Mailbag: Commit or Go Home

Q: What’s the very first thing you need to consider before you start investing in startups?

A: Let’s start with a couple of assumptions. I’m going to assume you know that startups are more risky than most assets in your portfolio. I’m also assuming you know there’s more upside to startups than most assets in your portfolio. Those are important things to take into account before beginning your startup investing journey.

But in the spirit of you asking for something less obvious, I’m going in a different direction.

The most important thing to consider before you start is commitment. Investing in startups is not like investing in public stocks. Historically, the S&P 500 returns between 8% and 10%. That’s pretty good. Professional stock pickers might help you get bigger gains. But investing in startups can be far more lucrative – if you can tolerate the risk.

Private startups either fail miserably or succeed spectacularly. Success is measured on a scale that doesn’t even apply to public investing. Instead of hoping for 30% or (if we dare) 50% gains from our public stocks, we aim for at least 200% gains from our startup stakes. And 400% to 900% is easily within reach for those startups that hit it big. The difference between 30% (a great gain for a public stock) and 200% (a muted “spectacular” gain for private startups) is one whole order of magnitude.

When startups fail, it means they go under. It’s not uncommon. Failure in public stock investing (unless you’re investing in microcaps or penny stocks) means the price has dropped by 5% to 25%. Big difference.

Another thing to keep in mind…

Startups that succeed spectacularly aren’t exactly a dime a dozen. Out of a portfolio of 10 to 20 holdings, one to two big winners is a reasonable expectation.

So if you just invest in one, two or five startups, your chances of holding a startup headed for spectacular success is slim. You need a portfolio of at least 10 startups. Fifteen is better. And 25 is better than 15. The limit is how much you can afford and how many companies you have time to follow.

You should have, from the beginning, a commitment to invest in at least 10 startups. If you can’t, for whatever reason, it’s best to stay away from startup investing. It’s not for you.

+ Andy Gordon, Co-Founder, Early Investing

Q: Do you think pot stocks have finally bottomed?

A: The largest cannabis ETF is now down 59% since its highs in March (it’s down 39% for the year). But I do believe that the pot stock correction is probably done or close to it. Cannabis stocks have jumped higher this week, probably at least in part due to the House Judiciary Committee approving a bill that would lift the federal ban on weed.

It’s great to see that Congress is finally getting the message that two-thirds of Americans want cannabis legalized. But this is the U.S. Congress. So we shouldn’t get our hopes up for federal legalization just yet.

Still, this is a fast-growing industry, and it’s just getting started. I’m looking for bargains in this environment.

There are some caveats to my argument that the industry may be bottoming.

First, I’m more comfortable with U.S. pot stocks than Canadian ones at this point. In Canada, you can sell cannabis across almost the entire country, and the market is more mature and competitive. In the U.S., each state is its own little cannabis kingdom, and you can’t ship outside state lines (legally).

Some states have oversupply (Oregon); some don’t (Maryland). The prices are a lot higher in places where there’s undersupply. So on average, I prefer U.S. stocks, specifically ones selling in states with more tightly controlled markets.

My second caveat is that this is a retail investor-dominated market. There’s never been such a large and fast-growing industry without institutional (big financial firms) participation. This means the market is extra volatile. It will overshoot on the way up and on the way down.

Dollar-cost averaging is a great tool to use for such a volatile industry. Buy the same amount of stock periodically (once a week or month usually). In my view, now is a great time to get started.

+ Adam Sharp, Co-Founder, Early Investing