The Perils of Pattern Matching

It is almost impossible to escape the term “pattern matching” in investing circles. It is how seasoned investors rationalize why they invest in specific ideas, teams, and markets. It is the kind of stuff that only a long career in investing can teach you.

Experience is a venerable teacher, and by no means does it make sense to ignore the learnings from a life filled with rich experiences. That said, decades of research in cognitive psychology, behavioral psychology, and economics have exposed the many frailties in human reasoning and decision making. Being a long-time student of these topics, I couldn’t help but notice the traps.

As applied to venture capital, I think of pattern matching as the tendency to predict the outcome for an investment based on learnings from prior investment decisions.

So, why could pattern matching be perilous?

Outcome bias

When investors say things like, “We had a great outcome with our previous investment in this entrepreneur. We should really back him again”, there is likely to be outcome bias.

When we use the nature of the outcome (good or bad) to evaluate the quality of our original decision-making process, there is outcome bias. To use a simple example, let’s say I buy a Peloton and gain 5 pounds in the month after buying it. Clearly, buying the Peloton was a terrible idea, right? Now, what if I had lost 5 pounds instead? Should I be crediting the Peloton then? Now, what if I also told you that I had also been pursuing an intermittent fasting plan during that time?

In the example of our successful entrepreneur, could it be possible that the entrepreneur had the good fortune of being in a great market and near-perfect timing without actually planning for it? If so, could the timing and market factors have outweighed the entrepreneur’s execution in determining the outcome? What if his next idea is in a terrible market?

Outcome bias is also what makes startups market themselves as Stripe for X, Uber for Y, Airbnb for Z, and so on. Have you ever heard of Blockbuster for A, WebVan for B, or Irridium for C?

An oversimplification of what applied to X applies to Y is a classic decision-making trap. In such situations, it’s good to look at what is different about this new problem, the players, the current market dynamics compared to the analogy whose outcome we are enamored with.

Stereotyping

Sometimes, investors will say that their intuition or gut tells them that a particular entrepreneur will be successful. Reasons that might be used to back such intuition include pedigree, confidence, storytelling capability, etc. They have undoubtedly seen all these traits in several other entrepreneurs who have delivered outsized returns. More often than not, most of these entrepreneurs are likely to fall into some familiar combination of racial, geographic, demographic, and gender groups. Unfortunately, research has clearly shown that the tendency to lean into one’s gut, unfortunately, is where unconscious bias stems from.

Not all successful entrepreneurs are extroverted and sound overconfident. Some wildly successful leaders are notoriously introverted and tend to underpromise and overdeliver.

I wonder if some of us are overpaying for opportunities because we have an unconscious stereotype of where a first-class class CEO comes from, what they look and sound like.

Other forms of stereotyping based on intuition make us investors blind to statistics, base rates, and the law of small numbers.

Substitution bias

Faced with the question of whether or not a company can succeed in a crowded marketplace, an investor might say, “Well, they are funded by top-tier investors, and they are a team of serial entrepreneurs. There is an excellent chance that of all the companies out there, this one will do well.” There is substitution bias at play here. When faced with complex questions, our mind substitutes them with more straightforward questions that we find easier to answer. Instead of answering the specific question about competitive differentiation, we replaced it with investor and team pedigree questions.

The tie-in to pattern matching here is the thought that top-tier investors have made great decisions in the past and will continue to do so. While both serial entrepreneurs and top-tier investors have several unfair advantages that they bring to bear, using that as the overwhelming reason for investing is, I am sure, not what the VC set out to do.

What can we do about pattern matching then?

Despite decades of research in decision science, scientists are far from figuring out a silver bullet. However, seasoned investors know that the mind can play insidious tricks when it comes to decision making. Here are a few solid principles and processes I have come across so far.

Use a boring checklist.

The beauty of the modest checklist is that it allows for the independent evaluation of multiple decision-making criteria. Checklists are being used even by Rocket scientists and Brain surgeons in order to manage complexity in decision making. While we are at it, I would add that in my view, an investment memo is not a substitute for a checklist. While in-depth investment memos will do a phenomenal job in articulating first principles, in particular, a boring checklist will do a much better job of keeping biases in check and that too, consistently.

Think in first principles.

A first principle is a foundational fact or assumption that cannot be broken down further. When dealing with complex technological problems and solutions, break things down into first principles. As an example, if you encounter a solution that protects a user from vulnerabilities in Kubernetes, understand the first principles of Kubernetes and then layer on the whys and hows of vulnerabilities on top of that. For most of us, this kind of stuff is tough to do. Many of us don’t have the time to think about first principles when we have a fast-moving deal. However, there are no shortcuts here if you want to truly unravel why a particular problem is worth solving or why a specific solution makes business sense (or not). All too often, investors try to invest in hot categories. However, my humble belief is that an early-stage investor will do far better if they put in the time and effort to uncover a category even before it becomes one.

Seek out and encourage dissent.

Seasoned investors are wary of falling into the trap of confirmation bias, i.e., the tendency to listen to feedback that confirms our beliefs. I am suggesting that investors take the more extreme step of going out of the way and seek out views that contradict their own. When doing so, it is important to avoid sharing our views prematurely so as to not bias others’ points of view. Finally, when you do hear dissenting views, don’t just put it on the cons side of a flat pros-and-cons list. Doing so, apparently, is a sure-fire way for an overconfident investor to ignore dissenting views. This is according to Annie Duke, the famed author of “How to Decide”. She argues that assigning probabilities to likely outcomes is the best way to overcome confirmation bias that a list of pros and cons is susceptible to.

I would love to hear the thoughts of my fellow investors. What processes have you found to be helpful? Comment or DM me @veenormous.