The word “diversification” comes up a lot around crowdfunding and alternative investments, but there are important differences in what it can (and can’t) do to your risk and reward potential, depending on the type of investments you’re making.
Right now, the biggest categories of investment choices among crowdfunding platforms are:
- Angel/Startup (eg, FundersClub, Crowdfunder, Wefunder)
- Real Estate (eg, Patch of Land, CrowdStreet, RealtyShares)
- P2P Loans (eg, Prosper, Lending Club, Upstart)
Most of the choices across the platforms are between Debt and Equity investments (and of course all P2P Loans are debt). Success with both types of investments depends on diversification, but for quite different reasons.
In Nassim Taleb’s outstanding book, “Antifragile”, he describes two kinds of risk: “concave” and “convex”. If a risk profile is concave, then when the unexpected or unlikely happens, the impact is almost always negative, and the best you can hope for is that nothing bad happens. If a risk profile is convex, then unexpected or unlikely events can create substantial positive outcomes, and the sky is the limit on the best case.
What does that mean for alternative investing? Well, when you invest in debt, the best-case scenario is that you earn the promised interest rate and get your full principal amount back. Your upside is capped, and no matter what happens will never exceed the promised interest rate of the loan. On the other hand, the worst case scenario is that the borrower defaults and you lose not only the interest payments, but also all of your principal. That is a concave risk profile.
As a simple example, think about making two loans of $1,000, each at 20% interest, paid monthly over the course of a year, with installments of $100.
- The first loan is paid back on time and in full, so you get $1,200
- The second loan pays for 6 months, but then defaults, and even though you try for the next 6 months, you’re unable to recover any more from the borrower. So you started with $2,000 and ended with $1,800, for a combined return of -10%! Even just one missed payment on one of the loans drops your return from 20% to 15%. Which is still a healthy return, but much less than you were initially expecting.
When you invest in startup equity, the worst-case scenario is also that you’ll lose your entire investment, but there is no limit to the best-case scenario, so there is no cap on your potential upside. That is a convex risk profile.
That asymmetry in potential outcomes (and rationale for diversification) is really important:
- With debt investments, you generally expect they’ll go well, so to minimize the impact of picking some losers, you diversify because you know some of the loans will default.
- With startup equity investments, you should expect most of them to fail, so rather than try to pick the winners, you diversify to maximize your chance of being exposed to the outliers that generate huge returns.
While the potential upside on equity investment is unlimited, the reality remains that most of them will fail. This post from David S. Rose includes some helpful data and insight from an experience angel investor that’s well worth reading if you’re contemplating an equity crowdfunding investment, but he also reveals a very common perspective among “traditional” angel and venture investors:
Developing a Diversification Strategy
That difference in risk profile (concave vs. convex) between debt and equity investments suggests a different approach to diversification for each:
- With debt investments, the very best you can hope for is to minimize your losses, so it’s probably not worth your time and effort to exhaustively review the details of dozens or hundreds of real estate deals or P2P loans. Save your diligence energy for the equity deals! If you do want to invest in debt, find a low-cost way to spread your risk across a wide variety of loans (at least 100 or more). Prosper and LendingClub offer automated investing tools that can do this for you for P2P loans (and LendingRobot can do it across both platforms). For real estate, AlphaFlow, Fundrise, RealtyMogul, and Rich Uncles all have products offering wide exposure, in some cases for as little as $1,000.
- With equity investments, you want to spread your bets as widely as possible, over an extended period of time, but at the same time try and give yourself whatever edge you can. If you’re trying to just get in on the next hot Silicon Valley startup, you’re facing the disadvantages David S. Rose described. But if you know a particular industry really well, pay close attention to opportunities in that industry (and look for funds that target that space). Right now “tech” is permeating nearly every industry in our economy, including ones you probably know much more about than most VC firms. And if you have insight or experience in particular geographies, you might focus on equity real estate deals in those areas, so you can have more confidence in evaluating the deal’s critical assumptions on occupancy or appreciation (CrowdDD is an excellent resource to help you on due diligence for real estate deals).
Bottom line: With debt investments, the goal of diversification is to minimize losses and preserve principal. With startup equity investments, most of your investments will be losers, so spread your bets widely and wisely.