One of the most common questions I get about startup investing is, “How much of my portfolio should I invest?”
It’s an important question, especially because of a law that’s going into effect later this year…
When it passes, everyone will be able to invest in privately held startups online. For as little as $100 worth of equity.
It’ll be kind of like the popular crowdfunding site Kickstarter. But you get equity instead of rewards. In a few years, it’s going to be a very big deal, mark my words.
Startup investing is already happening online, but only for “accredited investors” (as defined by the SEC).
And let me tell you, it’s groundbreaking. There are excellent deals to be found, and the market’s growing by around 700% a year.
But once this goes live for everyone, some are likely to overdo it. Put too much in. Not diversify. Not do enough research. And lose money.
Don’t get me wrong; startups can be extremely lucrative investments. There’s nowhere else you have a reasonable chance at making 500 times your principal. Having the highest potential reward simply carries some risk…
That’s why it’s important for most people to limit their portfolios’ holdings of startups.
Conventional Wisdom, Right for Once?
They say you shouldn’t put more than 5% of your portfolio into early-stage companies… 10% maximum.
Convention certainly isn’t always right, but in this case it makes sense for most people.
The real answer, of course, depends on an individual’s situation. For example, it’ll differ depending on how long the person has until retirement. Or if they’re already retired.
Those lucky enough to be young and wealthy could probably afford a little more risk – as long as it’s a nice, diverse portfolio.
The bottom line: Don’t invest money you can’t afford to lose in startup companies. There is risk here.
With proper diversification – and selectivity – those risks can be minimized. And the chances of hitting a home run can be increased.
As I wrote a few weeks back, “Don’t fall in love with a pitch. Great ideas are a dime a dozen. Building a solid foundation around that idea is 99.5% of the challenge.
“Ask yourself a question: What makes this opportunity special? What gives these founders an edge?
“No matter how amazing – and unique – an idea sounds, I always assume there are five credible direct competitors. For crowded fields like food delivery and smart lighting, make it 50.”
That’s the single most important thing to remember in startup investing. No matter how much you love the concept, don’t invest just because it seems like a big idea. And if there aren’t competitors yet, there will be.
It’s just one aspect of being selective while investing in startups. For a more thorough read on how to be selective, click here.
Compared with stocks, building a diverse portfolio of startups is a different animal altogether.
With stocks, you diversify by sector and market cap. Relatively straightforward.
With startups, you want to think about portfolio diversity in a different way. The primary reason to spread your bets out here is because many companies won’t survive long enough to IPO or be acquired. It’s an unavoidable part of early-stage investing. Some companies will fail.
But if you do it right, some will thrive. And grow to be large, publicly traded companies one day. Or get acquired by a larger rival.
Returns in this world are driven by home-run investments: the ones that return 10 times to 100 times your initial investment. Unless you’re very lucky, it’s unlikely you’ll get one of these without enough diversification.
Here are the key strategies summed up:
- Invest in no fewer than 10 to 15 startups to increase the chance of one hitting it big.
- Invest over the course of a few years, as the market is more cyclical than stocks.
- Invest in companies that save users money, since they’ll do well in the event of a recession.
Funds that allow you to invest in many startups at once are another good option. You can read more about startup funds in these previous articles:
Proper diversification – and selectivity – is critical to successful startup investing. But it’s not a magic bullet. Which is why it’s important to start slow, learn as you go and limit startups to no more than 5% to 10% of your overall portfolio.
If you do all these things, there’s a great chance you’ll be rewarded.
Founder, Early Investing
P.S. In a few weeks, Andy and I will be speaking at the 17th Annual Investment U Conference. We’re going to share exclusive insights into the world of online startup investing with more than 400 attendees. If you can’t make it to Florida, you can still view our presentations through a live-streaming feed. Click here to learn more.