The odds for success are stacked against you when investing in venture capital funds

Investing in venture capital funds is a highly specialized business approach. It differs drastically from conventional investing, particularly in its uneven results. A venture capital fund may only expect to make money on one in 10 of its investments. However, that one winner may generate enormous profit.

The fund may turn out to be a great investment, even if it only makes money a few years in a decade. However, venture capital funds can be uncertain investments.

What you need to be aware of when investing in venture capital funds

Successful venture capitalists tend to have a record of success in business and in investing. Thanks to their proven ability, they can move quickly when they spot a worthwhile opportunity. Since they raise money from institutions, corporations and wealthy individuals, they can operate as a private company. All this relieves them of a large amount of legal and regulatory issues that they’d have to go through to raise money from public investors.

Today’s financial industry excels at creating investment products to sell to the public. Perhaps one in 10 of these new products are actually a boon for investors.

Before you buy speculative stocks that claim to have a business plan with Uber-scale potential, ask yourself this: Why would the plan’s creator offer it to individuals, with all the accompanying regulatory burden? In most cases, it’s because they’ve already tried to interest the top venture capital funds, and nobody was buying.

For the same reason, you should also be wary of venture capital funds that are open to individual investors.

Speculation and investing in venture capital funds

When a speculative stock or venture capital investment is losing money, it has a great deal of freedom to ponder its future. With a little imagination, it can always show that anything’s possible, based on a logical series of events that it says will take place as it advances inevitably toward profitability. Meanwhile, it doesn’t need to worry that its price-to-earnings or p/e ratio is too high, since it doesn’t have one—it has no “e.”

When a former money-loser finally starts making money, however, the handcuffs go on. Suddenly this speculative stock has a p/e, probably one that is sky-high. Inevitably the killjoys (like us) then start calculating how fast it needs to grow to justify its current stock price, let alone go higher.

Meanwhile, the company’s management has to look at dull, uninspiring matters like production, costs and deliveries, rather than ramble on about how wonderful things will be in a few years. Then too, once a company becomes profitable, it faces a new risk: the unexpected earnings downturn.

Limit aggressive investments like investing in venture capital funds to no more than, say, 30% of your portfolio

Ultimately of course, the percentage of your portfolio that should be held in either conservative or aggressive investments depends on your personal circumstances. An investor with a longer time horizon or without the need for current income from a portfolio can invest more money in aggressive investing stocks. But we think 30% is a good rule of thumb.

Cut your risk of investing in venture capital funds all the more by taking a conservative approach to your aggressive investing

For instance, you should hold your aggressive investments within a portfolio that reflects our three-pronged Successful Investor wealth-building philosophy. That is, invest mainly in well-established companies; spread your money out across most if not all of the five main economic sectors (Manufacturing, Resources, Consumer, Finance, Utilities); downplay stocks that are in the broker/media limelight. That way, you protect yourself from an unforeseeable industry downturn. You also increase your chances of stumbling upon a market superstar—a stock that does much better than average.

You may stretch these rules a little in aggressive investing, while still sticking to the general principles. You may invest in more companies that are less well-established, compared to a conservative investor. But avoid loading up on penny stocks, new issues or any stocks that expose you to a serious risk of total loss.

Does investing in venture capital funds excite you? Have you added venture capital funds to your portfolio successfully? Share your story with us in the comments.