If you find this blog useful remember to share it with a friend :)
Choosing How Much To Invest Can Be Difficult
When making an investment decision for our shared pot, one of the most difficult aspects is choosing a size. I will circle around the block in order to explain why this is the case.
For passive pots, my approach is pretty standard: I invest a specific amount on the same day of every month in perpetuity so long as my income allows it. The idea is that by using a time-weighted approach, it reduces all bias around choosing the ‘perfect’ time to buy. For me personally, passive pots have a long term/ indefinite time horizon so nuanced timing and sizing decisions are completely irrelevant. What’s more important is consistency. In terms of sizing, this is dictated by a static percentage of income. So what’s clear to see here is that for my passive pot (Nutmeg portfolios) I don’t make any active choices about sizing nor timing, the direct debit just comes out periodically.
However, for active investments such as my ETF portfolio and joint active pot alluded to at the start of this blog, chances are that timing and sizing investments will not be a systematic in the same way due to underlying differences in:
Time horizon risk metrics
Tactical strategy
Dealflow
For instance, when there are no high conviction plays at hand for these activities, contributions may sit in cash until deployed. As for sizing, my ETF portfolio uses ‘blow up’ scenarios to determine the weight of each additional asset. In practice, this involves deriving a size based on numerous conditions. Check it out below.
Rules of Thumb I Use For Discipline:
Maximum Risk Contribution: Worst Case = -10% of total portfolio*
Maximum Theme Weight: 50% of total portfolio value
Maximum SIngle ETF Weight: 25% of total portfolio value
Minimum Theme Weight: 5% of total portfolio value
Minimum SIngle ETF Weight: 2.5% of total portfolio value
This extract is from my two-part decision making framework which you can check out here & here.
Optimising Investment Size
For our joint pot, we invest in companies in the private market who are much earlier on the equity lifecycle than public companies. Typically early stage post revenue startups all the way up to late series stage pre-IPO companies. We honed in a focus on this segment because it’s super interesting, we can apply our experience from other segments of the market and perhaps most importantly although high risk it can generate some handsome returns.
For our pot we contribute equal amounts on a monthly basis and have been doing so for more than 3 years now. We take the approach that each of these investments can return max loss i.e. -100% and we lose all of our money which is entirely realistic given the nature of immature companies operating in often emerging segments.
In addition, deal flow is not consistent at the same pace across any given time period and sometimes we may not have the minimum cheque size required in liquid cash yet. With all these barriers and given the fact that we do not get to roll the dice regularly enough to maintain a turnover of held portfolio risk profile, sizing becomes all the more important i.e. how hard we swing the bat at each unstandardised opportunity. I had a think about this for a couple of weeks and decided on the following matrix. I’ll go on to explain the parameters I considered which underpin this.
Deal Settings
Fund Contribution = total amount of money put into the pot to date
Investment Size = potential size of the next investment
Initial Valuation = valuation of the company to be next invested in
Fees = any cost associated with deploying the next investment
In this example, the pot has had £23,530 of contributions over the life of its existence, the next explored investment size is £1,000 in a company worth £6m where fees are 12% on any potential gains through the form of carry and other factors. From the matrix we can see that in order to return the pot size this company will need to produce a liquidity event at just over 23x current valuation.
I will share the editable model with those of you on the premium channel in case you want to have a play around with it or a deeper chit chat.
This is just an example hurdle rate, for some people it could be 50% of the pot or 500% of the pot. With this frame of thinking, it becomes easy to g-check the conducted research - is the company capable of a 23x mark up? This may encourage to size up or down or swerve entirely. Happy to chat through this matrix with you guys, I know some people have a different approach.
The things we care about are the following:
Potential return of the incremental investment at hand
Rate of total contribution growth over time
(over time the aim is to generate a return above our total contribution amount which essentially is a continuously growing number given we contribute every month)
Increasing risk of negative portfolio return over time
Increasing hurdle rate for each new investment over time (becomes exponential after every outsized failure)
The way I look to manage the risks mentioned:
All fundamental research and due diligence should determine a sensible expected upside return multiple upon a liquidity event (downside is -100%). Then can use the matrix to scenario test this with various sizings.
We can simply model the impact each incremental investment would have on the portfolio overall (as measured by total contributions) by tweaking the relevant settings/conditions.
(see deal settings in the matrix above)
We also account for fees because for a small return it is not a big absolute figure but due to law of numbers when a company returns >1x and especially towards the >10x and beyond area it becomes much larger.
This impacts contribution risk even more as time progresses and contributions accumulate.
We can then use the matrix to determine in any given time, how we should size the next incremental investment.
The decision is ultimately determined by the hurdle rate required for the investment to be attractive.
For example, if we have a high conviction play and a hurdle rate of 100% of our contributions up until now, we can see based on the current valuation what multiple is necessary for this to be possible given the selected size of investment.
And again, can size up, down or swerve the deal accordingly.
Of course if we have maximum conviction we should invest the same size of the contributions so far but in reality this is not possible. Anyway, in reality it may be a case of deciding between £500, £1k and £2k or however much it may be.
The point is, we can choose a size that is somewhat optimal based on expected return hurdles and ongoing dynamic nature of contribution risk.
Contribution Risk can be defined as: contributing, investing and never generating enough of a return to cover all historic contributions plus the opportunity cost of investing elsewhere plus all the premium associated to funding early stage growth charged businesses
Anyway I will leave it there until next time, good luck salvaging summer and happy asset accumulation!
If you want to keep up with all the investment plays & drops over the year, join us on the premium channel.
Until next time,
Peace!
[If you’re a corporate person don’t forget to check out the crypto drop ➡ Trad-Fi to DeFi]