Why Should You Invest in VC/PE Equities?

Most investors, especially individuals stay far away from VC/PE types of stocks such as small biotech stocks because of their extremely high volatility in the stock market.  You can gain ten-fold return within a short period or you can also be entirely wiped out within an even shorter timeframe.  The latter scenario is scary.   However, in my perspective, only looking at the standard deviation to measure risk is very misleading for Venture Capital/PE investments.

Why?

Let’s put things in a simple framework. Assume you have a million dollars on hand to invest and you don’t have the secret sauce or are smarter than the rest of pack to beat the market.  So your choice of winning and losing are equally 50%.

So if you take a mainstream approach by only investing big stocks, if you win, you attain 5% in the 3 years ahead, if you lose, you reduce by 5%.  Reference the table below:

base $

year1_return year2_return year3_return
win 5% 5% 5%
$1,000,000.00 $1,050,000.00 $1,102,500.00 $1,157,625.00
lose -5% -5% -5%
$1,000,000.00 $950,000.00 $902,500.00

$857,375.00

 

If you take an unconventional approach by putting this one million into a private equity, which, if you win, you win till the third year with ten-fold in total, while if you lose, you lose it all:

base $ year1_return year2_return year3_return
win 0% 0% 1000%
$1,000,000.00 $1,000,000.00 $1,000,000.00 $11,000,000.00
lose 0% 0% -100%
$1,000,000.00 $ 1,000,000.00 $1,000,000.00 $0

Let’s not look at the percentage of 5% vs. 100% as a risk measure.  If so, obviously you should always run away from PE where you can be wiped out 100%.  Take another angle.  If you want to lift yourself from $1 million middle-income net worth class to the $10 million net worth bucket, what’s the probability of achieving this goal?

In the first scenario, you bounce up and down along the $1 million track the chance is zero to meet $10 million thresholds.  In the second scenario, you have 50% possibility to be a $10 millionaire.  I’d like to apply what I learned from basic quantum physics that quantitative change causes a qualitative change.  So a $1 million net worth vs. $10 million wealth sets apart two groups distinctively.  When you are able to hit an upper-level orbit, qualitative events can be triggered to open up more opportunities as a wealthy class member.

Looking around, you can see so many wealthy VC/PE capitalists placing their money into “conceptual” start-ups without any revenue for years.  Meanwhile, you can also witness more ordinary investors being complacent with investing in blue-chips with a mediocre return.

If you are young, you have tremendous human capital in the future.  If you are relatively rich put a chunk of your savings into PE and consider them as a sunk cost which is affordable.

Nevertheless, for people who don’t know a specific arena, say biotech, you don’t know how a new drug is developed.  Nor do you know as well the complex approval procedure by the FDA.  It is very risky to invest in these type of equities without some scientific knowledge base. Therefore, arm yourself with trustable experts if you do want to dive into this kind of investment adventure.

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