Small Investments, Colossal Gains. Use The Power Law To Swing For The Fences
In the 1992 Berkshire Hathaway shareholder letter, Warren Buffett wrote:
“In baseball lingo, our performance yardstick is slugging power, not batting average.”
Slugging percentage differs from batting average in that not all hits are valued equally. A home run is worth more than a single, so slugging percentage is the truest metric of a hitter’s “power.” Buffett’s point is that investors should measure themselves by overall return, not by how many investments they get right.
Venture capitalists operate with the same mindset: investing with the expectation that a small percentage of big winners will yield staggering results even if most of their investments fail.
This is commonly known as the POWER LAW.
It states that a small number of events or elements account for the majority of the overall impact or outcome. In other words, a disproportionate amount of results or returns is generated by a select few investments in a given portfolio.
In practice it looks like this:
The importance of the Power Law in investing lies in understanding that not all investments are equal, and a significant portion of gains can come from a few standout opportunities.
These same principles apply to investments in the web3 space.
Many bets lead to sad face memes, but also come with the possibility that one or two at-bats could bring outsized gains to your portfolio.
Putting it into Practice
- Diversification: While diversification is a common strategy to mitigate risk, the power law indicates that focusing on a few key high-impact investments may be more beneficial than spreading investments too thinly across various assets.
- Long-Term Vision: Superstar investments may take time to mature and deliver substantial returns, requiring patience and conviction from investors.
- Risk-Reward Ratio: Be willing to take on higher risk with select investments that have the potential for exponential growth, as the reward can be substantial.
- Avoid FOMO: Don’t waste your time chasing every trend or trying to invest in every “hot” opportunity. Instead, focus on thorough research and analysis to identify potential superstars.
The Power Law can lead to significant gains but implies that not all investments will perform well. Some investments may have minimal impact or even result in losses. Therefore, understanding and managing risk is still critical in any investment strategy, even when leveraging the power law concept.
When deploying a Power Law strategy for your portfolio always remember:
If you swing for the fences, be prepared for strikeouts.
Bonus Tip
Looking for more info? Check out “The Power Law: Venture Capital and the Making of the New Future” by Sebastian Mallaby. A fantastic and engaging deep-dive into successes and failures of VCs using the Power Law in practice.
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