The Courageous and the Herds
“What would life be if we had no courage to attempt anything?”
- Vincent Van Gogh
In our current economy, Venture Capital firms (VCs) are playing an instrumental role in allocating scare resources, (i.e capital) to parts of the economy most needed “efficiently”. There are several ways of defining efficiencies here but the general definition is: “an economic state in which every resource is optimally allocated to serve each person or entity in the best way while minimising waste and losses.” Hence, from an investment point of view, a VC’s purpose exists to find startups with the highest return in the future, in doing so by minimising losses.
Although VCs are trained to operate most efficiently, we have seen inefficiencies such as bubbles occurring and we have witnessed countless of them from a tech-bubble to a property bubble. The difficulty is actually judging if there is a bubble forming or not. Bubbles are hard to define. Just like a piece of art, how do we measure the intrinsic value of, say, Claude Monet’s Japanese Footbridge? Is it a bargain at £200m? Furthermore, how can we ensure that the intrinsic value of a startup is paid fairly? Valuing private companies, especially startups, is not an exact science; it can be seen as a work of art. If it is a work of art then the opinion of others will affect our decision. In the world of startups, we can draw some similarities from the stock market. John Maynard Keynes once remarked, the stock market is like a beauty contest. Therefore judging the winner is not a case of us thinking who is the prettiest beauty pageant, but is what the average opinion expects the average opinion to be. As a result we have reached third degree of thinking. Perhaps there are times, when one practices fourth, fifth or even higher degrees of thinking. Hence our own perception of what the startup’s intrinsic value is becomes irrelevant.
Being Homo Sapien, we are hardwired to conform to our society, hence we tend to fall into many cognitive biases. A VC may invest in the same startup others investors have and thus, ignoring their own privately-known information. This type of bias, called Information Cascade, can lead to both desirable and undesirable returns. When a Decision Maker (DM) with their own privately-known yet incomplete information sees other DMs reveal their information by i.e. investing in a startup, subsequent DMs may follow and thereafter establishing a pattern. Hence a DM who sees a pattern forming may invest too in spite of their own thinking and information that indicates them not to.
The question here is, is it rational for a DM to deviate from their privately-known information and invest? Or is the opposite true? This cognitive bias called “information cascade” occurs often in our lives, whether it is deciding on which restaurant to go to or deciding which film to see. However, it is not to ignore that, when startups generate traction from the market and interest from investors, it is usually perceived to be a positive sign for investment. However, this may also lead to a premature sign of a bubble. I am not opining that traction leads to a bubble, however it is when our judgments are clouded by a pattern formation we see developing. For example, if a DM are given two investments: Investment A with some traction, investment B with no traction, ceteris paribus, how does one decide what to invest? DM may outweigh A over B. Therefore, herd followers, although have less risk of falling far from short, have a higher probability of achieving average performance. But in exchange for safety from being much below average, they surrender their chance to achieve above average returns.
If we have a tendency of falling into cognitive bias, we have to do the unconventional. There are two things we have noticed that is happening. First, VCs are playing the game earlier by investing in pre-seed and seed stages, where capital requirements are much less, and returns are just equally as attractive to later stages. In addition, subject to bias is less common here because low capital requirements means a lesser need to share deals or co-invest with others. Secondly, VCs are “daring to be different”. The act of investing takes courage and going against the herd may seem “uncomfortably idiosyncratic”, a term coined by David Swensen at Yale University’s Endowment Fund, where conventional ways of thinking or belief is much more comfortable than unconventional. As a result, our ideas and assumptions may be challenged and ridiculed by others. However, in order to achieve great results, we have to accept both the risk of being ridiculed and chance of being praised.
To close, I’d like to leave you with a quote by John Templeton:
“It is impossible to produce superior performance unless you do something different from the majority.
