Startups as an Asset Class

This post is the intro to a series titled Angel Investing & Modern Portfolio Theory Considerations and was originally posted at disruption.vc.

Shark Tank

In 2009 the popular ABC television show Shark Tank took to the the airwaves following the success of the Japanese television showDragon’s Den. Shark Tank, if you don’t know, allows entrepreneurs to pitch a panel of successful investors on why their startup is the next big thing. If they see potential, the Sharks will invest their time and money into helping these businesses achieve success. The show has enjoyed tremendous popularity and produced real results.

AngelList

In 2010, a little site called AngelList launched with the intention of brining startups and investors together. A Thundering Lizard in the truest sense, AngelList is shaping up to be the Nasdaq of our generation and is not only benefitting from trends but creating them.

Evolution of the Startup Landscape

As interest in startups is growing, investing in them is becoming easier than ever. Investment minimums are coming down, data is now accessible, and investment leadership is becoming more available. All of this combined with favorable regulation changes is causing more, and a wider variety, of people to start thinking about investing in startups.

New Meets Old

The question that results from such an emergence of trends, data, and availability is how investing in startups would fit into a more traditional portfolio management approach. How does this asset class perform when considering Modern Portfolio Theory? In other words, how do concepts like diversification, efficient frontier, and correlation respond to the introduction of this new asset class. How should one be working this type of investment into the different stages of the wealth management lifecycle: accumulation, preservation, distribution and transfer.

Framing the Discussion

This is a large and emerging discussion, so it can be tricky to figure out where to start. Perhaps looking at how this new asset class integrates with more traditional investment concepts will be a good way to build bigger conversations.

Monte Carlo & Startups

Monte Carlo analysis is a way of evaluating the possible returns of a portfolio, or asset allocation, over time. The analysis looks at statistical returns and standard deviations of specific asset classes and runs multiple iterations to evaluate the overall confidence of an investment approach. Rich and available public market data makes these analysis fairly easy to conduct with the proper software. For private companies it gets more difficult as performance information isn’t as available. Certain signals like IPOs and acquisitions are helpful but withtransparency increasing these types of simulations will become more useful in understanding risk.

Diversification

Once we understand the risk posture of this asset class it becomes a question of how to get the proper exposure to it. By understanding the possible distribution of returns we can better understand the breadth of companies one would need to own to be properly positioned on the efficient frontier.

This would allow one to answer two questions:

1. How many companies do I need to own in order to have the best chance at a positive return?
2. What does that type of position cost me and is it consistent with my investment risk profile?

Correlation

After understanding how this asset class might fit into one’s portfolio it’s important to look at what its introduction does to the system as a whole. Given a specific timeline for accumulation, preservation, distribution, and transfer of wealth, does the addition of this more volatile asset class strengthen or weaken the overall probability of success.

Going Forward

The result of building these discussions and the public’s increasing understanding over time could be as significant as making investing in startups an option that can be enjoyed by non-accredited investors in risk-appropriate offerings. That type of shift could be rather significant with respect to startups, investors, and innovation in general.

Tweet me your thoughts at @bgadoci.