5 Reasons Angels May Have Small Portfolios

Why Angels Have Small Portfolios

The typical angel investor has a portfolio of just seven companies, the American Angel Survey, an effort to gather information from nearly 1700 accredited investor angels, reveals. The 75th percentile is just 15 investments, and the maximum portfolio is only 106 investments.

The small portfolios of typical angel investors surprise me because numerous studies of angel investing show portfolios that size are too small to ensure that the investor will generate an acceptable financial return at minimal risk. For instance, Monte Carlo simulations of angel investment return data indicate that investors need to build a portfolio of more than 50 investments to have a greater than 90 percent probability of a two times return on investment. In this week’s column, I will try to explain why angel investors build small portfolios.

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Why Angels Have Small Portfolios

Making Money Isn’t Their Goal

Eric Ver Ploeg, a former venture capitalist, who now puts together startup investment syndicates on Angellist says, “Most angel investors are investing for non-pecuniary reasons, so they rationally don’t care about optimal portfolio sizing,” he says.

Dave Lambert, a partner at Right Side Capital Management, a pre-seed stage investor, concurs. “Most have some other utility factor that is more important to them, whether they are aware of it or not,” he says. “Some specifically want smaller, concentrated portfolios because they enjoy working closely with the entrepreneurs. Some specifically just want to invest locally so that they can give back to their community,” he continues.

If investors are not trying to maximize their financial returns, then there is no reason for them to have large portfolios. Growing a portfolio is a way to remove risk, while generating a return. Lambert says, “If you consider that most angels don’t invest in a manner that maximizes their expected return, it’s not that surprising that even a smaller percentage operate in a manner that optimizes their risk/adjusted return.”

They Don’t Understand Statistics

Morris Wheeler, an investor with Drummond Road Capital says, “most angels don’t understand the concept of standard deviation. They think that if they put more money into fewer investments that they will have an opportunity to make more money. I can’t tell you many times I have heard people say, if I only put $10,000 into an investment I will get so diluted over time that my investment will be worth nothing. They simply don’t understand the difference between percentage dilution and value dilution.”

Another experienced angel says, “They are unaware of the Law of Large Numbers.”

They Haven’t Got the Time

Wheeler offers a third reason for small angel portfolios: limited time. He says, most angels “invest as a ‘hobby.” They don’t have the “pipeline to make that many investments… [and] can’t do the due diligence … [or] monitor that many investments.”

Venture capitalist Tim Schigel says, “People who enjoy working with startups … cannot possibly keep up with over 50 companies. They may actually enjoy getting their hands dirty with fewer companies.”

Marianne Hudson of the Angel Capital Association explains, “Most education I’ve seen has also recommended building your portfolio over time, say one to three companies per year…. Many … angels … are in the early stages of building their portfolios.”

Time affects angel portfolio size in another way as well. Because time is limited, some angels find it better to focus on selecting the right start-ups rather than on finding more of them to invest in. As Ver Ploeg says, “For an angel it is rational not to increase their portfolio size if doing so means spending less time evaluating and rejecting companies.”

Angels Overestimate Their Ability to Pick Winners

Former public equities hedge fund manager turned early stage fund manager, Larry Bernstein says, “Angel investing is just the most natural thing ever to bias otherwise smart people into overvaluing their own opinions on predicting the future.” Many angels think they don’t need a large portfolio because they know which new companies will succeed and which will not.

They Get Scared By Their Losses

An experienced angel offers another aspect of the psychology of angel investing — the horror of experiencing losses. He says, “Lemons ripen faster than plums: I’d guess that every serious angel I know recorded several losses prior to reaping their first positive exit.” Many angels see the money they have lost on bad deals and decide not to make further angel investments.

Discussion Photo via Shutterstock

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Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

One Reaction
  1. Scott: in the process of a little side project my partner and I have been working on – building a portfolio management tool for early stage investments (seraf-investor.com) – my partner and I have discovered a fifth reason: people don’t know what they have and they get overwhelmed by all the paperwork and details. In working with folks to get them organized and their portfolios online and visible with performance analytics, we were surprised how many said “now that I know what I have and I feel organized, I am feeling much more comfortable about adding to my portfolio.” That was a surprise to us the first few times we heard it, but now we accept it as established fact – when your angel investing is a disorganized paper chase, you tend to get overwhelmed and slow down. Once you get it laid out, you realize you have some good stuff, you’ve seen some returns and you get the confidence and sense of control to keep going again. Very interesting. -Christopher

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