Bonds vs. Venture Capital

I saw this interview on The Big Picture this morning and realised that right now, you can buy insured, tax-free municipal bonds with an approximate 5% yield. Just so you understand what that means. This is an investment with a guaranteed 5% annual return, practically zero risk as it is insured. And it is tax free. And it is liquid. And the transaction costs are minimal.

 

It reminded me that start-up VC investment is quite a different beast. Below, I have included a chart of the distribution of investment success in a very well established VC fund. This is a US technology oriented VC firm, the chart is some 5 years old. Neither I nor my company have or had any connection to this VC firm.

VC Return

 

So, the thought that occurred to me this morning was that in all likelihood nobody has ever been fired for buying insured bonds with a 5% yield. The story is different in venture capital. In a VC fund, different partners are responsible for different investments. Now, remembering probability theory, the standard deviation of the distribution of outcomes in a small group (e.g. the investments of one partner) is larger than the standard deviation of the distribution of outcomes in a larger group (e.g. the whole fund). This has got some interesting consequences.

An illustration of this would be the following. Imagine you buy 10 apples and distribute these ten apples to 5 people (lets call them partners). The problem is that two of these apples are rotten at the core, but you can’t distinguish the apples from the outside. You know that two partners are likely to get one rotten apple each. If one partner is really unlucky, that partner will get both rotten apples. In the VC world, when you end up with one rotten apple, you get frowned upon. When you end up with two rotten apples, you get fired.

I guess you have to choose whether you want a hassle-free guaranteed 5% or whether you play the high risk high reward game. Pick your poison.

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