How to Invest When Returns Follow a Power Law

In a very insightful post that I urge anyone interested in startup investing to read, Jerry Neumann explains the effect of power law distributions on venture investing. The power law distribution of returns in angel and venture capital investing has three important implications for investors: Make sure to diversify, pay attention to deal flow quality, and treat investments as real options.

But before I discuss the implications of a power law distribution for investments in startups, let’s first focus on what a power law distribution looks like. As the figure below taken from Neumann’s piece shows, power law distributions look very different from normal distributions. With power law distributions, outcomes are concentrated; a few cases account for most of the total result.

 

How concentrated the outcomes are depends on the alpha of the power distribution. For investments in early stage companies the alphas are moderately high. Neumann looks at a bunch of data and shows that returns in venture capital funds, angel investment returns, and venture capital investments themselves all have alphas of around two.

That empirical observation is important because it shows how concentrated the financial returns from investing in startups are. As Neumann explains, “if alpha is less than or equal to 2, one company is likely to return the entire amount invested in all of the successful companies.”

Power Law Distributions for Investments

This distribution of outcomes has several implications for venture investing. First, making money demands a large portfolio of investments. Your odds of hitting a winner increase with the size of your investment portfolio. As Neumann writes, “At a given alpha, the more investments you make the better, because your mean return multiple increases with the number of investments, as does the likeliest highest multiple.”

That means you need to make far more start-up company investments than most people, even most venture capitalists, make. As Dave McClure of 500 Startups argues, “Most VC funds are far too concentrated in a small number (<20-40) of companies. The industry would be better served by doubling or tripling the average # of investments in a portfolio, particularly for early-stage investors where startup attrition is even greater. If unicorns happen only 1-2% of the time, it logically follows that portfolio size should include a minimum of 50-100+ companies in order to have a reasonable shot at capturing these elusive and mythical creatures.”

Second, while diversification matters, so does deal flow quality. You need to make sure you are not just diversifying, but are diversifying across a portfolio of high potential start-ups. Most new companies have zero or near zero probability of generating huge returns. They are in small markets, have no competitive advantage, are in unattractive industries and bad locations, and are run by founders who don’t know what they are doing.
That’s a problem because as Peter Thiel explains, you can’t make up for bad deal flow with high volume.

Third, you want to treat the start-up investments like real options. You can’t know in advance which companies will take off. Moreover, it is often difficult to grasp how much and how quickly the highest performers will grow. Therefore, you want to have the option to invest in the future. By having the right, but not the obligation, to invest further on favorable terms, you improve your chances of getting high returns on your portfolio.

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This article, "How to Invest When Returns Follow a Power Law" was first published on Small Business Trends