Cradle Investing and  Modern Portfolio Theory

Investors can reduce risk by increasing diversification both within asset classes and across asset classes.  The lower the correlation  of returns across investments and asset classes, the greater the risk reduction. This is the essence of modern portfolio theory.  Still, there is a paradox when considering early round investing -- smaller investments allow for more diversification (good), but the investment management costs of investing in multiple small ventures is quite high so that overall returns are negatively impacted.  Further, early stage venture capital investments are both high risk/return and illiquid.  On the other hand,  early stage investments are also very different from other asset classes producing a low correlation of perspective returns. Those differences can compensate for the increased risk and earn early stage investments a place in the modern portfolio if investment management costs can be controlled.

 

For large investors the diversification benefits of early stage investing are usually outweighed by the costs associated with making such investments. Hence large investors often wait for companies to become more mature before investing. By waiting, large investors can invest a greater amount of capital in fewer and larger investments with  lower investment management costs. However, the more mature company more resembles a publicly traded stock investment.  Thus by waiting, investors give up some of the benefits of asset class diversification. 

 

Early stage start-ups have less available investment capital because larger investors tend to favor more mature venture investments.  The consequent reduced level of investment capital for early stage companies increases perspective returns (lower price from less investor competition) with the benefits of low correlation  of returns still in place. Cradle investing opens up early stage investing to more investors by reducing the time and monetary costs associated with investing in new start-ups.