The One Question Every Angel Investor Should Be Asking

The One Question Every Angel Investor Should Be Asking

Summary: The majority of angel investments are made by investors with no prior industry experience. This is a problem since one of the best indicators of investment success is the investor’s prior experience. If you are an angel investor, you should seek to invest in industries where you have prior experience OR invest alongside investors with prior experience. We believe so strongly in this fact that we’re building Fundify.com, a community of industry experts, to help.

Angel investors fund approximately 70,000 deals a year in the US, deploying north of $24 Bn annually. Most of the investors in those deals expect to lose money on their investment. But it doesn’t have to be this way.

A little while back, I told you how due diligence could improve your angel investing returns by 7x. Today, we’re looking at the same data set and highlighting another factor that will improve your investing returns. This factor is super simple and yields a 2.5x improvement on returns.

The best part is that you can test this factor with a simple yes or no question:

Do I have any prior experience in the industry I am about to invest in?

Let’s look at the data and see why the answer to this question is so important.

What the data says

Angel investing is about experience. While there are hundreds of potential factors that effect angel investment outcomes, your relevant prior experience might be the most important. The data shows that you don’t need a lot of experience, but you do need to have some. In truth, just one year makes a significant difference. The chart below shows the outcomes of investments made by individuals with and without prior experience.

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I’ll reiterate one key point from the above chart: A single year of experience is the difference between expecting to earn money or lose money on your angel investment. Gamblers at blackjack tables around the world would kill for the ability to shift odds like that. You can do it with a single question.

So you can improve your chances of not losing money by having experience. But what about the size of the winners? Simply winning and losing isn’t enough, we need to know the size of the winners to really judge which strategy is better. With that in mind, let’s look at how investor experience impacts the size of returns. No surprise: more experience is better than less.

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If the above chart weren’t enough, allow me to give you one more. The following chart shows aggregate returns for investors with varying degrees of experience. This is what a portfolio might look like if it were constructed based solely on the experience level of the investor. You’ll notice that each year of experience improves returns and that the first few years are the most important.

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Bottom line: Angel investors should be investing in areas where they have prior experience or should be investing alongside investors with prior experience.

That seems intuitive enough. It’s certainly a simple conclusion. But simple doesn’t always mean easy, and a further look at the data confirms this.

When we talk to investors, many will tell us that they prefer to invest in areas where they have prior experience. These same investors will later confess that they find it difficult to only invest within their areas of expertise and so find themselves in investments where they don’t have much prior knowledge. It’s a widespread problem.

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Take that in for a moment. 55% of sophisticated investors make investments with zero prior experience. This immediately raises the singular question: “Why?” Why do seemingly rational investors invest so irrationally?

One reason may be that it’s hard to find good investment opportunities within your industries of expertise. The process for finding investments is clunky, fragmented, unsophisticated and inefficient. It typically relies on social or professional networks and is a very time intensive process. There isn’t a great solution that helps you sort through qualified opportunities to find the ones that match your investment criteria. Because of this, investors jump at the first “good” opportunity they see.

This approach results in a diverse portfolio of investments in many industries, which the investor doesn’t have any real, deep domain knowledge in. Without prior experience, investors find themselves trying to quickly climb the learning curve so that they can provide additional value to the founders they are backing. It’s a difficult and inefficient process, which leads to all kinds of issues for both founder and investor. Is it any wonder articles like this exist?

A better way

You are an expert in something — whether it’s the 20 years you spent in hardware or the 18 months you spent in ecommerce. Let’s put that expertise to use.

Originally published here

Author

A.J. Watson

Community
Cofounder and COO of Fundify.com. Currently writing: data driven posts about angel investing.
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