There’s a never-ending debate between two schools in venture capital: one advocates for broad, diversified portfolios, while the other aruges that a highly concentrated portfolio is the way to do venture investing.

The first approach assumes that serendipity drives startups, making it impossible to predict which few will succeed. Therefore, it’s better to adopt an index-like strategy, building a broad portfolio to maximaze chances of hitting the next big thing and get decent market returns.

The second camp argues for making a few high-conviction bets, aiming to hack the power law—where a small number of outliers generate most returns. They believe in ability to identify these few outliers early on, and the focus on allocating all resources to amplify their success.

Private Markets vs. Public Markets. The Context

Many of you may know my addiction to scientific approach. In public markets the scientific truth is that you’d better off keep away from believing in your superpower. My mantra here is pretty simple: buy the cheapest index fund on a regular basis and deactivate your brain while doing so. That’s where my previous roboadviser startup came from. I still believe that this the only best approach for 99% of people and this is the only investment advice I dare to provide to my friends and family.

However, private markets operate differently.

In public markets information is believed to be evenly distributed and available for everyone at the same time.

Private markets are all about networks and arbitraging information sourced through these networks. As VCs often say, information is the currency. Hence, those with the best connections can spot the next big thing and make large bets with lower failure rates, justifying a more concentrated approach.

Recently, I re-read the Power Law book, filled with stories of massive bonanzas — 1000x+ returns that the likes of Kleiner Perkins, Sequoia, DST Global and other firms had at the time. These high-conviction bets made them iconic in venture capital.

Even as a long-time advocate of diversification, I found myself drawn to the allure of being contrarian to achieve legendary status.

However, this comes with survivorship bias. Many underperforming funds also had concentrated portfolios but faded away, unheard of. While a single investment can make a fund, missing that one critical opportunity can be disastrous.

Let’s crunch some numbers and find out who’s right.

Rebel Fund, which holds the most extensive database of Y Combinator startups outside of YC itself, offers valuable insights into this debate. Jared Heyman, a partner at Rebel, shared the math behind YC portfolios.

They conducted Monte Carlo simulations to test the performance of various YC startup portfolio sizes. The main finding? To achieve the highest return with the lowest risk, even with YC’s high-quality deal flow, you should aim for the largest portfolio possible, though diminishing returns appear after 50-75 companies.

Dave McClure, ex-founder of 500 Startups, reinforces this perspective by stating that “investing with conviction” is a myth.

David Cohen, founder of TechStars — another legendary accelerator with 20+ unicorns backed on their pre-seed stage  — advocates for the same approach.

David challenges the idea that concentrated bets lead to better returns with a bunch of his own findings.

Performance of one fund has nothing to do with performance of the next fund managed by the same manager. Access to a top VC fund today doesn’t guarantee success—it may underperform compared to funds that seem mediocre now, and vice versa.

David’s team also ran Monte Carlo simulations on their own portfolio startups (Techstars invested in many thousands of startups). Here’s what they found out:

If you build a portfolio of 15 startups, your median IRR is around 10%, similar to global equity markets but with a wider dispersion—from -8% to +31%. In contrast, random market deals yield a median return of 12.5%, with a narrower dispersion of 10% to 14%.

This raises a critical question: why take on higher risk for potentially lower returns with a small portfolio when a larger, more diversified portfolio offers higher returns with less risk?

Takeaways and Predictions

Millions of simulations show that the larger your portfolio, the more predictable your returns and the lower your risk, echoing trends seen in other asset classes.

This suggests that venture capital may evolve similarly to public markets, eventually offering ETF-like instruments with large, diversified portfolios and a passive approach for the masses.

While the timeline and path are uncertain, this seems to be the inevitable future of venture capital.

P.S.: I have to admit I’m somewhat biased as the founder of Uniborn, a platform focused on building large and diversified venture portfolios. However, as mentioned above, I’ve found myself occasionally drawn to the high-conviction strategy, only to ultimately reaffirm my belief in the power of diversification.

— Dmitry Samoylovskikh