Portfolio management is a long-tail game

When looking at the success of startups, a common belief is that one third of the companies fail, one third return their money and one third of the companies become successful enough to really move the needle on your investment portfolio. But is that true?

Correlation Ventures did research on all VC investments in the US between 2004 and 2013 to figure out the distribution of over 21,000 different investments. It turns out that close to 65% only returns up to 1x the initial investment, and only 10% returns an ROI bigger than 5x. So two third of the companies only return up to their initial investment and the other one third needs to make up for the loss of the rest.

Using the Correlation Ventures research data as a benchmark we have created a calculator to help innovation managers to understand in how many ideas they need to invest in order to move the needle. You simply put in your total budget and the amount of ideas you’d like to invest in and out comes a prediction of your ROI. The calculator uses the Monte Carlo computational algorithm and runs over 20.000 scenarios to create a reliable outcome.

It’s interesting to see in how many ideas you need to invest. That you should not put all your money in one investent may be common sense, but even 10 or 20 ideas are not enough. Portfolio management really is a long-tail game.

Since one third of the ideas need to make up for the two third that “fail”, having more ideas makes it more likely to make money. When you invest € 500.000 in 10 ideas each, only 1 will return up to € 5.000.0000. You still have a 1 in 250 chance that that one startup returns more than € 25.000.000, but that chance is really slim. The simulation shows that there is a 35% chance on a € 3 million profit, but at the same time also a 25% chance you will lose € 2,5 million.

But when you invest € 50.000 in 100 startups (same € 5 million budget), 7 of them will return up to € 500.000, two of those 10 up to € 1 million and if you are really lucky 1 more than € 10 million. In a best case scenario, the one third will get you € 15.500.000. That is enough to compensate for the € 3.300.000 (66x € 50.000) that you lost on the other two third of your portfolio and will give you a nice € 10 million profit on a € 5 million investment. Not bad! But that is the most lucky scenario. Running the simulation however shows a more likely profit of around € 7 million.

Why don’t you try the ROI Calculator yourself and see how well your portfolio will perform! It makes sense to run the calculator multiple times to see the effects of the Monte Carlo computational algorithm. You can clearly see the difference between making an initial investment of € 500.000 in 10 startups, or € 50.000 in a 100 startups. And that is without any stage-gated investments in place! The real money is in the double down on the investments that work, but that is a topic for next time.


Portfolio management is a long-tail game was originally published in NEXT Amsterdam on Medium, where people are continuing the conversation by highlighting and responding to this story.