The math behind diversification in Venture Capital

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This week we’ll be diving into the role math plays in structuring a portfolio of startup investments, illustrating just how important it is to be well diversified within this asset class. By now you might be thinking “why the hell do you guys mention diversification in almost every newsletter you release?”. Well, it’s for a very good reason of course! As you know, venture capital is a high risk, high reward asset class. Many of the investments you make won’t work out. That’s why it’s critical to have as many “shots on goal” as possible to be in with a chance of catching outlier performers. We have a couple of graphs, provided by AngelList, to illustrate our point. The first shows two things, based on the number of investments in our portfolio: First, the chance of losing money, and second, the chance of achieving a 3x, 5x or 10x return. Let’s take a look:

As you can see, the chance of achieving a 5x or 10x return remains relatively the same, no matter the size of the portfolio. What’s interesting is just how much the chance of achieving a 3x return grows as the portfolio does. What’s most interesting about this data though, is the downside protection of large portfolios. With a portfolio of ~10 investments, you have a 30% - 40% chance of losing money. At 40+ investments though, your odds of losing money drop below 5%!

Now that we know the role diversification plays in improving our odds of de-risking a negative outcome, let’s look at the best way to improve our odds of achieving a positive outcome. This comes down to firm/manager selection. As we mentioned earlier, VC is about finding outlier performers. At Shuttle, we only invest in companies that have a VC leading their funding round. And we don’t just work with any VC either, we’re very selective about who we partner with. The next chart shows us the chance of an average VC, a top tier VC, or a superstar VC, finding and investing in at least one outlier in a portfolio of startup investments:

As you can see above, in a portfolio of only 10 investments:

• The average VC has less than a 20% chance of investing in an outlier;

• A top tier VC has about a 37% chance of investing in an outlier; and

• A superstar VC has above a 50% chance of investing in an outlier.

The odds aren’t great for the average VC, or even a top tier VC. With a portfolio of only 10 investments, a 50%+ chance of investing in an outlier for a superstar VC is very impressive. If we look at a portfolio size of 50 investments, we see a very different picture:

• The average VC has just over a 60% chance of investing in an outlier;

• A top tier VC has about a 90% chance of investing in an outlier; and

• A superstar VC has above a ~97% chance of investing in an outlier.

With a portfolio that size, the odds still don’t look great for the average VC. Co-investing with a top-tier or superstar VC, on the other hand, will drastically improve your chances of seeing outsized returns.

Thanks for tuning in as always folks, we hope you learned something today. Please don’t hesitate to respond to this email with some feedback. We’re always eager to hear from our community about how we can improve our newsletter.

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The Unsophisticated Investor is brought to you by Scott & Rob, the founders of Shuttle. We’re both sick of private markets being a playground exclusive to the ultra-wealthy so we started a company to challenge the status-quo. Shuttle’s singular focus is to unlock private markets for Millennial and Gen Z retail investors and help them build wealth through the highest performing private market opportunities.

Scott & Rob
Shuttle Co-Founders