The importance of diversification in startup investing

The importance of diversification in startup investing

19th August 2016 by Clement Bigot

This article aims to explain the importance of a diversified investment portfolio, but please note that Seedrs does not provide legal, financial or tax advice of any kind, and nothing in this blog post constitutes such advice. If you have any questions with respect to legal, financial or tax matters relevant to your interactions with Seedrs or its affiliates, you should consult a professional adviser.

Diversification is a risk management technique by which investors invest their capital across a number of different asset classes, geographies and industry sectors in order to spread their risk exposure. The idea is, rather than making one big investment and putting “all their eggs in one basket”, an investor makes a number of smaller investments. Diversification is one of the fundamental concepts of investing, and with a diverse portfolio, an investor can lower the risk of losing capital and is more likely to yield a higher return overall on average. Let’s look at the different ways investors can diversify their investment portfolios to increase their chance of investment success.

Diversification is a huge topic to cover, so for the purpose of this post we will look at diversifying within early-stage businesses, such as the ones campaigning on Seedrs. Understanding how risk affects your portfolio, and how to use diversification to reduce it, can be the difference between a successful investment strategy and an unsuccessful one.

We all wish we had invested in Facebook, Uber or the multitude of other so-called unicorns that have emerged in recent years. The reality is, however, that the majority of people and institutions who invested in those businesses have also invested in a broad portfolio of other businesses which may not have been so successful.

To bring the concept of diversification to life, take this very basic example: an individual invests half of their investable capital in an ice cream company and half in an umbrella company. During the summer the ice cream company will be successful and return a profit, but since it isn’t raining, the umbrella company won’t do well. Conversely, during the winter the opposite will be true and the umbrella company will be profitable. In this scenario, the investor has diversified themselves against the effect of the weather on their portfolio.

As you can see from this example, the overall risk of a portfolio is reduced by investing in companies which are not perfectly correlated with each other, which means that they do not influence or depend on each other.

There are a few types of risk that affect a business’s success, but unsystematic risks are the most-easily mitigated through diversification.

Early-stage businesses, in particular, are more exposed to unsystematic risks, where most of the possibility of success or failure lies within the company and is not as dependent on the market as a whole. There are many types of unsystematic risk, but here are a few to be aware of:

  • Execution risk – The business idea may be fantastic, but does the team have the required skills and talent to reach their goals?
  • Market timing risk – Is now the right time for the business? Are they too early or too late to market?
  • Business model risk – Does the company have a clear business model which makes sense to you?
  • Technology risk – Does the company rely on a technology which is still being developed?
  • In addition to considering the risks involved with the business itself, diversification also means looking at the type and number of companies. A diverse portfolio frequently considers these three diversification verticals:

Sector/industry diversification
A well-diversified portfolio holds investments across a number of different industries and sectors. Each sector and industry will move in its own way and have its own relationship with the overall business environment. Some sectors will come into vogue and others will fall out of favour, and this will affect how well the company will do.

Time diversification
To a certain extent, the macro economy will affect all businesses. By investing in companies over a long period of time, an investor can smooth out some of the macroeconomic cycles like a national recession that may increase any business’s risk. This also helps to diversify against changes in the funding climate (in other words, the ability of early-stage businesses to access capital), which can prove very important when companies are looking to raise follow on rounds.

Geographic diversification
Investing across countries allows an investor to tap into different trends, knowledge bases and opportunities which can not only add significant value to their portfolio but can also diversify it to mitigate geographic risk.

If an investor made all their investments in a single country, then changes in government or regulation, for example, could significantly impact their holdings. The investor could also miss out on a boom in a certain sector, for example the fintech sector in London, if they haven’t look further afield to tap into the local talent and specialities of different markets.

It’s important to remember that diversification does not simply mean investing in every single deal an investor comes across; diversification is about ensuring that a portfolio includes a wide variety of investments. One of the benefits of self-directing investments on a platform like Seedrs is that an investor can use their own judgement based on what they like, the products that they buy, or based on trends that you have seen over time. The rise of the alternative finance sector has meant self-directed investment is becoming more popular, and investment platforms like Seedrs are just one of the ways an investor can diversify your profile on their own.

Remember that this post only refers to diversification with regard to early-stage businesses, which in itself should be diversified against with the remainder of your investible capital through investments in other asset classes such as fixed income, real estate or commodities. If you’d like more information on where to best allocate your capital for diversified growth, contact an independent financial advisor.

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Clement Bigot

Investment Associate at Seedrs

Digital Agency Kent