How to manage the investment in Equity Crowdfunding?

How much money is worth investing?

Investors often choose how much to invest in equity crowdfunding by following a gut approach, that is, by going by gut feeling and being inspired by individual campaigns they find. In this approach, they start with the project and decide how much to invest in the individual project. This is a typical mistake in financial decisions: starting with the instrument and not with oneself.

Proper financial planning starts with one's financial goals. One must understand what is the correct portion of one's capital that one can invest in equity crowdfunding. To find this answer you need to ask yourself at least these 4 questions:

• What is an amount of money I can afford to lose?
• How much money do I know I will not need over the next 3 to 5 years? (a minimum conceivable duration in investments in startups and SMEs)
• How much, on the other hand, will I need already in 1 or 2 years? (a suitable duration for real estate projects)
• How much do I want to invest to pursue aspirational goals? That is, to increase spending possibilities beyond my income capabilities

Through these simple questions we can find what is called the "tip" of the wealth pyramid, that is, the most profitable but also the riskiest investments. At the base of the pyramid should be the ability to generate income, having a cash fund for emergencies, perhaps insurance on one's home or human capital, a retirement fund to supplement the mandatory pension. These are all safety nets that can give us peace of mind that we are investing and not putting money at risk that we might need urgently.

How much to invest in each project?

Once you have decided how much to put into equity crowdfunding you need to decide how much to put into individual campaigns. Two approaches can be followed for this choice, which we can call the active approach and the passive approach.

With theactive approach you look for great deals, you carefully study all the campaigns to find the one that will be the most successful. Each campaign is analyzed with a critical eye and you try to find the best ones by evaluating various parameters that you can learn more about in this article (Go to lesson 6). Among the selected campaigns we are going to divide the capital to invest, either equally or proportionally to the interest we have. This approach is more difficult than it sounds because it is basically impossible to predict the future. Great business successes, like great failures, tend to be unexpected. It is amazing how many projects seemed destined for success and failed to get off the ground (think Google glass) and how many companies that did not seem to have the cards to win turned out to be colossal successes (think Amazon, which posted losses for its first 5 years of existence).

This is why it is good to consider the passive approach, that is, maximum diversification. In this approach, one invests in as many ventures as possible, consistent with one's economic availability or until one exhausts the investment capital we have allocated to equity crowdfunding, creating as diversified a portfolio as possible over time. A special case in point is real estate investments, in which it is preferable to invest higher portions of one's capital, given the significantly less risky nature, shorter timeframes, and the return expressed in percentage terms and not multiplicative of the invested capital, as is the case with startups/SMEs.

What does it mean to diversify one's investment?

Diversifying means distributing capital into investments that are as diverse as possible.

"Diverse" has both a quantitative meaning, i.e., distributing capital in numerous forms of investment, but also a qualitative meaning, i.e., they must have different characteristics from each other.

A first level of diversity is between startups (younger and with higher potential/risk), SMEs (somewhat more stable and established), and real estate projects (companies that specialize in construction/renovation of real estate and with predefined yield and duration).

Within these categories, one can diversify in terms of: commodity or business sectors, geographic scope, life stage, risk level, economic return mode, and timing of liquidation.

Why is diversification the golden rule?

Warren Buffett, one of the world's greatest investors, says that "diversification is a protection against ignorance," and to anyone who asks him for investment advice he says: If finance is not your job, the best thing to do is to follow a passive approach, that is, to invest in as many businesses as the market offers.

The returns of the entire stock market are driven by very few companies, in hindsight it seems obvious that you should only invest in those companies and take home a stellar return. But the truth is that no one can do it, not even financial experts. We like to think that it is possible and that some lucky people succeed, but we should not base our investment strategy on luck. The more we bet, the more likely we are to take home below-average returns; the more we diversify, the more confident we can be that we will take home the average market return.

In this way we make our investment more solid, we minimize overall risk. We make it an efficient and reliable machine. This approach is less satisfying, gives less of a taste of having made investment choices. Economist Samuelson said that "Investing should be as fun as watching grass grow or paint dry, if you want fun go to the casino."

Below we summarize the 4 reasons why diversification is the golden rule in investing (taken from "Investments. The Complete Guide," Hoepli 2022)

1. You don't know who will go wrong

The more we focus on one or a few companies, the more we risk seeing our capital evaporate. Spreading one's money over several investments is the only way to protect oneself from going wrong. In this sense, diversification means not putting all your eggs in one basket, and this is critical when investing in startups that have a high failure rate.

2. You don't know who will do better

Since it is impossible to predict what the winning cases will be, we can take all the possibilities knowing that there will be winners among them. The success of these excellent cases will outperform even the biggest failures, as happens in the stock market. This increases the chances that the portfolio as a whole will have a positive return. In this sense, diversification not only reduces the chances of being wrong but increases the chances of being right. As another great investor used to say, "Don't look for the needle in the haystack, buy the haystack" (John Bogle).

3. You reduce risk

The most fascinating aspect of diversification is that it operates as a synergy: unity is strength. This relates to the overall risk of the investment understood as the fluctuation band of the final result, which of course we want to be as narrow as possible. In this sense, thanks to diversification, the "risk units" of each investment that we add up offset each other, in other words 2 + 2 = 3. This is because different firms have returns that are uncorrelated: when one is doing well the other is doing badly, so having both creates a portfolio that fluctuates less, that is, less risky.

4. You manage emotionality

If I invest all my capital (or too large a portion) in a single form of investment, it is possible that I will not be able to keep a cool head and make decisions lucidly and rationally about the investment in question. This is because there are too large interests involved that would have a very large impact on my life. On the other hand, if my investment has been diversified into several instruments, I will be able to make decisions on each of them with less psychological pressure.

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