Time Diversification: Strategy for Investors

Last week, I had the pleasure of meeting Jim Robinson IV of RRE Ventures (twitter: @jdrive). In our conversation, he mentioned something I thought was super important, which was that successful investors also diversify across time, in addition to diversifying their investments.
I thought that this statement was extremely important and something that is commonly not done at all, and dangerous to ignore.
What is Time Diversification?
Time diversification is:
Adjusting your strategy based on what is going on in the economy at the time.
Learning from what worked and what didn’t in previous economic cycles, and applying those principles to where we are today.
Investing the right way for where you are today in an economic cycle and doing it across multiple economic cycles. The second part of this statement is hard for those investors who have not been doing this long enough to experience multiple cycles.
Why Time Diversification?
The main danger of not time diversifying is if you go out the gate strongly and put a sizeable percentage of your funds in a short amount of time, you may end up getting caught by the negative aspects of a given part of an economic cycle.
Anyone knows that predicting what will happen in the economy is near impossible. Famous economists’ track records on predictions are pretty dismal. So the only thing you can do is to spread out your investments across time and try to ride whatever upside is going on today while mitigating risks of the downsides that appear along the way.
But if you put out all your money in a short amount of time, you could end up investing at a time when there is a downturn right around the corner which could crater your current investments and leave you with little cash to recover. Think about all those investors who raised funds in 1999 or 2000 and put money into companies who had stratospheric valuations, only to see them disappear as the dotcom bust wiped out all that value in late 2000.
Or you may miss an upturn by investing in yesterday’s downturn driven investment strategy.
So ideally, your strategy will be affected by time diversification. For example, prior to the 2008 economic downturn, we were investing in startups who were building for users primarily and on the assumption that if you get users, you’ll eventually find a way to monetize. This strategy began to kill startups as we entered the downturn because:
1. Startups needed a longer time to generate revenue, and needed to survive a longer time to do so.
2. Startups’ burn rate was too high and they ran through money before they could get revenue or raise the next round. Many entrepreneurs were unwilling to give up their lifestyle and lower burn and thus died accordingly.
3. Prior to the downturn, startups could go raise their next round on little revenue but decent traction and great, quality product. As we entered into the downturn, investors became instantly conservative and if you didn’t have traction AND revenue after the seed round, your chances of getting funding dropped to zero.
Thus many of us changed our strategy and started looking for startups who could survive and gain early revenue to survive long enough to create a sustainable business model. This ended the popularity of consumer internet startups focused on interesting user activity and caused a rise investing in B2B startups, and those consumer internet startups who could build an early business model based on making money off users.
As economic conditions change, we should examine where the economy is at that time and what the conditions tell us about how we invest, and what we should invest in. Timing it is near impossible, so we hope that adjusting our strategy over time, taking our lumps if we don’t act fast enough, riding the upturns when they come can help us keep our returns in the positive.
Why Do People Ignore or Don’t Time Diversify?
Some reasons why people ignore time diversification, or don’t do it:
1. Naviete – Simple lack of knowledge that this is important can mean that someone didn’t think about time diversification. Or they may have learned about it in school but wasn’t aware of its importance, and thus forgot about it. Or didn’t know how to integrate it into their strategy.
2. Lack of real world experience – Humans learn best through experiencing things first hand. Many people simply haven’t been through enough economic cycles to know what to do depending on where they are in one. That’s why talking to guys like Jim Robinson IV is so valuable because they’ve been in it since before the dotcom boom.
3. Irrational exuberance – Especially in periods of upturns, it can seem that you can do no wrong. Think about between 1995-2000; investors in the early part of that period made tons of money and, as Jim puts it, we all looked like geniuses no matter what we did. Or it could be a period of investment flurry, like what I believe is happening now where lots of internet startups are being funded left and right; you feel like you have to get in or else miss out. So during periods like these you may experience irrational exuberance and thus invest fast to try to get at as many deals as possible because you don’t want to miss out. The problem is that you ignore the fact that your funds are also dwindling fast.
4. Conversatism kills – Venture investing in particular is a risk taker’s game; you really have to be out there investing constantly in upturns and downturns (which is partly the reason for this post). If you’re a conservative risk taker (yes I think such a person exists!) and you wait until you’re “sure” that you’re in an upturn, OR you get in a downturn and pullback after the downturn begins, you’re always going to be investing at the peaks and pulling out in the valleys.
5. Economic cycles can be very long – In fact, long enough that an entire generation may no nothing but incredible growth and prosperity. This was experienced in the period between 1982 and 2000 where the S&P 500 rose from about 100 to an intraday high of 1552.87 in 2000. Those growing up in a period knowing only growth have not experienced downturns and thus we can get fooled that value of our investments will always rise.
What to Do?
Some thoughts on what to do:
1. Pace your investments. Don’t get caught up in having to invest in every deal that comes along. It may seem that every deal is super hot and can’t lose, but experience tells me that everything looks hot but the probability of success is very low.
2. Be disciplined in the amount of money you invest in each company. Do not get over-exuberant and start making bigger bets in the beginning. Look at the total amount of money you have and make it stretch across many years. Pick an investment size that allows you to do this. I made this mistake in the first years of my investing. Originally I thought that I should do $50K investments. That drifted upwards quickly as I got caught up in the excitement of being involved in deals to $100K. But now, I am down to $25K chunks in an attempt to still be involved but not run out of funds. Just think back to the number of investments I could have made if I had stuck with $50K, or even $25K, if I had not done $100K chunks. For each $100K startup, I could have invested more broadly into two $50K or four $25K investments. Another danger of going out with too high investment sizes is that you may pick a lot of losers, or get caught in an economic downturn. Then recouping your investment gets harder.
3. Be a student of economic history and do not ignore it. The first big downturn I lived through was when the first Bush invaded Iraq. It was a tough time but it didn’t hit me too hard as I had a job. The second period was the dotcom boom-bust. That was much more severe; having been at Yahoo, I saw our stock climb to amazing heights in 2000, only to watch them drop to amazing lows by the end of the year. There was a time when we all thought naively that the run up in internet stocks would never end. We even snickered at those who left Yahoo in 1999 or 2000 and cashed out at “such a low stock price” of 150. Now who had the last laugh? There is nothing better than first hand experience of such events and looking at the dumbass thinking we had back then. Lacking that, all I can say is that you should read a lot, talk to a lot of people, and take lessons from those who have lived through these times. I would also caution you to really watch out for books which were written for a given period. I remember reading about real estate investing and how buying houses was a great, no-loss wealth building strategy. Well, now look at where we are with that. Examples abound everywhere; be careful what you read and add it to your knowledge base.
4. Invest when times seem bleak – It is scary to be putting money out in times of economic downturns. However, these are times when bargains can be found. You also don’t want to miss the next run-up in the markets by waiting too long.
5. Resist the temptation to be over-exuberant – It is tempting to try to chase all the hot deals going on at any time. However, in the last 4 years of investing, I have never seen a time where there WEREN’T hot deals around. I doubt that will change anytime in the future, so be disciplined and keep to your strategy.
6. Track valuations from the marketplace. – Keep track of them and watch out when the valuations start climbing. It is a signal that something is going on. It is not necessarily a bubble forming, but it could be. Most likely the competition for the deals has become fiercer as more money has become available in the marketplace for investment into startups. I would develop a limit to the valuation you are willing to stomach, no matter what the deal is and stick to it. Be flexible to violate the rule if you find something that you really like because you may want to get involved for reasons other than the valuation being too high.
What am I doing? Tracking the economy closely. Seeing what the government is doing, or not doing, or doing a crap job of. Keeping my ear out on what’s happening with valuations. Talking to venture investors and angels who are out there investing actively. I meet regularly with my financial planner and listen to what he is seeing out in the marketplace. I also talk to the entrepreneurs and see who is geting funded and why, as well as those that didn’t get funded. And then who got bought, or just went IPO, and how/why. It’s an immense amount of information but all of it is interrelated and affects what I am doing now, how I do it, and what I will do in the future.