You may be asking: What’s index investing and what does it have to do with startup investing? Even if you’re a savvy investor and are well-versed with index investing for stocks, you may have never seen its applications in the private markets. Essentially, index investing is all about diversifying your investments across a larger number of opportunities, instead of investing more money in fewer things. When we look at how the strategy of diversification has been successfully applied to stock trading, it should come as no surprise that diversifying any kind of investment will mitigate risk and help you come out on top. But, the real secret is how index investing applies to venture capital and startup investing.
(FYI – the terms ‘venture capital’ & ‘startup investing’ refer to the same practice of investing money in startups and can be used interchangeably).
Demystifying venture capital
The world of venture capital has been kept behind closed doors for decades, despite its founder’s lofty visions of democratizing venture capital by opening up investment opportunities to the public to fund war-veteran entrepreneurs. When it comes to startup investing, what we’re often shown are VCs (aka venture capitalists) touting their special sense for finding the next big opportunities, making the venture capital game seem out of reach for the normal person. News flash: it’s not! Times are changing fast and startup investing is now an option for the majority of Americans. The catch? We just have to learn how startup investing works to become ‘sophisticated’ investors.
Ok, but, even if normal people can start investing in startups, should they? After all, startup investing has earned quite the dangerous reputation, appealing to those with an appetite for risk. However, there’s more to this story than meets the untrained eye. Let’s take a look at a proven method that mitigates risk when investing in startups. Understanding the concept of diversification is key to startup investing success. Index investing is a prime example of the advantages of diversification.
How does index investing work?
Index investing – meaning, investing in a broad set of assets instead of a select few – is not a new concept. In fact, index investing is the strategy behind some of the most successful stock trading techniques used by top performing index funds, like the S&P 500, Dow Jones, and Vanguard. These funds have been around since the 1970s, beginning with the launch of Vanguard in 1976.
Even if you haven’t invested in the stock market, if you have a 401(k) plan, it essentially does the same thing as an index fund. 401(k) plans most commonly invest money in mutual funds, which diversify investments across hundreds of stocks. The ultra rich typically don’t put their money in index funds, but will pay for experts to diversify their investments all the same. Experienced investors all know that the most foolproof strategy is one that’ll manage risk and gain consistent returns over a long period of time, like index investing.
Active vs. passive investing
Index investing falls into one of the two main categories of investing strategies: active and passive investing. Index investing is a more passive form of investing, where investors “manage their expected risk and return by dividing their money up between different types of investments,” instead of trying to handpick stocks or time the market.
Why does passive investing work so well? It has a lot to do with how it compares to the alternative: active investing. To the dismay of many motivated investors, beating the market with active investing is really hard to do. To win, you have to outperform most other active investors out there, including the trained professionals, all of whom are investing in the same set of opportunities. And, check out this surprising fact: even the majority of professionals underperform. Because most investors – professionals or not – lose to the market, being on par with market returns actually puts you above average.
“There are several advantages of index investing. For one thing, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands off approach to investing eliminates many of the biases and uncertainties that arise in a stock picking strategy.” – Investopedia
So, index investing is a time-proven successful strategy for investing in the public markets. It’s no surprise that we’re seeing it work well for investing in private ventures, too.
Diversification is key to startup investing success
While index investing isn’t new, we’re starting to see experts show the application and effects of diversification for venture capital. The most notable of which is Abe Othman, the Head of Data Science at AngelList, who recently wrote about the ‘Startup Growth and Venture Returns’ report that analyzed thousands of AngelList deals over the past seven years. The big takeaway? Diversification is key.
“If you miss the best-performing seed investment, you will eventually be outperformed by someone who blindly invests in every credible deal. …
Conventional investing wisdom tells us that VCs should pass on most deals they see. But our research indicates otherwise: At the seed stage, investors would increase their expected return by broadly indexing into every credible deal.”
In an insightful Q&A with Abe Othman from the Kauffman Fellows, it’s pointed out that over a 10-year timeframe, “indexing beats 90-95% of investors picking deals, even when those investors have some alpha on deal selection.” How’s that for overwhelming odds? Essentially, “any selective policy for seed-stage investing—absent perfect foresight—will eventually be outperformed by an indexing approach.” If you want to be a successful venture capitalist, you’re better off learning diversification than emulating your favorite ‘shark’ investor from Shark Tank.
The future of investing & a note on ‘credible’ deals
Startup investing is the future of investing – with the right education (cue: Doriot), everyone will have the access and knowledge to take advantage of – and mitigate the risk for – these lucrative opportunities.
Just how lucrative are we talking? As Abe Othman explains, “At Seed, you may be missing out on something like a 5000x return that would completely and totally change your life.” (‘Seed’ refers to one of the earliest investment rounds startups raise). Today, a very small percentage of investors are generating significant wealth from startup investing. Since companies are waiting longer to go public, the gap is growing wider between startup investing and stock investing returns. In other words, “a powerful wealth-creating engine now exists entirely in the private markets.”
All in all, the data shows that investing in early-stage startups gives enormous returns in comparison to investing in the stock market. We believe this opportunity should be available to everyone, instead of just a handful of elite venture capitalists. According to AngelList:
“Our results suggest that each successive year of a company’s existence is worth less and less from the perspective of compounding investment growth. For instance, we can expect a company to grow about as much in years three and four, or in years four, five, and six, as it does in its first year. So…winning early-stage investments get more time to compound at higher growth rates.”
In sum, if you want the biggest returns on your investments, startup investing is the winning ticket. The trick is turning this high-risk, high-reward investment into a more palpable strategy for long term gains. Successful startup investors mitigate risk by diversifying and putting money into every ‘credible deal’. So, the million-dollar question (literally) is: what is a ‘credible’ deal? This requires specific knowledge to determine, but it can be learned. Plus, diversification takes some of the pressure off by encouraging investments in 25-30 high-potential startups instead of larger investments in just a few. Abe Othman says that if a startup has a good chance of raising a series A from a VC, it’s likely a ‘credible’ deal.
If you want to prepare for the next wave of opportunity in investing, start learning how startup investing works. Become a ‘sophisticated’ investor and get your piece of the high-growth entrepreneurial economy. Start by signing up for weekly insights on startup investing from Doriot to embark on your journey from investing noob to ‘sophisticated’ investor – we’ll help you every step of the way.