Thoughts on Maximizing Your BWA Returns
One of the most fundamental themes in modern finance (something I was teaching at Wharton 40 years ago with what is know as Portfolio Theory. Published in the Journal of Finance in 1952 by Harry Markowitz and validated in angel investing studies, the theory demonstrates that a higher return for any given level of risk can be attained by diversifying your holdings.
Simply put, over time you can expect higher yield by holding $10k in 25 different companies rather than $50k in 5 companies. Concentrated investing in early stage companies has been found to produce lumpy returns.
From a pure financial point of view, we have done a pour job supporting this vital principle. Last week, as we reviewing BWA’s investments we found a very serious imbalance with two or three companies seriously over-weighted. A large number of our investors have half their angel portfolio in one company. While we love to get big checks when we’re raising funds for a new deal, each investor should give serious consideration to their angel holdings.
The best angels start with an allocation from their overall savings and look at this portfolio. If you target invest $250k over the next five years you could put $10k in 25 deals and have a well diversified fund. Starting with a deal you like and putting in $50k creates a much higher risk .
This is how the Angel Capital Association views diversification for Angel Investors: http://www.angelcapitalassociation.org/data/Webinars/2016%20Slide%20Presentations/ACAWebinar-PracticalApproachestoDiversification-FINALJune9.pdf
One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification – chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.
For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls “risk”.
The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.
In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one’s nest egg. (To learn more, see Introduction To Diversification and The Importance Of Diversification.)