I was chatting with an engineer exploring new opportunities yesterday. He was at an inflection point in his career and had two incredible paths before him. One, join a product or venture studio and get his hands dirty building different products simultaneously. Two, find a co-founder and start his own company. Both had immense appeal to him. And he was unsure what path he should take, in fear he might like the other path more once he committed.
The feeling of regret is often inevitable. Especially when you have the incredible options before you, but without the luxury of time. We often ask ourselves, “How much do I value each opportunity?” Most of the time we do a quick mental calculation. We look at the biggest value of each opportunity and their future potentials. For those who prefer a more nuanced approach, we create two (or more) long lists of the pros and cons of each. Both approaches are extremely rational.
Yet, there’s still something missing. Either something that gnaws at our conscious telling us, maybe there’s something we haven’t considered. Or realizing that in constructing these lists we’ve made the decision way more complicated than it needed to be.
Rather the question I find that offers more clarity is, “How much would I sacrifice to obtain this opportunity if I no longer had it?“
Humans are naturally loss-averse. We react more strongly to losses than we do to gains. For instance, we feel the pain of losing our wallet with $100 in it, than we feel the ephemeral joy of winning $100 in the lottery.
At the same time, we tend to take most things for granted until they are taken away. There are a million and one examples. We often don’t appreciate our significant other until they leave us. We take our parents for granted until they are no longer with us. The same is true for friends, homes, personal belongings, and memories.
I also prefer the nomenclature of “I” over “you”. Unlike rational decisions, where it is most insightful to abstract oneself from the situation, irrational decisions require a true introspection of oneself. After all, regrets aren’t usually rational.
While I can’t speak for everyone, my best decisions have often been a permutation of rationality and emotions. When the nuance of each decision leads to an incalculable algorithm and frankly, decision paralysis, I find it useful to channel emotional loss as a tool to make tough choices in life. Pursuing new opportunities, at least for me, is no exception.
The DGQ series is a series dedicated to my process of question discovery and execution. When curiosity is the why, DGQ is the how. It’s an inside scoop of what goes on in my noggin’. My hope is that it offers some illumination to you, my readers, so you can tackle the world and build relationships with my best tools at your disposal. It also happens to stand for damn good questions, or dumb and garbled questions. I’ll let you decide which it falls under.
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The other day, I saw a post on r/venturecapital (and now you know what my Reddit handle is) asking how prospect theory relates to venture capital. Admittedly, quite thought-provoking! Ever since college, I’ve been a huge behavioral economics buff – how human psychology dictates market motions. And, prospect theory happens to fall in that category.
First developed by Daniel Kahneman and Amos Tversky, prospect theory is a behavioral model that says humans are naturally loss-averse. Oh, you might know the former Nobel Prize bugger from authoring Thinking, Fast and Slow, a book I highly recommend if you’re curious about the intricacies of how our brain understands the data around us. Simply put, we react stronger to losing something than when we gain something.
*As you can see, this graph is safe for family-friendly programming
For example, I’m more likely to feel the loss after losing my $1500 cellphone than the ephemeral gain of winning a grand and a half in the lottery. On one end, you’re probably thinking that makes sense. On the other end, you’re probably calling me a loser for spending so much on a cellphone. Well, joke’s on you. I got my phone for $250 on Black Friday. But I digress. In another instance, if you look at kids, they’re more likely to throw a tantrum if you take away a marshmallow on their plate than give you a hug for giving them an extra marshmallow.
Similarly…
As you might expect, prospect theory informs many of my investing/sourcing decisions, including:
So, you’re probably now thinking: “Gimme the deets.”
While prospect theory suggests people typically weigh the impact of their losses more than they so their wins, VCs are humans at the end of the day. Just like your amateur naive stock trader will hold on to losses, and sell their wins, many VCs tend to do the same, as a reactionary measure.
It’s counterintuitive. But the name of the game in early-stage investing is not about how many losses you’ve sustained (especially when 7 out of every 10 go out of business, 2-3 break even, and hopefully 1 makes it), but about the magnitude of the wins an investor makes.
For instance, if you’ve invested in 100 companies, and 99 go out of business, and 1 makes 200x, you just doubled your fund. Of course, a successful fund typically makes 3-5x cash on cash multiple. Just our fancy way of saying your fund returns $3-5 for every dollar invested by a limited partner (LP). Although there are some nuances, many VC investors use cash on cash and multiple on invested capital (MOIC) quite interchangeably.
Guess for you to be counted as a successful investor, that one investment’s gotta go to 300x, at the minimum. In reality, you’re probably not going to have just one investment perform. Especially if you’re in the top quartile of VCs out there. You’re looking at a ~2.5% unicorn rate. So 2-3 investments of your 100 investments should be valued at over a billion dollars. Unless you’re Chris Sacca, who I hear returned 250x cash on cash for his first $8.4M seed fund, which included the likes of Uber, Twitter, and Instagram.
Of course, larger funds are harder to return. It’s easier to return a $10M fund than a $1B, much less a $100B. While I’m not supporting the only $100B vehicle known to date, the losses that fund sustained made the front page news a while back. And though by monetary value, they lost more than most other funds out there. Percentage-wise, they’re not alone. But in the public and media’s eyes, their losses are weighted more heavily than smaller funds.
In closing/Disclaimer
But hey, I’m no registered investment advisor. If you’re looking for which specific startups to invest in, please do consult with a professional. While I may share what startups have attracted my attention here and there, my thoughts are just my own thoughts. And, this post is merely me sharing the correlation between venture capital and prospect theory, plus a few digressions.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
Yesterday, I grabbed a coffee with a friend – now a newly-minted manager. Between congratulations and hearing what she’s been up to, we dove into a rabbit hole about performance reviews. And out of everything she shared, there was one question that caught my attention:
What do you say “No” to now that you didn’t say “No” to when you started?
People are inherently loss-averse. We react stronger to losses than gains. Economic prospect theory has taught us that much. Essentialism, probably best popularized by author Greg McKeown, or a methodology that helps us differentiate between external noise and our internal signal, takes it a step further. For example, the questions:
How much do you value an opportunity?
And, How much would you sacrifice to obtain an opportunity?
… carry two different emotions. We take many aspects of our lives for granted. But when we lose any aspect of it – be it a body part, a friend or family member, or a habit – where we once lacked appreciation, we now find true value.
What we say “No” to carries layers of scar tissue – of our past we don’t want to relive. The French language has an incredibly apt way of describing knowledge. Savoir denotes simple knowledge acquisition. Connaître implies a familiarity with knowledge that is deeper and carved into one’s heart. When my friend decided to ask that question, she is looking for what her team members connaissent.
I love it! And I’m gonna steal it (well, with her permission)! For each time frame, we have a new set challenges to ‘pattern-recognize’. Founders have it cut out for them. And just by the nature of their work, they need to learn – fast.
“When I studied Tai Chi for a year, I thought I knew what I was doing. And I thought I was really started to understand it. But after 2 years, I realized everything I thought after a year was wrong. It was just wrong. But now I understood.
And then after 4 years, I realized everything I thought after 2 years was wrong. And he went on with this story and this pattern, but now I understood. And after 8 years, everything I thought after 4 years was wrong. And now I’ve been training for 16 years; everything I thought after 8 years was wrong. And now, I finally understand…
It’s easy to think we’re in the dark yesterday, but in the light today. But we’re in the dark today too.”
So, in foresight and honest vulnerability, I will take my friend’s question a step further:
What will you say “No” to tomorrow that you aren’t saying “No” to today?
I have a love-hate relationship with that word. On one hand, I love and seek to learn from creative souls. It’s a trait that I seriously respect in individuals, regardless of industry, profession, or background. On the other hand, it’s rather amorphous. What’s creative to me may not be creative to you. We are bounded by the parameters of our experiences and what we, as individuals, are exposed to.
So, where do innovators draw inspiration?
Over the years, I’ve seen inspiration stem from three main frameworks:
The flow from art;
Margins;
And, what people dislike.
The Flow from Art
I seem to find that the data largely (with a few outliers) points towards the following:
Art precedes science. Science precedes tech. Tech precedes business. Business precedes law.
Art is bounded only by one’s imagination. Science, which draws inspiration from art, is limited by our physical universe and the fundamental laws. And, tech rides on the coattails of science, restricted by the patterns recognized in our universe by scientists before them. Similarly, business can only optimize existing technology. Following suit, regulations and legal practice can only debate and prevent ramifications that have turned from hypothesis to reality.
On one end of the spectrum, fiction has driven innovation on the fundamental, scientific front. Scientists have tried to make the impossible – fiction, superstition, assumptions, and imagination – possible. On the other end, the legal and regulatory space has empirically lagged behind business innovation. From autonomous driving to the shared economy to video games, a regulatory emphasis came only after incidents occurred. I’m a huge proponent of founders becoming self-regulatory. But that is a discussion for another day.
Margins
As Jeff Bezos famously said:
“Your margin is my opportunity.”
In the lens of a businessperson, profits exist on the margins. In a fully saturated market, as we learned in economics class, perfect competition will squeeze out profits. That margin can be delta between human perfection and imperfection. It can be the difference between a naive and sophisticated individual. It can also be the blind spots between a self-awareness and ignorance.
The good news (and bad news?) is that humans aren’t rational. As much as we try to be, we’re not. We repeat the same mistakes. After all, that’s where our favorite stories come from – the fact that we’re imperfect. If we were rational, our friendly neighborhood kid from Queens wouldn’t have to struggle with identity. Or, Skinner, the head chef at Auguste Gusteau’s restaurant, wouldn’t be out to exterminate my favorite rat chef.
From a nonfictional front, if we were rational, gambling, the lottery, therapy, and more wouldn’t exist. In fact, there’s a whole industry that capitalizes on human imperfection – insurance. We choose to reach for that last cookie when we know a healthier diet with less sugar is better for us (I’m guilty as well). We set New Year’s resolutions to work out more, but regress to our couch norm after the first month. Walter Mischel famously conducted The Marshmallow Experiment. When given the option to wait 15 minutes to double their treats, many children opted for immediate gratification.
There would be way fewer founders if they were rational. I mean, come on, the numbers work against them. 90% of startups fail. So, from a VC’s perspective, we have to ask ourselves:
What’s is the underlying notion that makes this product work?
What is that innate theme in human or societal development that won’t disappear anytime soon? What factors produce such a trend? And what margin is it taking advantage of? Uber was made possible with the evolution of smartphone and faster data. As more data were archived online, Google became a reality because of the internet and browser. Two current examples of underlying notions include:
Audio, including, but not limited to, podcasts and audiobooks, is the new form of content consumption. Not only does it free up consumers’ hands and eyes up, audio content is often easier to digest. The spoken word has been around millennia, whereas print is fairly new invention. Emotions and sarcasm is often easier to relay via audio than via print. So, what else is possible?
With growing consumer sentiment against traditional social media, like Facebook, Twitter, and Instagram, there is a shift to social experiences surrounding active participation. Sarah Tavel writes a great piece on this. Examples include Discord, Medium, TikTok, and user-generated content (UGC) in video games, like mods and in-game skins. Many of the traditional social media platforms leave users with a more negative passive experience, where they feel a sense of FOMO (fear of missing out). Through active participation, users can be a part of the conversation, rather than watch from the sidelines.
What do you dislike?
Speaking of negative experiences, aversion is a strong motivating emotion humans have. Like prospect theory illustrates, loss invokes a stronger response than gains. It also happens to be one of the reasons why I probe how obsessed a founder is about a certain problem.
In a recent interview with Andrew “Kappy” Kaplan, host of the podcast, Beyond the Plate, Grant Achatz, legendary chef, talks briefly about how he drew inspiration from his daughter’s dislike of cheese, yet she still ate pizza and grilled cheese sandwiches. Similarly, when his guests at Alinea didn’t like sea urchin, he thought about the ‘why’ and if he could circumvent their aversion by playing with various variables, including iodine concentration.
So, what do you dislike (with a passion)? What about the people around you? And can you figure out a way to change or eliminate that frustration? Take some time through the idea maze.
In closing
Ideas come in all shapes and sizes. Some may be more obvious than others. Some may snowball into a best-selling one. Although I’ve shared the three most common frameworks that I’ve personally generated and seen others find inspiration, it is, of course, not the only ways to exercise your creative muscle. In fact, the first step into being more “creative” is being cognizant about everything around you.
Two years ago, one of my former professors recommended I start ‘idea-journaling’ every day. Since I’ve started, I began noticing more and more stimuli from my surroundings, conversations and frustrations.
It may be a start, but it’s by no means an end. Stay curious.
