In a world as eventful as we see today, investing has never been so exciting/excruciating. An angel could easily be on the right or wrong side of any given investment, depending on their luck or (more dependable) insight. However, because they invest their own money, most angels like to minimize the risk of losing as much as possible while growing profitably. However, growing money often means taking risks. So how do you take risks without really taking risk? This article talks about one of the ways you can do that using a simple, easily digestible portfolio construction method.
There are several ways in which investors optimize their investing portfolio. This optimization aims to maximize returns for investors while minimizing the risk attached to the invested asset. One of the most commonly used tools in this optimization process is the Modern Portfolio Theory(MPT). Put simply, MPT is a framework that optimizes investment portfolios by balancing risk and return. It assumes that investors are rational and seek to maximize returns while minimizing risk. It also assumes that investors are risk-averse and would prefer less risk for the same level of return.
MPT suggests diversifying investments across different asset classes can minimize risk and maximize returns and recommends that investors focus on their overall portfolio, which will reduce risk through diversification. MPT also suggests that investments with low and negative correlations can reduce overall portfolio risk. Investing in a diversified portfolio can mean choosing from alternative assets such as equities (early and late stage), treasury bills, FX, real estate, and cash.
This diversification thesis can also be applied to a specific part of the broader portfolio, i.e., equity. This focuses on selecting companies based on a critical analysis of their risk and returns and balancing the equity portfolio as appropriate. As you may know, two types of market risk exist:
Using historical data, correlations could be used in this scenario to understand the relationship between different sectors in the equities market. There are 11 market sectors which are: communication, consumer discretionary companies, consumer staples (e-commerce and other B2C models would fall here), energy, health care, financial sector, industrial, SaaS, and Hardware, materials, real estate, and utilities. Correlations between these sectors can be seen below:
Note: Tech companies in the consumer discretionary and consumer staples sectors mostly have the same standing in relation to technology investors. Discretionary products are consumer products/services that are unnecessary (cars, TVs, vacations), while staples are required in everyday life, like food, clothing, and soap.
How the Table Helps You with Your Portfolio Construction
Correlation simply tells you the relationship between two sectors. You already know it wouldn’t be a safe bet for your entire portfolio to be (say) fintech-based. Still, the table further explains that you shouldn’t be overly invested in both fintech and industrials because they are highly correlated. This means that if the financial sector seems to be doing poorly, there’s a high chance (75% chance to be exact) that your investments in industrials won’t do well either.
For startup investors, this can be used to build a portfolio of startup investments to achieve the highest possible return for a given level of risk. In addition, by diversifying investments across different startups, investors can minimize risk and maximize returns. This approach can be particularly relevant given that startup investments are often considered riskier than traditional investments.
When building a startup portfolio, investors should consider the correlation between startups, as investments with low or negative correlations can help reduce overall portfolio risk.
