Concentration - The Golden Rule of Investing
The past four years, as CFO of Full Harvest, I have worked side by side with all of our investors as we grew from a seed stage startup to Series B. We needed help along the way from our investors and the investors who had smaller portfolios, the investors who understood our business better, were far more helpful than the investors who had countless investments, who had highly diversified portfolios.
Concentrated investing has led to the world’s greatest fortunes.
Bill Gates made the vast majority of his fortune in Microsoft and it continues to be by far the largest share of his net worth.
Elon Musk made a small fortune co-founding PayPal and then poured all of that money into Tesla.
Jeff Bezos spent almost his entire career founding and building Amazon…
Moreover, the Tom Brady of investing, the Greatest Of All Time, Warren Buffett espoused and practiced concentrated investing to build his $120+ billion fortune. As Warren once said…
Diversification may preserve wealth, but concentration builds wealth.
Yet, despite these concentrated fortunes, modern portfolio theory and the world’s leading business schools teach that diversification is better.
When it comes to early stage investing, diversification is emphasized even more, and many seed stage investors from the famous accelerator Y Combinator to leading marketplace investor FJ Labs have portfolios with thousands of companies.
I will argue that any full-time early stage investor (pre-seed to Series A) should have a concentrated portfolio. It is better for the investor and their returns and better for their portfolio companies and their founders. To keep it simple, let’s define “concentrated”, for early stage investors, as no more than 5 deals per partner per year.
The argument for early stage diversification is that investors don’t know which company is going to be the next $100B company, so they invest in as many solid companies as they can to hopefully get into the next Google or Amazon or Uber.
I will argue that that is the wrong approach, and focusing on 3-5 early stage investments per year is the better path.
Concentration for concentration’s sake is very dangerous, and concentrated investing requires a lot of time and effort for it to pay off. Investors have to build conviction around industries, companies and entrepreneurs - which takes a lot of time. The only way you can build that level of conviction is if you are targeting a smaller portfolio, therefore enabling you to spend enough time with prospective investments to develop a deep thesis and strong conviction. You can’t do that if you are trying to make 50 investments a year and evaluating thousands of companies.
While the majority of early stage investors are highly diversified, with hundreds of portfolio companies, there are some that have maintained the discipline and rigor to stay concentrated and they are some of the most successful venture capital funds in history - Union Square Ventures, Benchmark Capital, and Emergence Capital are a few examples.
To use another Warren Buffett quote…
Diversification is protection against ignorance. It makes little sense if you know what you are doing.
Full-time investors should not be ignorant, they should be informed, deeply informed about the sectors, companies and people they are investing in. Information leads to conviction which leads to concentration. If you know what you are doing, be concentrated.
Being a valuable asset to your portfolio companies is also critical to be able to win deals and to be able to invest in the best entrepreneurs. Being able to get into the best companies and invest in the best entrepreneurs sets apart the world’s top venture investors. The vast majority of early stage companies will want their investors to understand their businesses deeply and to be able to provide meaningful support. The more concentrated the investor, the more they can understand the business and the more time they have to support.
This concentration and conviction from investors directly benefits their portfolio companies and entrepreneurs as well. At the earlier stages, companies need external support, guidance, mentorship, etc. from their investors and advisors. If you are invested in 100 companies you can’t do that. Therefore, diversification at the early stages will increase your investments chances of failing or performing poorly.
As shared above, I experienced this first hand at Full Harvest; our concentrated investors understood our company deeply and provided significantly more value when compared to investors who had massive and diversified portfolios.
Concentration is the Golden Rule of Investing…
Invest unto others as you would have them invest unto you.
If you are a passive investor and don’t have time to become highly educated on what you are investing in, YOU SHOULD DIVERSIFY and probably invest in a low fee ETF.
But, if you are a full-time investor, there is no excuse for ignorance and no excuse for diversification. Full-time early stage investors should be informed, should develop conviction, should deeply understand their investments, should be able to provide support and add value if needed. Full-time early stage investors should be concentrated, it is better for the investors and better for their portfolio companies.