The Venture Capital industry, and early-stage investing in general, requires an ability to judge future success with limited current information. The outcome, more often than not, is failure. Why then, do VCs and Angel Investors limit themselves to investing in only a select few companies, instead of spreading out risk across a more diversified portfolio in an effort to find more winners?There exist many challenges to converting from an active, high conviction, and concentrated investment philosophy into a passive, diversified approach. In this paper, we address these challenges in an attempt to understand what, if any, possibility exists for early-stage investors to adopt this investment style.
Active vs Passive Investing
Active investing can be defined as a hands-on approach to selecting investments, generally under the assumption that the investor has additional knowledge about a company that the market has yet to recognize and available opportunities to exploit these insights are available. Active investors, therefore, make selective investment decisions based on these beliefs and their convictions and tend to hold more concentrated portfolios.Passive investors, on the other hand, eschew selectivity to invest in the broad market, with the return of their portfolio therefore equal to, or within close proximity of, the “market” return. Therefore, while active investors have abetter opportunity to outperform the market, they also have a greater chance to underperform. The degree to which they outperform the market can be attributed to skill, luck, or a combination of both.The question for early-stage investors who are selective is the same: how much success can be attributed to skill vs luck, and if luck, are they - and by this, we truly mean their LPs - better off investing in a more diversified portfolio to offset the impact of being wrong?
Why Early Stage Investors Are Active Investors
Angels and early-stage VCs are by definition active investors. As we detail later in this paper, this is due to behavioral reasons and structural ones.Recently, however, Reg-CF and crowdfunding platforms are creating opportunities for investors to invest smaller amounts into more companies, and even in an automated fashion, essentially offering to “buy the market” like a passive investor.