Problem: Quantifying Risk 

In my undergraduate financial markets class, we were taught Modern Portfolio Theory which seeks to maximize returns and minimize risk.  In one exercise, we had to calculate the best asset allocation between equities and bonds to give the highest expected return.  This calculation was based on some quantifiable risk and correlation of risk.  

The real world of course is quite different than what is on paper — choosing what to invest in isn’t quite so obvious.  In fact, a lot of the beliefs in quantifiable risk calculation have been thrown out the window in the last few years due to the financial crisis and the contrarian thinkers like Nassim Nicholas Taleb who were proven correct about financial institutions’ inability to identify and manage risks.  Without proper quantification, the models for asset allocation are thrown into question since you don’t know how much risk you are taking when buying publicly traded securities.

With this in mind, how can entrepreneurs improve asset allocation for their hard earned money?

Solution: Just Accept You Only Know Riskiest and Riskless

Taleb argues that if you accept that you can’t quantify risks well, then you should be hyperconservative or hyperaggressive instead of just mildly either. He writes in The Black Swan:

Instead of putting your money in “medium risk” investments (how do you know it is medium risk? by listening to tenure-seeking “experts”?), you need to put a portion, say 85-90 percent, in extremely safe instruments, like Treasury bills — as safe a class of instruments as you can manage to find on this planet.  The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios.

This Talebian asset allocation could make a lot of sense for entrepreneurs.  You have no idea of the risks in “mild risk” assets and you have no ability to influence whether IBM stock goes up or down.  You do know your startup company can be worth a lot and you do have a say in its outcome; however, you also know it is extremely risky.

Examples of Talebian Asset Allocation by Entrepreneurs

Now, this may seem extreme, but I’ve actually met an extraordinarily successful entrepreneur in Norwalk, CT recently who has been doing exactly this since the start of his entrepreneurial career 15 years ago.  He plows some of his gains into angel investments but a lot into his own new companies.  He argues that in fact this is more manageable risk than putting money into a small-cap or blue chip firm since he directly influences the outcome and management of the company.  Putting the other 85% into T-bills makes sense since it will store the value, provide liquidity if needed, and generate some incremental cash.

Of course, he had the benefit of multiple successful exits so I asked one of my angel investors, who only recently had a huge exit from a successful company he founded, what he did with his fortune.  After selling some of his shares to a private equity firm in 2008, he was going to give his money to a major private wealth manager to handle; however, he was in the middle of starting a new company so he forgot to authorize allocation of his money outside of cash and t-bills — fortunate for him since the market dropped double digits during that time.  Now, he primarily makes angel investments and starts new companies.

That brings me to the last case, where you haven’t had a large exit yet and in fact don’t have substantial piles of cash — this would include myself.  In that situation, entrepreneurs are generally inverted in asset allocation (85% in venture-capital style assets which is really just 1 company, 15% in cash or treasuries).  I think this actually make sense when you’re young and can try several times to achieve an extraordinary return from your sweat without the same risks you have later in life like failing to pay a mortgage.  

Other Ways Of Improving Asset Allocation

Ideally, young entrepreneurs would be able to at least spread risk a little across a few companies.  This will expose me to the same possible returns with a lot less risk.  This is why I think what Josh Kopelman at First Round Capital is doing with its startup equity exchange for its portfolio companies is amazing.  

SecondMarket recently opened up the illiquid market for later-stage startup company shares.  Of course, the companies have to be huge by then often times with market caps in the hundreds of millions or billions.  

It would be great (though unlikely) for financial reform to allow startup founders to be put their own equity value toward meeting the accreditation requirements for angel investing. 

Does anyone have other great ideas for improving entrepreneurs’ asset allocations?