Is investing in startups the best way to diversify a portfolio?
Diversification means spreading your investments as widely as possible. Not only does this mitigate risk, but also increases your exposure to growth opportunities.
Truly diverse portfolios may have investments spanning several asset classes, as well as geographies and industries. And whilst investors often have their favourite assets, deciding on one asset class as your definitive route to diversification can be counterintuitive.
All asset classes have their individual merits and opportunities for diversification. With it most commonly seen across stocks and shares and property, startup investing can be just as fantastic as a route for the investor looking to diversify - and there are numerous reasons why.
A spectrum of opportunities
The stereotypical attractive opportunity for startup investors is perhaps a tech sector endeavour. Certainly, the lucrative IPOs and takeover deals involving Silicon Valley’s brightest over the last decade or so have turned many people onto enterprise investment.
But as an asset class, part of the allure of startups is that they are abundant in just about every sector. Any industry in the world can benefit from disruption and entrepreneurs are only too keen to make it happen. Backing startups can take you into an array of different sectors, thus bringing added diversity to your portfolio. If one of your investments suffers in an industry-wide downturn, investments in better performing sectors in your portfolio may offset any damage or risk.
The broad range of choices also enables you to pick several firms in the same growth market, increasing the likelihood of what US investors sometimes refer to as the ‘Babe Ruth Effect’.
Baseball legend Ruth was struck out a lot, but conversely was one of the game’s biggest hitters. This is a metaphor for startup investment in that for all the failures that may occur, one home run can deliver exponentially lucrative returns. This is why diversification within the startup portion of your portfolio itself can be so important.
Tax reliefs and incentives for the startup investor
Against other asset classes that enable you to diversify your portfolio, startups have the added attraction of potential tax incentives, particularly for UK investors.
The long-established Enterprise Investment Scheme (EIS) is designed to encourage investments in small, high-risk companies in the UK. For investors, it means a tax relief of 30% of the cost of the shares purchased in the company, set against your income tax liability. With up to £1m of investment eligible for the relief, a tax reduction of £300,000 is possible (without taking into account the higher thresholds for knowledge-intensive companies).
The Seed Enterprise Investment Scheme (SEIS), meanwhile, rewards investors who back even earlier stage businesses. Investors can obtain 50% relief for income tax on the cost of shares, on a maximum annual investment of £100,000 - and both schemes have a wealth of additional reliefs and incentives that are accessible.
Detectable and addressable risks
Each startup investment is usually preceded by extensive due diligence; periods of in-depth research into the business. Key considerations include the management team, business model, target market, money and momentum – often termed the 5Ms of startup investment.
During this process, in which you question every aspect of the company, you may unearth signs of systematic, financial or personnel-related risks. At this stage, you can uncover these risks and either decide not to invest or, if you intend to be reasonably hands-on as an investor, help the entrepreneurs address them.
Startup investing gives you some influence over the performance of your interests. This can be especially beneficial if you choose to back companies in your area of expertise
Stocks and shares do not generally offer any degree of influence to investors, save for the odd vote at an AGM. In their growth journey, the biggest risks to startups may be internal and addressable. For stock market investments, they may be unforeseen and market-wide, and for the latter, your only decision as they approach is to sell up or sit tight.
Economic fluctuations tend to play out cyclically, affecting businesses, individual markets and investments with their every movement. Startups offer a way of diversifying towards a longer-term investment approach.
Realising the management team’s planned exit may take upwards of five years or even a decade. Playing the long game with startups, while your other investments march to the macroeconomic beat of the day, allows you to diversify the timeframe of your investments.
And this is important to understand, as diversification isn’t just about asset types. It’s about adding variety in every sense to your investment portfolio via an effective portfolio diversification strategy. Therefore, assuming you choose your startups wisely, your investment could bring added security, longevity and growth to your portfolio.
Easy to access
While investing in startups means lots of upfront research into specific opportunities, many would argue it requires less specialist knowledge when compared to the likes of stock market investment, for example. Clearly, some experience of what makes businesses successful is useful - so too is a willingness to accept the high risk, high reward nature of startup investment - but as an asset class, it is relatively easy to get started.
The dawn of crowdfunding sites has opened up access even further. Within a few clicks and screen swipes, platform users can build up a portfolio of startup interests, often with micro-investments spread across various industries.
Conversely, exiting startups is not as easy since they are an illiquid investment, but patience can pay off if the startup achieves its exit goal.
Portfolio diversification via startup investing
Startups can be a great way to diversify a portfolio that perhaps already contains other asset classes such as property, stocks and bonds. Sophisticated investors may back 20 or 30 ventures at any one time, giving them a stake in a range of growth opportunities.
According to the Kauffman Foundation, angel investors with their own entrepreneurial success behind them will usually have a “portfolio of conservative investments” to support their retirement and legacy building. They will then allocate a fraction - often between 5 and 15% of their net worth - to startup investments, the organisation reports.
As well as diversification, startup investment brings many additional benefits. Among them is the sheer excitement of being involved in a business as its adventure begins. Also, you may be supporting innovation or the generation of new jobs and opportunities in your area. Many angel investors also enjoy the chance to put the expertise gained throughout their careers to good use.
With anyone looking to add startups to their portfolio for the first time always advised to thoroughly research each opportunity and consider it carefully, get it right and your portfolio could be significantly boosted in the long term.