While the yearly returns (IRR) of the average angel investor are between 25% and 30% (according to numerous independent studies), the majority of angel investors are losing money.
The facts above indicate a high skewness in the distribution of returns for angel investors (meaning that the average return is driven by outliers and most angel investors are performing below-average). Angel investors who are outperforming are often labelled “skilled” or “lucky” in media and tech communities, where there is a lot of attention for the 1% of startups that end up generating a >20x return (and the angels who invested).
While skill and luck are undeniably factors that impact the extent to which an angel investor is successful, there is one factor that seems to trump all other factors that are in play here: diversification.
“It is psychologically difficult for investors to admit that their best investment is worth more than the rest of their portfolio companies combined. So they ignore or hide that fact, and it becomes a secret.” — Peter Thiel
A Data-Oriented Approach
It is no secret that there is a high failure rate in the early-stage startup asset class. Research by David S. Rose indicates roughly the following distribution:
- 50% of startups fail (defined as a <1x return) and
- 20% only generates a dollar-for-dollar return
- 20% generates a 2x-3x return
- 9% generates a 10x return
- 1% generates a return that exceeds 20x, often referred to as a “home run”
Alex LaPrade, one of the first employees at Dispatch and Angie’s List, has ran a Monte Carlo simulation on the AIPP database. This demonstrates clearly that by massively diversifying a portfolio, angel investors can offset the losses they face on most of their investments by outliers that generate above average returns.
So how many startups does one need to invest in? When looking at the simulation of LaPrade (below), we can see that more is always better in terms of risk mitigation and optimising expected returns. However, we can see the Law of Diminishing Returns is at play here.
The odds of breaking even drastically increase when diversifying your investments from just a couple of startups to 20 startups. The chance of breaking even increases from 83% to 99%, while the chance of tripling your money increases from 58% to 67%.
If you want to improve your odds even more at this point, you need a lot more diversification. If you’re invested in 500 startups, the odds of losing money are basically obliterated while the odds of tripling your money are at a whopping 96%.
The Babe Ruth Effect: Playing The Numbers Game
With the data above in mind, angel investors should be focussed on increasing their odds of investing in a home run (>20x return), since it offsets the many losses. This is often referred to as the Babe Ruth Effect. Babe Ruth, one of the best baseball players ever, struck out 1,330 times during his career. Yet, his many home runs where sufficient to offset these many failures and made him go down in history as an absolute legend.
“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.” — Babe Ruth
So if the data on portfolio performance in angel investing is widely available, why is it so hard for investors to internalize the Babe Ruth Effect? Behavioral economists have pointed out people’s predisposition to avoid losses in many studies.
This loss aversion in angel investing is a very emotionally-driven process and as ones portfolio increases in size, the expected number of losses increases as well. Angel investors often overestimate their ability to pick winners and try to limit their investments because they just don’t have the bandwidth to follow up on them.
Important to note is that this research is backward-looking by simulating results as if investments in early-stage startups were combined. However, every angel in this research made his investments without this power law in mind. Blindly throwing money at every startup you encounter just to get to a certain number, probably won’t work out the same way. This is why we came up with a solution that enables smart diversification and provides access to high-quality startups.
The Pitchdrive Way
It’s hard to generate deal flow, qualify startups, negotiate valuations and term sheets and follow up on investments as someone’s portfolio increases in size. To invest in 20 startups or more would be a full-time job, and would require a substantial amount of money to be invested. Faced with this challenge, our founding angels launched Pitchdrive to provide a frictionless way to build a highly diversified portfolio of investments in early-stage startups. We source, qualify, negotiate terms and valuations, and enable you to keep track of key metrics effortlessly. Chipping in is possible starting from €5k, and enables investors to build a portfolio that is massively diversified with smaller capital commitments.
We are currently accepting a limited number of new angel investors to join. Want to start diversifying right from your phone and unleash the Babe Ruth effect in your portfolio? Don’t hesitate to reach out to firstname.lastname@example.org.