Our Inner Irrational Investor

What do baseball and early investing have in common?

If you said hitting home runs, I wouldn’t argue.

But it’s something else, something deeper.

For example, Chris Davis plays for my hometown baseball team, the Baltimore Orioles. He’s a big home run hitter.

Again, that’s not the biggest thing he has in common with early investors – though yes, the better ones also hit plenty of home runs.

Okay, let me explain.

Follow the Money

Last year Chris hit .262 – a pedestrian batting average.

Let’s look at another well-known player – José Iglesias. He plays shortstop for the Detroit Tigers. Last year he batted .300.

Both play great defense, but José gets the edge here. He’s a magician with the glove.

Guess who makes more money?

Based on the above information, perhaps you’d say Iglesias.

But batting average isn’t the most important metric in evaluating offensive impact.

Slugging average is far more indicative of a player’s offensive contribution.

The difference between the two?

Batting average measures frequency of hits. For example, 30 out of 100 hits will give you a .300 batting average.

Slugging percentage takes into account the quality of your hits. Doubles count twice as much as singles; home runs count four times as much.

It’s calculated by taking the number of total bases and dividing them by the number of at-bats.

Davis hits a lot of home runs. His slugging percentage last year was .562. He had 47 home runs – almost a third of his 150 hits.

Iglesias belted two home runs… out of 125 hits. His slugging average was .370 – nearly 200 points below Davis’ .

The big money follows slugging average.

It’s why Davis scored a huge contract with the Orioles last year – a seven-year deal that will pay him $161 million.

Iglesias got a one-year $2.1 million contract from the Tigers.

Anybody who knows baseball wouldn’t blink twice at the disparity.

The Irrational Investor

Yet our irrational investor brains are wired to be more like Iglesias than Davis. To hit singles and try our best to hit for average. Avoid making outs – or, as investors, suffering losses – as much we can.

It’s called loss aversion. The term was coined in 2007 when the first experiments on this kind of behavior were undertaken.

It was found that we suffer and fear losses about twice as much as we value and appreciate gains.

It’s plain to see when considering a simple coin game…

Tossing a coin is a 50-50 bet, as you know. The game is this: If it comes up tails, you make $100. If it comes up heads, you lose $60. I guarantee you 10 flips.

Risk tolerance isn’t exactly the same from person to person, but studies have shown that the average person would not take that bet.

Even though the math says the most likely outcome is that you’d make $500 (five times tails) and lose only $300 (five times heads).

Not good enough. The risk is still too great. You have to expect to make at least $600 against a possible loss of $300 to accept the risk.

We like to win. But we hate to lose even more.

Compounding this matter, investing is NOT the same as flipping coins.

Being right most of the time – frequency of correctness – isn’t what matters.

It’s slugging percentage. Put another way…

It’s how much money you make when you’re right versus how much money you lose when you’ re wrong.

You can be wrong a lot more than you can be right and still make pretty good money… if your winners are big enough.

No Brag, Just Fact

This is truer with early investing than any other kind of investing you do. (Here’s one of several posts Adam and I have written on this.)

Experienced startup investors understand this. They see losses as a necessary component to success – part of the package deal, so to speak.

Dave McClure is a good example. He founded 500 Startups, a VC company that has now invested in more than 995 startups.

In his blogs, McClure is equal parts brash and boastful. Last week, he blogged about investing in three Unicorns: Twilio, Credit Karma and Lyft. They were each valued at less than $5 million when he invested.

They’re now worth more than $3 billion – each a 60,000%-plus winner.

McClure has certainly earned the right to brag. But in his blog, he also added that “I didn’t just invest in three companies, I had to make lots of little bets in more than 40 startups to get lucky enough to discover those outliers.”

There’s absolutely no shame in that statement. McClure isn’t giving away any secrets or making a big confession.

It’s less an admission than a proclamation that says, “This is how I do it and how you should do it too.”

To make sure everybody got the message, he went on to say that “most of my investments failed.”

You can’t get much clearer than that: YOUR ROAD TO SUCCESS IS PAVED WITH LOSSES. And yet…

This loss aversion thing nags at us. Won’t let us go.

It’s in our nature. When we risk loss, we feel it as surely as we feel hunger when we go without food.

That’s the rub.

How do we overcome our own nature?

Some Suggested Remedies

Warren Buffett says pay attention to the math. “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.”

Russell A. Poldrack is a professor of psychology at Stanford University. He says to “focus on the process of making [good] decisions rather than the outcome alone.”

Good decisions sometimes result in bad outcomes and bad decisions sometimes lead to good outcomes. But over time, good decisions favor good outcomes.

And me? I think it helps to have a benchmark – even if it’s a rough one.

As an investor, you strive to do better than the markets, right?

As an early-stage investor, you can create a benchmark, then try to better it.

Your startup benchmark would track survival and growth rates.

As a rule of thumb, half the startups that do a seed round drop out before reaching a Series A round. Half of those don’t make it to a Series B round.

(From that point, the attrition rate improves but is still substantial. If you want, you can replace the 50% dropout rate with a one-third rate.)

For growth – to keep things simple – startups that reach another round should increase their valuations by at least two times.

Not hard to remember: 50% survival rate and a 2X valuation growth rate… per round.

If you do better that that, you have a lot to be happy about.

If you do worse, it could be a signal to improve your investing skills.

Or, as Poldrack points out, it could be that good decisions are leading to bad outcomes.

So don’t beat yourself up. And, remember, it’s not the end of the world. In early-stage investing, all it takes is one or two big winners for your portfolio to achieve positive results…

And possibly spectacular success.

Invest early and well,

Andy Gordon
Founder, Early Investing