Angel Investors and Diversification

It’s not unusual to hear the term diversification when it comes to finance. Basically it boils down to not putting all your eggs in the one basket (there are caveats here, but they are philosophical ones which I am not going to address).

It is worth talking a little bit about the ins and outs of diversification though. So, how does it work? 

First, what is risk? Simply put, it is uncertainty. It just means that our returns vary from what we expect. This variance can be wide (high risk) or it can be narrow (low risk).

Diversification means we are eliminating risk by combining individual assets into a portfolio. If we only have one asset, then we are exposing ourselves to risk.

But, there is more to it than this. A lot of people I speak to think that if they diversify, then they will be fine. Unfortunately, it isn’t so simple.

We can categorise risk into 2 broad parts – diversifiable and non-diversifiable. Straight away this tells us that we can’t just eliminate all risk.

Non-diversifiable risk stems from things that systematically affect most firms. Things like high inflation, economic slowdowns, exchange rate fluctuations, changes in market confidence etc.

We can't just eliminate all risk - diversification doesn't work that way.

Diversifiable risk affects only a limited number of firms (or assets) in the market. For example, labour strikes, financial difficulties or technology becoming obsolete.

There is obviously a lot more to it, but you get the idea. Some risk we cannot diversify away.

So back to angel investors. My research found that angel investors are diversifying the risk of their angel investments by investing in other early-stage businesses. The driver here is that diversification is always the solution. It certainly helps, but only when we use it properly.

I spoke to angel investors who adopted a diversification approach within their angel asset portfolios. One investor had 30 angel assets, another 18.

The question we need to ask is - is diversification a good approach for angel investors?

I don't think it is.

There are 5 key reasons why diversification is not a sound approach for angel investors.

1.      The ability to anticipate a return in an early stage firm is much less compared with long established ones

2.      New ventures are very risky and most of the ones that last more than 5 years don’t provide much more than an income for its founder (see Shane’s great book The illusions of entrepreneurship – details below)

3.      Information asymmetry (the difference between what we know and what we don’t) is considerably higher in new firms

4.      Angel investors operate in industries where they have knowledge and experience.

5.      Increasing the number of firms in the portfolio means less involvement in the firm’s day to day operations (post-investment involvement)

The first 3 problems can’t be solved by diversification. The 4th problem is the killer here, angel investors operate in areas where they have experience, this limits their ability to diversify (though there might be some exceptions, such as within an angel group). The last problem is created by diversification.

Angel investors don’t necessarily get involved in a firm solely to reduce risk, but it does have the effect of reducing information asymmetries.

More importantly, by increasing the number of investments, an angel investor is reducing their ability to become involved in the firm. This involvement is very important – an angel investor adds value – they use their contacts and knowledge to grow the business.

There is actually evidence from the formal venture capital markets for getting involved in a firm. The research shows that formal VCs (and remember, they are much later stage than angels) have fewer underperformers when they take on post-investment involvement.

My inkling is that angel investors are speculating, not diversifying

So while diversification can be effective in dealing with risk, it must be done properly. My inkling is that the majority of angels that are “diversifying” are really just speculating that one of their deals will be a big win (sort of like what some formal VCs do).

There are probably more complicated explanations related to self-image for why angels adopt a diversification strategy. Nonetheless, this new behaviour is pretty interesting.

Shane's book details are below. I've included a link in the main article - well worth a read for anyone interested in entrepreneurship.

Shane, S. (2008). The illusions of entrepreneurship: The costly myths that entrepreneurs, investors, and policy makers live by. New Haven, Connecticut: Yale University Press.