#003: Invest Like Venture Capitalists (Part 3/4): Quantifying worst, modest, and best case scenarios
Did you ever ask yourself: What could I exactly lose vs. how much could I exactly win? — You might lose 5% of your net worth but your win might be life-changing !
In this post, I explain how I quantify three possible scenarios when investing in Crypto.
Once you understand how to estimate and control risk with respect to your current net worth then you can entirely focus on opportunity.
This enables you to think really big when investing.
Unfortunately, most people think about risk out of context because they don’t consider its relation to one’s net worth.
You can download the full content of this article as a PDF-presentation at the bottom of this post.
In life, you only need to hit one home run. But to get there, you have to swing the bat many times.
In part 1 and 2 of this series of posts, I explained how I apply the venture capital power law to maximize my chances to hit a massive return with Crypto.
In this post, I will show you how to quantify possible return scenarios prior to investing.
With this framework you can invest regardless of current market conditions while consistently maximizing your likelihood to substantially increase your wealth.
Recall that we are talking about high-risk high-return investments where each individual investment on average has a higher chance to fail than to succeed.
But you are optimizing the total number of investments for having a big winner in your portfolio.
Applying a rule of thumb of angel investing, it is not recommended to allocate more than 5% to 10% of your (liquid) net worth to such high-risk investments.
I personally cap my total Crypto investments at 5%.
Setting the stage for your investments
As Jason Calacanis (well-known angel investor in Silicon Valley and author of the book “Angel“) states, as an angel investor you probably need to invest in at least 50 startups over 3 years in Silicon Valley in order to have a chance at an outsized return.
Personally, I am investing 5% of my net worth in about 150 investments over a time frame of 3 to 5 years, which implies investing in 30 to 50 projects per year or 2 to 4 projects per month.
If you follow this strategy, then on average you will invest 0.03% (=5%/150) of your net worth per project.
As this is on average, some projects you might invest more and others less.
Especially, on the investments that gain value you might want to double, triple or quadruple down at a later point.
Regarding your first couple of investments, I certainly suggest to stick to those 0.03% per investment as an upper bound.
If you completely fail on your first 10 investments you will have lost 0.3% of your net worth, which generally is still less than what the stock market could recover in 1 month averaged over a decade assuming a 5% YoY return on all your other non-Crypto investments.
Let’s have a look at possible concrete scenarios.
Scenario 1: Loss & estimation of potential worst-case
First, let’s consider a possible worst-case scenario to understand the potential downside.
- 90% (= 135) of your 150 investments go south and are completely lost;
- 5% (= 8) of your investments (= 5.3% to be precise) return exactly the invested amount and thus, result in a zero-sum game.
- 5% (= 7) investments (= 4.7% to be precise) return twice the invested amount;
In the end you will have a loss of 4.27% of your net worth (see table and graph below).
Again, your strategy for traditional investing should make up for that loss after max. 2 years (averaged over a decade).
Scenario 2: Modest positive return
A scenario that might reflect “angel” investing more realistically could be the following:
- 70% (= 105) of your investments are lost;
- 10% (= 15) of your investments provide a 1X return (= zero-sum game);
- 14% (= 21) of your investments provide a 2X return;
- 2% (= 3) investments provide a 5X return;
- 2% (= 3) investments provide a 10X return;
- 2% (= 3) investments provide 20X return;
Your total return on a 5% net-worth investment will be 5.4%.
Hence, you made 0.4% profit relative to your net worth. Inflation over 10 years will most likely swallow that profit.
The overall investment performance is 8% (= 0.4% / 5%), which over a period of 10 years is certainly not life-changing but probably worth taking the risk as the outcome could have been scenario 3 (continue reading).
Scenario 3: Life-changing return
Now, let’s go through the scenario we are aiming for, which is almost exactly identical with scenario 2 above.
However, the difference is that instead of harvesting
- 2% (= 3) investments that provide 20X return
- 1.3% (= 2) investments provide 20X return;
- 0.7% (= 1) investments provide 1000X return;
Your overall performance will be a stellar 992X or 661% ROI or +33.07% profit relative to your net worth.
Clearly, a 33% increase in net worth is life-changing to most of us, except for the ones who are so incredibly rich that a 33% increase in net worth won’t affect their life in any way.
Additional aspects to consider
For the sake of completeness, I am going to mention further points that you want to have thought through while on your venture journey.
DCA a.k.a. dollar-cost averaging
As the Crypto markets are incredibly volatile, depending on the amount of investment it might make sense to distribute it in “investment-chunks“ over time.
It is not uncommon that the price of a token fluctuates 20% (or more) up or down from day to day.
Thus, if you are planning to invest several hundred dollars into one token, you might want to distribute that investment over the course of several weeks or several months
Doubling down on investments
If you observe 4X to 10X growth on an investment, you might consider quadrupling your initial investment amount.
Of course you still want to keep an eye on the percentage of net worth of that particular investment.
If you quadruple, then you would now be invested with 0.03% + 4 x 0.03% = 0.15% of your net worth, which you might probably still be okay with in case you lose it.
However, I suggest not to invest without explicitly understanding the percentage of your net worth at stake.
I personally don’t invest more than 0.2% of my net worth in one single token due to diversification and regret-minimization.
Time-frame to harvest returns
Don’t expect to harvest returns earlier than 3 years but possibly not before 10 years after your initial investment.
Some tokens have exploded within 3 years and others might suddenly take off after nothing happens for a long time.
In any case, the amount invested should not be cash that you might need any time soon. These are possible long-term investments that might not materialize at all.
Regret-minimization and opportunity cost
Minimize regrets when you invest and when you take profits.
When you invest, constantly be aware of the overall investment amount as well as a single investment amount in percentage of net worth.
It is the only way to make a sound assessment about what risk is at stake and what opportunity you might take.
Furthermore, also understand the opportunity cost of an investment in real life (IRL).
Ask yourself the question: what would or could I do with that amount instead?
Could or would you buy an iPhone, a new car, 2 weeks of holidays at the beach?
Characterize and define your IRL opportunity cost before you invest so that you understand what IRL sacrifice you did in case you lost the money.
Tracking mistakes and learning from experience
Because you are reading this post, you are already actively avoiding one of the biggest investment mistakes to be made: investing without a sound strategy that is based on first principles.
However, by “mistakes“ I rather mean mistakes in line with the strategy.
Analyze and track the following moves to get better at the VC game:
- Investments you did not do:
- Track them and understand why you did not invest. Recall that “a loss“ in VC is characterized by the winners you missed (a.k.a. your “anti-portfolio“, e.g. click here for an example).
- Investments you did execute:
- Write down notes and comments in your spread-sheet describing why you did invest.
- Keeping your investment memos up-to-date will help you get better at assessing opportunities and decision-making year after year.
- Times when you doubled down on an investment or when you decided not to double down.
The simplest way to keep your memos in one place is a spread sheet describing tokens you are invested in and potential investment opportunities.
- When investing, understand the percentage of your net worth at stake.
- Understand the opportunity cost: what else could or would you buy if you did not invest? Be clear on the potential sacrifice you are taking.
- Once you understand how to estimate and control risk with respect to your current net worth, you can entirely focus on opportunity.
Don’t miss Part 4/4 of this article series, where I explain how to concretely pick the individual investments.
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PDF / Slides
Download the entire content (parts 1 to 4) as a PDF-presentation here (feel free to share it).
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