My biggest criticism of this analysis is his wild overstatement of the benchmark return. Where in the world do you get 8% safely in equities and/or real estate? It's more like 3-5% because the world is awash in capital with precious few places to put it into play.
Which in a way would support his main point more strongly: venture returns are inevitably coming down from 12% to 7 or 8% annually.
This is one example of a number of ways the article is weirdly disingenuous. Thea author compares returns to equities but risks to nothing, as you point out. Separately, when he cites an estimate of 3.01% annual return from alpha and 4.62% from beta, all he has to say is that "most" of the returns are from beta and that fees are high, pretending not to understand that returning 3% per year due to alpha after fees would actually be quite impressive and valuable.
Everything of interest here is a consequence of the author's decision to use annual rate of return as his figure of merit.
Simplified example: you have a pool of investment opportunities where with probability 0.01 you gain $100 and with probability 0.99 you lose $1. So your expected gain from making a bunch of these investments is a gain of 1c per investment. If you make a million of them then with very high probability you gain something very close to $10k in total, on your $1M investment, a 1% gain. Now, suppose each of these investment opportunities takes 10 years to do whatever it does. Then (to first order) your return rate is 0.1% per year, more or less all the time; so your average return rate is about 0.1% per year. So far, so good.
Now suppose that you can only make one investment. Then your annual return rate is 99^(1/10)-1, 1% of the time, and -1 the rest of the time. Key point: 99^(1/10)-1 is about 0.6, which is a lot less than 99/10. So your average return rate is now absolutely wretched.
So, have we just discovered something interesting about the real costs and benefits of high-variance investments, or merely blinded ourselves with science? The latter, I think. I'll try to explain why.
Why use averages to summarize things, in the first place? Because they describe what usually happens in the aggregate. When they fail to, or when that isn't what you care about, averaging is unlikely to tell you what you want to know. So, does our averaged return rate tell us anything useful about what happens in the aggregate? Why, no. Suppose A and B both invest $1; A loses his money and B doubles his. And suppose each of these things happens over 10 years. Then their return rates are -1 and +0.072 respectively; their average return rate is extremely negative; but A and B collectively neither gained nor lost any money. Similarly, if you make a whole lot of investments then the average of your return rates is not the same as your overall return rate. (That's exactly why the author's calculation produces the results it does.)
Here's another way of looking at it, which I actually prefer. There's nothing magical about annual return rates. But the author's curve would look completely different if he plotted six-monthly return rates (it would be worse [EDITED TO ADD: than the author's annualized curve) for smaller numbers of investments) or five-yearly return rates (it would be flat and show a positive result for any number of investments). So what the curve illustrates is not a fundamental truth about investment, it's an artefact of preferring to look at return rates over a time period that differs from the length over which the investments make whatever return they do.
The stock market generally returns around that amount, though not in a stable manner. (Hence its hard to infinitely borrow stable capital at 5% to fund unstable returns at 8%).
7% real return is a relatively high assumption. In the article Ritholtz assumes 8% nominal returns and 2-3% inflation, so 5-6% real returns. Even assuming 5% real returns is somewhat optimistic. Developed countries in the last 100 years or so have achieved that, but most places in most time periods have not.
Ok, fair enough, but today's Risk Adjusted ROI is quite low. And comparing returns from a couple of decades in the past with current returns seems unhelpful to me.
My point is that your standard has to be for your choices of the capital today versus historical returns. So if you compute for expected value of a million dollars sitting in a bond fund today, versus sitting in a basket of startups, are the returns less in the latter case?
Totally agree on not timing the market and staying invested. Nonetheless this analysis raises more questions than answers for me.
First, as you often see in these studies, they use the S&P500 which has returned a 9 or 10% annualized rate for decades now. How realistic is it to see someone's entire wealth invested in just this benchmark? Diversification will almost always mean returns lower than than the S&P. Ultimately this erodes at the findings of the study.
Second, there's no mention of yield which is basically the guaranteed portion of the return. This portion alone accounts for a quarter of your annual return making it another compelling reason to be invested early.
Pages 3-4 specifically, but the whole paper is excellent. RE has returns that are reasonably (imho) similar to securities over the long term, low volatility, and you need to live somewhere (although you might see greater returns in the capital markets depending on your entry/exit points [1] and risk tolerance).
I’d caution that recent equities returns are very likely an outlier, part central bank easing, part yield chasing, part unsophisticated money, and arguably unsustainable.
8% return in equities market? Wow... I did not know what I can just invest money in the stock market and get rich...
The 8% annual return is impossible to achieve (BTW, that is number what sharks tell to "retail investors"). Between 1998 to 2008 the annualized return on SP 500 was about -1.35% (yes negative and there was huge boom during 2000s). And that is excluding all fees.
I think 8% would be an excellent return for limited partners who invest into VC funds...
The problem is you are applying post-hoc analysis.
While a theme was that the outsized returns can come from ideas which sound bad, it doesn't necessarily say that all outsized returns come from bad-sounding ideas.
Not only that, but I think reading the essay will show that the outsized returns are not known until several years after demo day.
Sometimes bad ideas are just bad ideas. In the Venn intersection between bad-sounding-ideas and good-ideas - the 'bad sounding and not good' is a much bigger area.
To me, the entire essay is about making sure that institutionally, the bad-sounding-but-ultimately-good ideas are not left out. Trying to further identify and silo them at application stage would be even more fraught.
I forgot to mention that I am from India where those kind of returns aren't unusual. Mostly because India is still in the high-growth phase of development.
Which in a way would support his main point more strongly: venture returns are inevitably coming down from 12% to 7 or 8% annually.
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