Portfolio Construction

Portfolio construction is a critical skill for investors.

Every investment is a bet. Ideally you have explicit guesses for a) what the possible outcomes are, b) how likely each outcome is (probabilities), and c) how much money you should be willing to place on each bet. If you get into the habit of writing these things down, especially your probability estimates, you'll be doing better than 80% of investors already. In fact, getting good at estimating probabilities for things throughout your life is probably one of the most underrated skills there is (see Annie Duke's great book Thinking in Bets). Thinking in bets is the essence of good judgment. Apply a confidence level to all your thoughts. Risk-weight your investments. Believability-weight the advice you receive.

“It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” - George Soros

Why is thinking in bets important for building out your portfolio of angel investments?

First, assume that you want your portfolio 5x over the next decade. Why 5x? It's rough, but assuming that you can get 7% annually in the stock market, If you just put your money in the S&P 500 you would double it in 10 years. Furthermore, the stock market is incredibly liquid, you you need to earn a premium on your angel portfolio in order to make up for the lack of liquidity.

Second, realize that power laws drive returns. In fact, power laws drive virtually everything. In most VC funds, the best investment accounts for >50% of the returns. The top investment is better than the rest combined. The same is true of the 2nd investment vs. the rest, the 3rd investment vs. the rest, and so on. If your portfolio is going to 5x, this means that your best investment needs to at least 2.5x the entirety of your deployed capital. This is why you hear that VCs expect the vast majority of their bets to go to zero - the top performers more than make up for it. Data from Cambridge Associates shows that out of a decade of investments, around 4,000 annually, the top 100 generated over 70% of the aggregate returns. To win, you need to invest in the outliers. In fact this is true not just in investing, but in most business ventures as far as I can tell. Advertising is 70%+ of Google and 90%+ Facebook revenue. iPhone is 50% of Apple revenue. Parks are 70% of Disney revenue. etc.

The power law also implies that you need to have a diverse angel portfolio, in order to have a shot at finding the outliers. This Monte Carlo Simulation shows that if you have a portfolio of 10 companies you have a 29% of 2x'ing your money, while if you have a portfolio of 100 companies you have a 57% chance of 2x'ing your money. You'll also notice that achieving a 5x return, our target, makes you a top decile investor. This game is not easy! And increasing your portfolio size from 100 to 1,000 doesn't improve your odds that much. You need diversification, but the benefits fall off fairly rapidly.

For a venture portfolio, this means that you need to have strong conviction that each bet could more than return the entire portfolio. That is, if you are investing $1M, and you're making $50k bets, you believe that each bet could 20x ($50k to $1M). There are a few levers that go into this - the company's valuation, your check size, etc, which are summarized by your ownership percentage of the company. This implies that it's critical that you maintain your ownership percentage in your strong performers, at the expense of your weaker performers, or even new investments. Maintaining ownership is more important than the company's valuation. Many investors focus on investing in unicorns, but owning a meaningful stake in a strong performer at exit,  regardless of valuation, is almost always more impactful than investing in high valuation companies where you only own a small, diluted sliver. As a rule of thumb, most VC funds reserve 30-50%+ of their capital for follow-on.

Back to our example. Assuming our best investment needs to at least 2.5x your entire portfolio, that means that one investments needs to go from $50k to $2.5M, or 50x. As we said, ownership percentage is important. Let's say that when you first invested the company was valued at $5M, so you owned 1% of the company ($50k/$5M). Let's assume that over time the company raised more money and issued more shares, and your ownership percentage was diluted from 1% down to 0.5% (50% dilution is pretty common). In order for your investment to 50x to $2.5M, because of dilution that means that the company valuation needs to grow 100x, from $5M to $500M. That's a lot of growth! This example implies a few things:

  • Dilution lowers multiples substantially
  • More investments in the portfolio (ie smaller checks) means you need higher multiples on the top performers
  • The more top performers the better
  • Portfolio multiple is driven by multiples on the top performers

This is why reserving capital for follow-ons into your best performers is so critical, and why investors often care more about ownership percentage than dollar amounts or valuations. Founders who try to raise small amounts on lower valuations in order to preserve their equity are often surprised that investors don't want these terms. But it may ultimately be easier to raise $4M on $20M (20%) vs. $1M on $10M (10%).

"The way to build superior long-term returns is through preservation of capital and home runs...When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig." - Stan Druckenmiller