Psychology of early-stage investing (Part III)
This is the final part in the series of blogs about mental models from the field of psychology which impacts an investor and how to be aware of it while making investing decisions. Click here to read Part I and click here to read Part II
In continuation of our previous blog, let me introduce you to 5 new mental models in psychology which are very important for every investor to understand.
11. Gambler’s Fallacy
Humans intuitively find it hard to deal with randomness, as a result, we tend to put a tremendous amount of weight on previous events, believing that they’ll influence future outcomes. But truly independent events, do not “balance out” for eg. You flip a coin 3 times and each time the outcome is ‘heads’. On the 4th flip, the probability of heads or tails is still the same 50%. If you assume that there is a higher probability on the 4th flip to get tails, then it is called Gambler’s Fallacy.
The reverse of Gambler’s fallacy is also a bias. For eg., if a cricketer has scored 3 consecutive centuries, one is “in-form” and is more likely to perform well in the 4th match also despite all matches being independent events. This fallacy is called “hot hand” fallacy. Similarly, in investing, if we come across a 3rd-time entrepreneur and his first 3 startups have been very successful, then we either fall prey to Gambler’s fallacy and expect his 4th startup to fail or we fall prey to hot hand fallacy and expect his 4th startup to also be very successful.
Important note: Pure independent, unbiased and random events (like a coin flip) can be seen mainly at casinos. In real life, events are interrelated, complex and interdependent and hence there can actually be self-correction, balancing, or skewed outcomes (for eg., the serial entrepreneur or an ‘in-form’ batsman). It is important to understand the relationships between events on multiple levels to predict the outcomes with better probability. For eg., in investing, we try to do this by researching the industry trends, macros, consumer behavior, at multiple levels to garner insights and build investment thesis. Investors who have these insights have higher success rates and they do not base their decisions on such fallacies.
12. Social Proof
When humans are in an uncertain and unfamiliar environment, they try to resolve the ambiguity by following others. Being part of the majority acts as protection from criticism. For eg., if all reputed VCs are investing in e-scooter startups or last mile mobility, then others will also tend to invest in the same sector due to the Fear Of Missing Out (FOMO) which is also a version of Social Proof fallacy. This behavior is driven by the assumption that surrounding people possess more knowledge about the situation and hence its best to follow them.
Small decisions can actually be made based on social proof (assuming the quality of the decision taken by a group is better than one single member of the group) since it saves time. Recommendation engines/product reviews in e-commerce work in this way. But for crucial decisions like investing, one must apply your reflective brain and not fall for this fallacy. Articles by reputed VCs in Silicon Valley do not serve as ‘recommendation engines’ for early-stage investors in India.
13. Reason Respecting Tendency (RRT)
RRT is where people want the answers to something but don’t care to know the background information or reasoning to gain a better understanding. When people justify their behavior they face less resistance because humans have a widespread appreciation of the importance of reasons. Now this reason could be ‘nonsense’ but our need for making sense makes us believe in nonsense as well. For eg., An investor already has a positive bias for a transaction in his/her mind. While evaluating, as long as the founder provides reasons and justifications (even though actually they might not make any sense) the investor is satisfied and thinks the reasons make sense because the investor was not looking for a reason in the first place, but just an answer, no matter how unreasonable the answer is.
Similarly, if an investor rejects a deal and provides a well-phrased reason for the rejection, then the founder is satisfied (even though the reason cited didn't make any sense) because the founder wanted an explanation and the use of the word “because” in the well-phrased reason imply an explanation. RRT bias is ingrained in our minds and hence to overcome this, we need to ask ‘Why’ and question every reason multiple numbers of times till we fully understand it.
14. Liking Bias
Natural tendency to ignore the faults of those we find likable while doing just the opposite to the people we don’t like. It is a conditioning device which makes us like people with whom we have positive associations. You see so many examples of VCs funding their own kind of entrepreneurs like founders from the same school or the same organizations as theirs. This bias affects investors independent thinking. It is also applicable to entrepreneurs who find certain VCs ‘likable’ due to various reasons and biases. In early-stage investing it is very difficult to separate the person (entrepreneur) from the deal but as you invest in more mature companies, investors should concentrate exclusively on the merits of the deal and look at the facts and situations objectively to avoid the ‘Liking Bias’
15. Winner’s Curse
Simply put, winner’s curse says that in a competitive auction, the highest bidder will typically overpay for the asset. We see this happening in large funding rounds of startups where the valuations swell quickly because of a competitive bid situation created by the investment bankers/startup. If you do not wish to overpay, find situations that are reverse of an auction. But if you want to participate in the auction, then make sure you know the true value of the startup and avoid greed, envy, and other competitive pressures to invest in the startup or you should have critical information that others aren’t privy to.
This concludes by 3 blog series on “Psychology of early-stage investing”. Hope you enjoyed reading it as much as I enjoyed writing it. I would like to again state that these are a collection of ideas as said by Charlie Munger and many other thought leaders in various books and forums. I have tried to summarise them and included examples from my stream of work based on my understanding.
Please click here to read Part I
Please click here to read Part II
Please feel free to reach me at firstname.lastname@example.org or 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
> Antifragile By Nassim Nicolas Taleb