Psychology of early-stage investing (Part I)
In this series of blogs, I talk about the various mental models from the field of psychology which impacts an investor and how to be aware of it while making investing decisions.
What’s a mental model?
Simply put, a mental model is a way a person thinks which constructs one’s world view and the way one interacts with the outside world. These models shape our actions as to how we act or behave in a particular situation.
Why should we know mental models?
Only if we are aware of the mental models, we can better understand the world around us and also solve/approach a problem in a better way. These models become tools for the mind, the more you know, the better it is. These models can be from multiple disciplines like psychology, physics, economics or statistics and have applications in our day-to-day life as well. This series of blogs will focus only on the mental models we come across in psychology and how we can use them in our decision-making process. Key benefits of learning mental models are to become a multidisciplinary independent thinker and to better understand when to follow and when to reject the conventional wisdom.
How to use these mental models?
Best way to remember them is while you are reading this blog, link the model to your personal experiences. This way you integrate them into your existing knowledge and then can reuse them whenever you want. Make them a part of your thinking habits.
But before we begin let’s first understand…
What is a psychological bias?
We have two types of brains — 1] Reflexive brain (System 1) and 2] Reflective Brain (System 2) Whenever our brain needs to take a decision, our reflexive brain jumps up and tries to solve it voluntarily (like 2+2 = ?). No effort required, quickly the answer is given. But when the question is complex, the reflective brain needs to put in the effort, think, and analyze. The reflective brain is slower. Under many conditions, some questions which should ideally be delegated to the reflective brain, our reflexive brain insists on making a decision and ends up creating systematic errors. These errors are called psychological biases.
In early-stage investing, many such psychological biases exist. Our aim is to delegate our decision making to the independent thinking reflective brain and not let our reflexive brain influence our decisions.
I will cover a total of 15 mental models in a 3 part series. Let’s start with the first 5 mental models:
- Variable Reinforcement
We know that a person will be motivated to repeat an action if one gets a reward for the same. But when the reward is received unpredictably, a person will continue to repeat his actions and this behavior will be reinforced strongly every time he/she wins a reward. This model is used extensively by companies to retain users. For eg., Google Pay Rewards swipe to earn cash backs or Slot machines in casinos. We continue to use apps which have unpredictable ‘feeds’ like FB, Instagram, Twitter or Linkedin since mind doesn't know what content is coming next and this unpredictability reinforces our action of continuous scrolling. Video games also operate on the same model. Products which have variable rewards can be really addictive and habit forming. As an early stage investor, I would look for such products.
2. Contrast-Misreaction Tendency (CMT)
Humans focus on the relative advantage of one thing over another and estimate value accordingly. Let us say we are evaluating 3 deals simultaneously. All the 3 deals are independent of each other and should be evaluated on an absolute basis. However, CMT bias will make us compare the three deals on our investment criteria and evaluate relative valuations for each. Another example is let’s say our last 10 evaluated deals did not pass the internal investment thesis. The 11th deal, which is slightly better than the average of the first 10 will look like a very promising deal and we would have created a CMT bias in our mind. These are the mistakes which every investor needs to avoid.
Nowadays, many large VCs are starting seed funds, I hope the seed team and the growth team are different including the decision makers. This is because CMT bias will be at play here. If you have recently made a USD 30 mn investment then it is very likely that you will end up paying a higher price in a USD 1 mn deal.
Please note, that in CMT bias, if you fail to perceive the change due to small contrast, the misreaction may not happen to lead again to a wrong decision. For eg., if you are comparing ‘A’ with ‘B’, then ‘B’ becomes the reference point. If reference point itself changes due to context or new environment then the value you assigned to ‘A’ becomes flawed. The small incremental changes in ‘B’ will go unnoticed, there will be low contrast, so slow that it looks constant and we will not be able to register the change in the trend and revalue ‘A’ until it’s too late.
3. Deprival Super Reaction Tendency (DSRT)
The irrational human response to perceived “near miss” or “almost there” can be termed as DSRT. Slot machines have ‘calibrated near misses’ which makes us believe that we just missed the jackpot by a whisker and this reinforces our actions to continue playing on the machine. Humans experience a similar level of sadness to an ‘actual loss’ of reward and a loss of an ‘almost-possessed’ reward. For eg., Imagine if we come to know about a startup and we fail to engage with them due to management bandwidth issues, and then later after some time, this startup gets funded from a reputed VC fund. This perceived “near miss” is DSRT at play which will reinforce us to next time engage with every startup that comes our way (which might or might not be the right strategy)
4. Loss Aversion Bias
Simply put, pleasure from a $10 gain is significantly lower than the displeasure of losing a $10 bill. Investors hate to realize losses. We hold on to our losers too long and sell our winners too soon. For eg., if a bad investment has an exit option at 1x returns, we still might hold onto it thinking it will later give us 3x returns, whereas we might exit a good investment giving us 5x returns which we should have held on to for 10x returns. This loss aversion bias is also sometimes the cause of throwing good money after the bad money by reinvesting in the bad investment to average down the purchase price or in the hope that things will be better from here and we will get 3x returns.
5. Do Something Bias (DSB)
Most of the investors force themselves to stay busy with some task or meetings. The urge to ‘act’ tends to intensify after a long period of no deal closures. This is also partly due to the fact that VCs have to deploy the money within a specified time period and hence they fall prey to the DSB. In seed and pre-seed investing, there are proponents of ‘Spray and Pray’ investing style as well. But remember, more decisions you have to make lower the quality of each decision. Patience is the cure to the DSB. Another cure is ‘Don’t read too much of news’, deal announcements, hot sectors to watch out for, etc aids the DSB.
I will cover 10 more mental models in the next two blogs in this series. Hope you enjoyed reading this Part I.
Click here to read Part II
I can be reached on firstname.lastname@example.org. Please visit us at www.gembacapital.in
This blog series is inspired by reading the blogs at Safal Niveshak. If you wish to know more details about these mental models, then I highly recommend you to visit their blog.
Further reading on mental models can be found at Farnam Street Blog by Shane Parrish.
Few good books to read on psychology related mental models are:
> Thinking Fast and Slow By Daniel Kahneman
> Art of Thinking Clearly By Rolf Dobelli
> Predictably Irrational By Dan Ariely
> Seeking Wisdom By Peter Bevelin
> Influence: The Psychology of Persuasion By Robert Cialdini