Investing is Simple, Not Easy
Summary
- Compounding is the single most powerful force when it comes to investing (Saving + Investment + Time = Wealth)
- Angel investing allows you to diversify a portion of you portfolio with investments directly in businesses that have the potential to generate outsized financial returns
- It’s not about the frequency of your wins and loses, but the magnitude of those wins and loses
Introduction
Do you know the single biggest factor that separates the most successful investors from everyone else? Furthermore, do you know it’s something you have total control over?
You don’t need to have a Ph.D. in mathematics or a degree in finance to understand the very simple formula that governs investment returns over time:
Saving + Investment + Time = Wealth
This equation works beautifully to generate wealth because of the power of compounding interest. The key here is that compounding interest is calculated based on the principal plus all of the accumulated interest from previous periods. It shouldn’t come as a surprise then that the number of compounding periods makes an enormous difference (this point cannot be overstated enough!).
Let’s look at a quick example. The U.S. stock market has historically returned roughly 10% annually. If you compound your money at 10%, in 25 years you would realize a 10x return on your investment, so if you invested $100,000, in 25 years you’ll be sitting on a cool $1,000,000.
But wait, what if your time horizon was 50 years? At a 10% annual return, it means you would realize 100x return on your investment and turn $100,000 into $10,000,000 (all you parents and grandparents pay close attention)! So, the true power of compounding is not only having the financial discipline and resources to make the initial investment, but time.
As Warren Buffet is fond of saying, investing is simple, but not easy. While the formula for generating wealth is straightforward, the single most challenging aspect for most of us is having the discipline to stick with your long-term financial plan, invest consistently pay-check-after-pay-check, and not panic when periodic bouts of extreme volatility hit (such as we are witnessing in the global financial markets now due to the emergence and spread of COVID-19). Oftentimes, we are our own worst enemy when it comes to investing, selling our winners too early and holding our losers too long.
But compounding is only part of the equation.
Optimizing for Black Swans
What if you don’t have a 25 or 50-year time horizon or aren’t disciplined enough to stick with a long-term financial plan? Or, what if you’re simply impatient and would prefer to spend all of those future riches today?
Take a moment and think about every person you’ve ever seen on the Forbes billionaire list…what is the one commonality among all of them? They are all business owners. They all started business empires which generated extreme levels of wealth for themselves and their families.
Now, clearly entrepreneurship isn’t for everyone for a myriad of reasons we don’t need to get into here, but did you know there is another way to be a business owner and reap the same (or similar) rewards as the entrepreneurs who pour their blood, sweat and tears into building their empires?
One of Charlie Munger’s core tenets when it comes to investing is to treat a share of stock as a proportional ownership stake in the underlying business. So why not invest in businesses that have the potential to generate outsized financial returns for your portfolio?
You could do this by investing in the public markets, but as Meb Faber, Co-founder and Chief Investment Officer of Cambria Investment Management, says, “while power laws dominate both private and public markets, the lower starting point of angel investments with a $10 million market cap allows for a potential moonshot to occur perhaps more easily than a public stock trading at a $10 billion market cap.”
So why not take some of your hard-earned capital and invest it in other people who have great business ideas and optimize your portfolio for positive black swan events (i.e. give yourself a chance to strike it rich)? In other words, become an angel investor.
The Power of Mathematical Thinking: Frequency vs. Magnitude
There’s a common misperception and cognitive bias when it comes to angel and venture capital-style investing: frequency of loss. While it’s absolutely true the risks are higher when it comes to investing in the private markets and you are much more likely to lose 100% of the capital you invest in any given startup than if you invested that same capital in the public markets, it’s also true that the potential rewards are far greater too. When it comes to investing, risk and reward are opposite sides of the same coin. The more risk you take, the higher the reward you should expect.
But here’s the catch, which the best investors in the world intuitively understand: it’s not about the frequency of your wins and loses, but the magnitude of those wins and loses.
As Babe himself said, “How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.”
So again, this comes down to a simple math problem, this time it’s the concept of expected value. In statistics and probability analysis, the expected value is calculated by multiplying each of the possible outcomes by the likelihood each outcome will occur and then summing all of those values. By calculating the expected values, you can choose the scenario most likely to give the desired outcome, in other words the scenario which has the highest positive expected value.
Expected Value = (Potential Reward x Probability of Occurring) — (Potential Loss x Probability of Occurring)
Let’s look at another quick example:
Let’s assume you’re considering making a $25,000 investment in a startup and you assign a 90% probability of the startup failing (in-line with the base rate of startup failure). That’s the risk side of the equation and defines your potential loss. On the reward side of the equation, if there is a 90% chance of failure, then you are assuming a 10% probability of success. Furthermore, let’s assume you believe this investment can generate a 10x return on your money, or $250,000, then the expected value of your investment is $2,500 [($250,000 x 10%) — ($25,000 x 90%)].
What if you assigned the probability outcome not as 10x, but 100x on your investment, in other words a true outlier on the return distribution curve)? Then the expected value would be $227,500. Either way though, theoretically this would be a good investment since it has a positive expected value. Of course, it’s important to keep in mind it should be viewed as relative to the expected value of other investment opportunities you have, but you get the idea.
The key point here is that the expected outcome of winning your bet needs to be large enough to account for the higher probability of losing the bet. That’s why venture capitalists only invest in companies with enormous market opportunities and business that can scale quickly. The nuance for you though, as an angel investor, is you don’t have a $1 billion fund to return to limited partners and so don’t necessarily need to hit a 100x return (although of course it would be nice).
A well diversified portfolio of startups that gives you a statistical probability of success, in our humble opinion, seems to be a smart way to enhance the return potential of your portfolio, diversify your investments away from the volatility of the public markets, and invest in entrepreneurs and companies that you believe in. The higher risk, given the proper portfolio construction and upside potential, should take care of itself. And who knows, maybe you won’t have to wait 50 years to earn that $10,000,000 (just don’t get your hopes up).
— Neil Littman
Special thanks to Meb Faber, Co-founder and Chief Investment Officer of Cambria Investment Management, and his blog “The Get Rich Portfolio” for the inspiration and many of the examples in this piece.
Disclaimer: Bioverge is not a registered investment advisor and nothing contained in this blog is meant to be a recommendation on how to allocate your assets or is intended as investment advice. Returns presented here are not necessarily representative of the companies listed on Bioverge and do not reflect projected returns. This blog is meant for informational purposes only.
