Herd Investing and Social Proof
“Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster.”
- From Charlie Munger’s talk on the Psychology of Human Misjudgment at Harvard University in June, 1995
A common critique amongst entrepreneurs and venture capital investors alike is that VC’s are herd investors, preferring social proof from their peers to relying on their own gut and instinct. I’d be remiss if I said it wasn’t true for venture, however it also tends to be true across all investment categories. After all, it was Warren Buffett who called the stock market a “voting machine” in the short run.
The number of VC’s though is much smaller than investors in public markets as the barrier to entry is much higher. As a result, all of the VC’s I’ve met tend to be incredibly smart and thoughtful. This lends itself well to social proof as firms believe that their peers are making smart decisions. That’s why when a sector gets hot (more often than not, for good reason), it spreads like wildfire. The problem is by the time this happens, it can be too late.
I came across this idea this past weekend. There is a category we’ve been very interested in at Metamorphic for over 6 months now. We’ve made an investment in the space and have done a lot of work to get to know the right people and learn as much as we can to help the company (as well as future investments). Over the course of the past month I’ve met with many folks working at other VC firms and startups. When talking about which categories and ideas were most interesting right now, this specific category was omnipresent in just about every single conversation.
This isn’t the first time this has happened to me. The cycle tends to go as follows. Company x is the first in its category to gain significant traction. It either raises a very large amount of money at a high valuation or exits at a large price point. The technology world starts to take notice and articles and blog posts come out with headlines such as “Why ____ is big business, company x gets acquired for $$$”. Smart operators and investors analyze the category and the acquisition. Other companies in the space start to raise more money at higher valuations than they would have previously raised and more smart people start companies in the space hoping to cash out on the latest mega trend.
The issue however, is that it anybody who is onto anything interesting will quickly have multiple competitors (and/or copycats) fighting for the same users, business development deals, and investment dollars. Deals become competitive and rounds become oversubscribed leading to overfunded companies. Because investment dollars become abundant, customer acquisition costs are driven higher and higher. There are often success stories in this second wave of companies, but lots of dead bodies lay in its wake. This type of market is increasingly difficult for investors and entrepreneurs to navigate.
At first I thought this market behavior would be unique to the world of startups and overeager venture capitalists. I then stumbled on a talk Warren Buffett gave at Sun Valley in 1999. Buffett (indirectly criticizing the overvalued tech stocks of bubble 1.0) talked about a few industries in which had major impact on people’s lives but didn’t provide massive impact for investors — most notably the automobile industry. There were over 2,000 car makes, many of which went out of business or made little to no money. Investors in the industry lost money on most, if not all of their investments. However, had you invested early on in Ford after they invented the first car, you would’ve been filthy rich.
The point here isn’t that early stage VC’s shouldn’t look to invest in exciting companies in emerging sectors once there is one massive exit, but rather we shouldn’t be so focused on specific sectors so that we mistake the forest for the trees. I’ve found the best way to defend myself against this unconscious (or sometimes conscious) bias is to really understand the category, learning everything there is to know as well as the macro forces that made it popular to begin with. Once you understand this, you can find interesting opportunities by identifying founders with keen insight and unique perspectives; a significant competitive advantage (or as Peter Thiel calls them “secrets”).
I’m curious if other people (investors and entrepreneurs alike) experience this as well. If so, how do you keep yourself honest and rational? If you have thoughts or experience here I’d love to hear them.
