Investing in startups? Here’s why portfolio size matters.
Creating consistent returns from venture investing is challenging, but there are definite strategies that can optimise your portfolio and reduce the chance of loss.
One question that is commonly asked is, how large should a portfolio be? You’ll find that the majority of funds aim to build a portfolio of anywhere between 5 and 15 investments on the basis that this small selection are hand-picked unicorns-to-be.
Unfortunately, probability dictates that in most cases, they won’t be. As investors know well, most startups fail within the first five years. What they might not know is that, according to research from Cambridge Associates, fund managers pick winners only 2.5% of the time. More than a decade of data reveals that out of more than 4,000 VC investment rounds annually, the top 100 generate between 70 and 100% of industry profits.
There is a more effective approach which draws on our findings about annual growth in the startup market as a whole, which you can read in full in our whitepaper.
In short, the UK startup market sees consistent annual growth, but the average annual growth of most UK VCs is much lower. How can funds go about more effectively capturing the annual growth of the market?
One part of the answer is: build larger portfolios.
We simulated the performance of portfolios of 10, 20, 30, 40, 50, 60, 70, and 80 investments, running each selection 10,000 times, then analysing the mean returns and variation of returns measured.
Our analysis showed that as the number of deals in the portfolio increased, the mean growth approached the mean of the cohort. Similarly, the variance of portfolio growth decreased as the portfolio size (sample size) increased. Simply put - the larger the portfolio, the more closely its growth will come to the overall growth of the UK startup market as a whole.
A larger portfolio reduces growth variance, minimises the chance of losing capital, and improves the odds of a 3x return.
It was on the basis of these findings that SyndicateRoom’s approach, and our fund, Access EIS, was built. We selected 50 deals a year as a starting point for building our portfolio - it represented a balance between how many deals we could initially complete whilst reducing the variation of growth significantly. When these 50 deals are combined across three years to build a portfolio of 150 deals, we find that the probability of losing capital is significantly minimised (but will never be 0), whilst the odds of returning 3X of cash invested is higher than 50%.
There is more to it, of course. Replicating the growth of the market requires access to as broad a selection of deals as possible, and our analysis showed that if access to the top deciles of the population was not possible, this could have a marked effect on growth. We will explore this issue, and how our model was built to solve it, in a later article. But for the next time you are pondering the question, how large should my portfolio be, based on our research, the answer is: the larger the better.
Visit our website to find out more about our fund, Access EIS, and investing in startups.
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