Unlike taxes, risks are something you can evade but not entirely avoid. In venture capital (VC), there are no permanent solutions to risk, only compromising opportunities for growth and success. One of the key strategies for mitigating risk in venture capital is diversifying your portfolio.
Diversification functions as a safety net for your portfolio, providing a crucial layer of protection. Investing across various companies and industries will reduce the negative effect if one investment fails.
But how do you go about diversifying your portfolio effectively? Randomly picking a bunch of companies and hoping for the best is not enough. A successful venture capitalist takes a strategic approach to diversification. It is common practice, for instance, to conduct due diligence before making a private equity investment. Additionally, there are alternative methods to minimize risks and maintain greater control over your money and investments.
In this article, we will discuss portfolio diversification, its benefits, and ways to reduce risk.
What is a diverse portfolio?
Venture capitalists need to develop strong portfolios in particular sectors and niches that align with their investment thesis and values. This helps ensure your investments are not scattered and gives you the ability to make headways in chosen directions. Ultimately, that can be beneficial in establishing a strong identity and positioning yourself in the industry.
However, considerations of risk and returns make it necessary to branch out to a certain degree as a way to avoid putting all your eggs in one basket. Diversifying your portfolio entails investing in dissimilar companies from either the same or different verticals. Spreading out your investments across multiple sub-sectors (or sectors) and geographies limits your exposure to poor returns across the board.
Why should you diversify your portfolio?
Investing in several different companies reduces the risk of losing capital in case your investments in one industry or geography do not yield returns. It increases the chances of getting a return on your investment as you are no longer reliant on companies operating in the same space. Diversifying your portfolio increases the amount of innovation and potential you are exposed to and can act as a strong bulwark against market volatility.
It is not easy to discern a company’s potential for growth and success, especially in its early stages. Being able to do so consistently over time is even more of a challenge. So, while you may be willing to make an intelligent gamble based on research and past investment experience, it makes little sense to limit your portfolio and hamper your chances of scoring multiple wins.
Success in venture capital investing is not so much about predictability as it is about adapting to turbulence and shifting market priorities. Diversification can help absorb the impact of less-than-expected returns in some of your investments. A strategic diversification of investments is vital to staying in the game as well as getting better at it.
In many ways, the point of venture capital is to look for and support innovation. Although having a focused area of interest is crucial in terms of long-term strategy, you are more likely to stumble upon unconventional yet promising companies once you venture out of your comfort zone.
How can you diversify your portfolio?
Now that we are clear about the ‘why’ of portfolio diversification, let’s explore the ‘how’. Here are the best principles to keep in mind while diversifying your portfolio:
- Diversity begins with people
It is no secret that a promising company rests on the shoulders of the people that are building it. To achieve true diversity in your portfolio, you have to meet with founders with diverse backgrounds, ways of working, and visions for the future. Your due diligence process must still be solid, but consider modifying your selection criteria in ways that make it possible to engage with a broader group of people. The wider the net you cast, the more likely it is to find opportunities that are not only vastly different from your standard fare but also in alignment with your goals.
- Don’t forget due diligence
When choosing to branch out into industries that you may not have a strong grasp of, it becomes even more important to conduct due diligence thoroughly and effectively. Diversification, although a numbers game, must not come at the cost of quality in deal flow . Invest some time and energy into thorough research on each of the companies that you may be keen on investing in.
- Get in early
It is impossible to maintain diversified portfolios through multiple funding rounds as you will end up investing higher amounts of capital over time. That being said, it is vital to onboard a significant volume of companies in the early stages so that you can assess their value-add and have your pick when the time comes to commit to a few.
- Manage resources effectively
Managing a high-volume portfolio can be more resource-intensive in comparison to a more focused investment strategy. In the latter case, you are likely to contribute more resources to the few investments you have. Diversification, on the other hand, demands placing smaller bets in a wider bunch of companies. The key here is striking the right balance between generating value for the companies and managing your resources. Consider the potential of each company, the state of the market, as well as your own reserves and capacity while deciding resource allocation.
5. Balance is the keyHaving a finely balanced approach is fundamental to an effective portfolio diversification strategy. Although diversification has undeniable benefits, it would be unwise to spread yourself too thin. At the end of the day, cultivating and maintaining a strong identity and focus is still important. Find the middle ground that works for you and enables you to play the long game.
6. Continue monitoring your investmentsDiversification doesn’t end with making investments. It is even more important to keep a close eye on each portfolio company to see how they are faring as time passes. Having sufficient visibility over them is what will help you make informed decisions and contribute to your success as a venture capitalist.
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Zapflow provides the perfect solution for managing a diverse portfolio. Our platform allows you to streamline all your VC workflows, be it keeping track of each company’s performance, the resources allocated to it, and details such as exit strategy. You can also use Zapflow to directly communicate update requests from your portfolio companies.
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