More Money
Okay, so you’re convinced diversifying will help you avoid going broke, but can it also earn you more in the process?
The next graph shows the probability of getting back at least 3x your money. The number of rolls on the horizontal axis progresses exponentially.
One great thing about math is that it doesn’t lie. This model proves that given enough rolls, tripling your money is a near certainty.
At 1,000 rolls, your probability of at least tripling up is 93%. (And with that many rolls, losing all your money is impossible).
At 10,000 rolls, the odds of doing anything less than tripling your money is 365,000:1. (For comparison, your chance of getting struck by lightning in a given year is 200,000:1).
Key Takeaway: If you have the opportunity to make profitable high-risk, high-return investments, like those typically found in venture capital, your #1 priority should be how to diversify.
Notably, this assumes all the bets one makes have a positive and equal expectation, and that every check size is the same amount.
The Optimal Number of Check Sizes
The next question becomes, how many checks should I write? Like most things in life, the answer is, it depends.
While there is no one-size-fits-all, I can give you a framework for how I believe one should think through this. And I think it starts with who you are and what your objectives are.
Venture for Professionals
Prfoessional investors, or fund managers are akin to professional poker players. Losing is simply not an option, and therefore, professional fund managers essentially have to make enough investments that they virtually guarantee a return for their LPs.
How many investments? Again, pulling from the work of Kevin Dick at Right Side Capital, here’s what the math says.
It takes a minimum of 15 investments to have a 90% chance of breaking even. Of course, that’s not very compelling if you’re managing a fund.
For a 90% chance of doubling your money, it takes 70 investments. Not bad.
For an 80% chance of tripling your money, it requires more than 200 investments. I believe that’s about where you want to be.
Naturally, all fund managers are different, but I believe most would like to be tell LPs they are very confident (more than 80%) that they can triple their money over the life of the fund. Being able to prove that using math is very convincing.
The irony is that very few funds aim to make this many investments, precisely because it requires more admin and work. Many funds do a mere 40 investments, which puts them at just above even money to return 3x.
I’m not a gambler, but if I were, I wouldn’t be jumping to take that risk-reward proposition.
I believe this approach is a novel way to approach venture. It’s even an opportunity to attract like-minded LPs.
Venture for Non-Professionals
I classify a nonprofessional as anyone not managing a fund or other people’s money.
This doesn't mean they’re not a savvy and profitable investor, but rather the risk-reward calculation is different when they’re answering to LPs.
The most notable difference between pros and part-time investors is their portfolio construction.
Since a professional presumably has a much higher percentage of their net worth in venture, and they manage other people’s capital, they must show a profit. The best way to do this is to diversify.
An amateur, on the other hand, doesn’t need to guarantee a certain profit in venture, since they ‘should’, in theory, only have a discretionary amount of money allocated to this asset class.
Venture Portfolio Construction
Before we outline the optimal number of check sizes, we have to understand how to construct a reasonable venture portfolio.
The predominant question here is, what part of one’s portfolio should be in venture in the first place?
Like always, the answer is, it depends. I’m going to assume most non professionals don’t have the risk profile to have a huge amount of their net worth in start-ups, where their capital is locked for 10+ years.
I’m also going to assume most people invest in other noncorrelated asset classes, such as stocks, real estate, bonds, crypto, etc. Therefore, the average investor may only allocate something like 10% of their investible portfolio toward venture.
Let’s play this out.
For simple math, we’ll assume John has a $1M net worth, and wants to allocate $100,000 toward venture.
Regardless of how many checks he decides to write (more on that in a minute), let’s focus on the impact of this $100,000 on John’s overall portfolio over the next decade (the time it takes for him to make all of his venture bets).
If we conservatively assume John will double his net worth in 10 years, his total portfolio is $2M. Even in the absolute worst-case scenario, where every VC investment he makes goes to zero, his max downside is $100K, or 5% of his net worth. While it’s painful to lose money, in practicality, this won’t affect him much.
The most important consideration for how much risk one can take in venture is how their venture allocation compares to their overall net worth. The less impact it has, typically due to the smaller overall allocation, the more aggressive one can be.
This is good news, because it means non professional investors can compensate for their lack of diversity through careful overall portfolio construction.
Although I cannot give financial advice, this is why I personally believe allocating smaller amounts to venture is a good option for most non professionals. It takes the pressure of needing the start-up to succeed and allows them to bet more aggressively on the investments they make.
Diversification for Non Professionals
Naturally, diversification is a challenge if you’re investing part-time. Let’s do some simple math to illustrate this.
Assume John wants to make 100 investments over the next 10 years. That’s 10 investments per year or roughly one per month. That means John would have to look at 20 or so deals per month to pick one that’s investible.
Where will he get that type of quality deal flow?
Remember that diversification only makes sense if each bet has the same expectation. It’s not a license to pick poor quality deals, just how in poker, playing more hands for ‘balance’ only makes sense so long as they are all profitable. Otherwise, it’s better to simply fold.
I believe a more reasonable number of check sizes is 50. According to the model, that puts John at nearly 100% chance of at least returning his capital, which protects his downside risk.
For a part-time investor allocating roughly 10% of their net worth toward venture, this seems like a good risk reward.
That puts John at 5 bets per year over a decade, which is much more manageable.
How Non Professional Investors Can Easily Diversify
Finding high quality venture deals can be challenging. This is why it may make sense for non professionals to join a syndicate.
It’s a great way to look at pre-vetted deals within a niche you know and like. The deals come to you and you have the choice of which ones to invest in. Platforms like AngelList make this a breeze.
My syndicate, WHealther, focuses on early-stage start-ups in the health and wellness space, as well as web3. It’s focused and niche, and gives investors access to certain types of start-ups they wouldn’t find elsewhere.
The Optimal Size of Your Checks
The final variable of the equation is the size of each bet.
At the outset, it may seem like one should divide their allocation (for John, it’s $100,000) by their desired number of bets (in this case, 50) to determine their proper check size.
In our example above, this would put John at $2,000 per bet. This is another reason why joining a syndicate is helpful, because with such a small check size, John is never going to go directly to the company. In my experience, a start-up typically wants a $50,000 check size or greater.
However, this math is a bit deceptive and also inefficient. It doesn’t make sense for John to allocate $100K to venture and leave it sitting in cash for the next decade.
Second, John is likely in his prime earning years, which means his net worth will grow while he is planting his venture seeds.
Therefore, it would be prudent for him to use a bit of forecasting to determine how much he will earn and save (increase his net worth) while he is investing in start-ups.
For example, if John earns $200,000 a year, and saves $100,000 of it, his net worth will conservatively be $2M in a decade. If his other assets appreciate it may be closer to $3M. (He bought Bitcoin, right?!)
Working with the $3M net worth figure, John will deploy $300K to venture. At 50 investments, that’s $6,000 per investment.
That means John has $100K/$6K or 16 potential investments he can make right now. He may want to lay the groundwork, hustle a bit, and knock that out in 24 months.
Each year, he’ll set aside some part of his savings to replenish his venture portfolio, eventually getting to the cruise control pace of 5 or so bets per year.
Put another way, each bet John makes will represent $6K/3M, or 0.2% of his net worth. Naturally, this is quite conservative. What you ultimately decide will depend on your personal situation.
Venture Check Size Formula
Here’s a simple framework and formula you can use to determine the appropriate check size for your individual situation.
Questions to Answer:
1. What percent of my overall portfolio do I want to allocate toward venture?
2. How will I feel if I lose the majority of this allocation?
3. How much time do I have to allocate toward venture?
Once you are clear on the above, you should have an idea of your risk tolerance. The more risk-averse you are, the smaller your ideal bet size and the more investments you should consider making.
Here are the variables to consider to figure out your ideal check size.
1. Time Horizon to Invest: (10 years is a good starting point).
2. Number of Investments to Make: (Default is 50).
3. Percent of Portfolio to Allocate: (Average is 10).
4. Future Net Worth: (What you expect your net worth to be when your time horizon expires).
Investment Size = Future Net Worth / # of Investments x Percent of Portfolio in VC
For example, if your future net worth is $3M, the # of investments you want to make is 50, and you’re allocating 10% of your portfolio to venture, here’s how that would look.
Investment Size = 3M / 50 x 10%
Investment Size = $6,000
Final Thoughts on Venture Capital
I love venture capital and believe it has a special place in managing a portfolio. It takes a certain type of risk profile and temperament to bet on start-ups, but there’s an energy and excitement there that’s rarely found elsewhere.
Regardless of how you construct your venture portfolio, I believe planning ahead with the exercise above (or some variation of it) is prudent before making venture bets.
It’s not only fun and exciting but will leave you feeling more in control of your portfolio and future.
Once your ideal portfolio is constructed, you get to the fun part, making bets. In my next article, I’ll share how I find my deal flow. If you’re not already, subscribe to be notified when it drops.
I hope this article served you. If you found it helpful, please share it far and wide.
Alec