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Bubble 2.0

Bubble 2.0 #1: Understanding Systematic Risk

A lot has been written recently about Bubble 2.0. The current bubble. There have been posts on Techcrunch about the Bubble 2.0and we do have many people speaking about this, including Jason Calcanis and Mark Suster on This Week In. Jason was fuming about investments made by a firm DST (Digital Sky Technology) backed by Russian LLPs. His concern was the amount of investments made by DST and some of the bets DST have taken, which are much more like playing a lot of hands like a deuce-ten or a four-seven on a poker table. However, DST is also an investor in Facebook. They led an investment of $200 million in Facebook at a $10 billion valuation in 2009. In January 2011, DST and Goldman Sachs co-led a $500 million investment round in Facebook, valuing the company at $50 billion. In last couple of years, DST has led the $180 million investment in Zynga and led a $135 million investment in Groupon at a rumoured $1.35 billion valuation. Subsequently, DST invested again as part of Groupon’s $950 million round in January 2011. It will be interesting to note how recent IPO of Mail.ru unfolds. The stock is currently trading at around $37 on LSE.

At the MBA we learn a lot about how the mechanics of a rational investment decision plays out with an internal rate of return in a company’s investment strategy. However, we are also aware of the other mode of investment. The one which at its most flamboyant extreme has been called casino banking but we will call it what it is – portfolio theory. It is a model of the tradeoff between the expected returns and risks of alternative investments. The most famous, and the original, model of the expected return–risk tradeoff is the Capital Asset Pricing Model (the CAPM). The CAPM says that investors require a higher expected return for taking on more risk and gives a precise definition of risk. The rate required is determined by adding the risk-free rate (to compensate for investing) to the risk premium (to compensate for the additional risk).  We are also aware of systematic (non-diversifiable or market risk) and unsystematic risks (diversifiable or unique risk) that drive the principle of diversification, where investors reduce risk by eliminating unsystematic risk. The fact that investors can eliminate unsystematic risk by combining risky assets into a portfolio implies that an asset’s risk premium also known as the ‘beta’ (its expected return in excess of the risk-free rate) depends only on its systematic risk.

Portfolio TheoryTo put these in very simple words, the more we diversify our portfolio the lesser unique risk we are exposed to.  But this is nothing new. However, it is interesting to note that our returns are as long tailed as our risks. At a VCPE class, one of our external lectures with years of private equity experience, Malcolm Smith, once told me that of the sixty odd deals he has been involved in, had it not been for six of them, he would not have managed to pay his mortgages. There is definitely a long tailed distribution where across our investments we have only a handful of ‘hits’ – the ones that gives you a 10x return or more. Essentially gamblers as opposed to seasoned poker players are fascinated by big hits. Many venture capital investments in the technology space are looking to take up these unsystematic company risks and bet on scale driven businesses. This is more like playing a hand with crack cards in poker and waiting for three good cards on the flop. The more of these investments in a particular industry and more of the systemic or market risk do we build into investments in that space.

In retrospect,  what does this mean for us? And do I agree that there is a Bubble 2.0?

Further thoughts will be explored in the Bubble 2.0 series of posts.

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About suvajyoti

digital media futurist, entrepreneur, MBA, photojournalist, blues guitarist, computer engineer.

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