The four paths to getting an edge in startup investing and why it doesn’t work in public markets
by Paul Bennetts via paulbennetts.co
It’s possible to gain an edge in venture investing. It is little-known, though, as an unfair advantage over any market is challenging to build. It may form from information, analysis, or behaviour. But, a delta in these is rare.
It’s unusual in markets that are transparent. All information is available to all. Investors have large but equal datasets. They have limited capacity with prospective investments to communicate. Insufficient interaction leads to inadequate depth and passive paths, not active studies.
Most resign, but some don’t. Enterprising participants try deep research. They hire analysts to count customers entering Starbucks hoping for a hint on future sales data. Nonpublic, nonmaterial data points are combined to form valuable clues. Signs that together might suggest an appreciable change in company value is imminent, the mosaic theory of stock analysis. However, be careful. They could uncover material, nonpublic information. Acting on a single data point that in itself could move the market is prohibited. The route of the detective is appealing despite most uncoverable macro, industry, and company data points being seen and analysed by all.
In startups, though, information is scarce. Most data remains hidden in portfolios. Try looking up the growth rate for the S&P Index of Australian S-A startups over the last 12 months. Widely distributed passive data is limited.
Active data can be produced in venture investing. The VC, who meets fifty e-commerce startups, will assess the next e-commerce opportunity better than the angel who sees ten. This is not the same as reading fifty annual reports. In interviews, the level of insight is correlated to the level of rapport. Varying levels of interaction lead to diverging depth across investors. An information advantage through activity can develop.
In public markets, expert analysis that leads to a contrarian view is trying. Most industries grow slowly with the economy. Industry structures are stable. Things don’t change fast enough.
Industry dynamics for startups, by their nature, are in chaos, driven by the delta in product differentiation. The capacity for superior analysis increases with the level and speed of innovation. And different data coupled with similar analytical prowess can lead to inconsistent theses. An analytical advantage is more likely to form in startup investing.
A behavioural edge is available to all but troublesome for most. Investors suffer from biases. Investors gather facts and see them in such a way as to support their pre-conceived conclusions. Subjective confidence in one’s judgement is reliably greater than one’s objective accuracy. Investors feel losses more than gains. Good outcomes are their own doing. Bad outcomes are the fault of others. The second-order effects of future actions are underestimated while the benefits are overestimated. More choice leads to decision paralysis. Investments chosen by one fund predict the choices of other funds to a remarkable degree. Investors inherently prefer narrative to data — often to the detriment of understanding. Market participants tend to extrapolate recent events into the future indefinitely. Bias. Blindspots. Emotions. Beliefs. Irrationalities. The mind is jelly. And of course, these only affect everyone else, never you.
The monk can take advantage of the crowd held by bias. Understanding the mind is an undervalued investment strategy. And it’s open to investors in all markets.
Venture investors are just as fallible and impulsive. They have one tab on TechCrunch, one tab on Twitter, one tab on Bloomberg and one tab on Crunchbase. They suffer from an abundance of complexity. Most can’t go meta and play in long-term thinking. All investors, including venture, suffer from or can take hold of a behavioural advantage.
Startup investing offers one additional facility for building an edge. Rivers. Opportunities flow in rivers nearby. One part of the stream will yield. Another part may not. And investors are stuck trawling just one river. Investors will spend an inordinate amount of time perfecting their net with marketing and networking. But an unskilled investor can deliver an edge just by prospecting in the teeming river.
In venture, there is an immense capacity to outcompete the market through active data, superior analysis, mind control, and the choice of a river and one’s skill with a net. But I would contend that most concentrate on just the last faculty.
The norm, as you can see, is for more transparent markets to have limited potential for an edge. It may be why most prominent venture capitalists do not engage in public markets beyond index funds. Instead, they concentrate on building their edge in private markets.
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