Venture Populist

Contrary to conventional cliché, there is very little that is binary about venture investing outcomes. It is not just feast or famine. Rather, outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater on your initial investment.

What does appear to be binary is the manner in which prospective investors in private ventures perceive the asymmetric return profile of venture investment outcomes….most either adore it or abhor it.

On one hand, an investor like Jim Rogers is attracted to what he no doubt views as a positive asymmetric profile of venture investment outcomes. His venture acumen began developing at the age of five by selling peanuts and by picking up empty bottles that fans left behind at baseball games. In 1970, he co-founded the Quantum Fund. During the following 10 years the portfolio gained 4200% while the S&P advanced about 47%. Nice.

In a recent rant Rogers opined not only that “diversification was garbage”, but also went on to say that “you only need four or five good ideas in your life to get really rich”.

(Note that Rogers says “really” rich…which seems a bit elitist seeing as how only one or two good ideas can make one simply rich.)

Nevertheless, 90X returns over the S&P implies that he had very little fear of placing losing bets.

But what about those less adventurous souls that eschew positive asymmetric return scenarios in favor of more traditional investments with binary and symmetrical outcomes? Why are there so few angel and venture investors despite the compelling data of the asset class’ returns and the proven history of private enterprise as the single greatest creator of family wealth?

Economics psychologist Daniel Kahneman explained this behavior with his 1979 nobel-winning, Prospect Theory which describes decisions between alternatives with uncertain outcomes where the probabilities are known. In prospect theory, Kahneman identified Loss Aversion–people’s tendency to strongly prefer avoiding losses to acquiring gains. In fact, studies suggest that losses are twice as powerful, psychologically, as gains.

In their perpetual pursuit to mirror the risk-free rate of return, some investment advisors are factoring prospect theory and loss aversion into their asset-allocation schemes. But loss aversion studies opposing symmetrical outcomes…such as either winning $100 or losing $100. It provides little insight with respect to investor’s fear of positive asymmetric return profiles.

I prefer the wisdom in David Gal’s 2006 study, A Psychological Law of Inertia and the Illusion of Loss Aversion, which discounted loss aversion as “superfluous” and found instead that risk/return tradeoff decisions were decidedly “influenced by a tradeoff between the status-quo and change”. Gal calls it inertia, noting that that people will tend to remain at the status-quo when they have no clear preference between the status quo and an alternative option.

The rigid portfolio allocation to the same traditional asset classes within the same stale strategic asset allocation model is the status quo that Gal is referring to. The results have been far from compelling yet most investors, and their advisors, keep doing the same thing while expecting different results.

In a recent WSJ article, Jason Zwieg accounts for this “mental lazziness” that prevents  investors and advisors from challenging their status quo approach to investing (and consequently, not embracing alternative asset classes and strategies). “In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the confirmation bias…people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.”

Try Harder. Properly allocated, private equity and venture investments can materiality improve a portfolio’s risk/return tradeoffs and benefit from the proven superior performance of the asset class. But, expanding your repertoire by opening your portfolio to private investment opportunities requires commitment and effort to educate yourself on the rules of the engagement and evaluation.

Achieving superior returns by embracing private investment requires initiative…not inertia.

Album: Underachievers Please Try Harder, Camera Obscura, 2004

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