Given a 10% chance of a 100 times payoff, you should take that bet every time. —Jeff Bezos
The individual investor should act consistently as an investor and not as a speculator. —Ben Graham
Above: Only win, place, or show earns that sweet, sweet dough.
An investment is no more than a pecuniary bet on an uncertain future.
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To invest in Apple is to bet that the company’s luxury hardware, closed-walled ecosystem, and lucrative service offerings will continue to produce prodigious profits.
To invest ExxonMobil is to bet that we fail to quench our global thirst for oil and gas anytime soon.
To invest in Enron was, as it sadly turned out, to invest in accounting fraud and rampant malfeasance.
The above companies all come from public markets—those open securities exchanges in which the entire population can invest. Private markets—the realm of private equity, venture capital, and other such illiquid asset classes—are more opaque than their public counterparts. This is due to numerous factors such as information asymmetry, liquidity, and difficulty in price discovery/valuation.
In light of fewer, more inconsistent datapoints, private market investors rely on archetypes and frameworks in order to place their proverbial bets. Nowhere is this more common than the Wild West that venture capital—particularly at its earliest stages: pre-seed and seed funding rounds. Sans revenue, retention, or reliable metrics, investors over-index on more abstract considerations like the team, the TAM, and the technology.
When passing on potential investments, a friend of mine often grunts the following phrase: “Right race, wrong horse.”
Its simplicity belies its elegance and profundity. Put simply, it indicates that though the trend (whether demographic or technological) is correct or market is large enough, either the technology is subpar or the team cannot compete.
Some concrete examples include:
Juno v. Uber or Lyft
MySpace v. Facebook
Fisker Automotive v. Tesla
Yahoo v. Google
Rdio v. Spotify
Inspired by the above examples and those four simple words, I present the Horse Racing Theory of Investing.
Startup investors must invest in the right jockey (i.e. team), riding the quickest horse (i.e. the product/service), running a race (i.e. attacking a problem or going after a market) where both rider and steed have an unfair advantage (i.e. superior technology, experience, or distribution).
It’s simple, but far from easy.
Though Meatloaf would say “Two Out of Three Ain’t Bad,” investments that bat a thousand tend to win.
Despite the above metaphor, be sure not to conflate gambling with investing. As Paul Samuelson once said, "Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."
With that, I ask:
Who do you have your money on? Seabiscuit or Lucky Dan?
Who’s the jockey? A short, svelte veteran or gawky, uncoordinated novice?
Is the track turf or dirt? Is this the Melbourne Cup or Kentucky Derby?
Nail the above and you might just hit the trifecta.
Off to the races!
Per my about page, White Noise is a work of experimentation. I view it as a sort of thinking aloud, a stress testing of my nascent ideas. Through it, I hope to sharpen my opinions against the whetstone of other people’s feedback, commentary, and input.
If you want to discuss any of the ideas or musings mentioned above or have any books, papers, or links that you think would be interesting to share on a future edition of White Noise, please reach out to me by replying to this email or following me on Twitter.
With sincere gratitude,
All frameworks are wrong, but some are useful. Is this one? Please let me know in the comments.
I would say it's useful, but before considering it, and the questions it poses, I would ask a different question. Is the race fixed?
There are two ways the race could be fixed:
1- It does seem like the bigger VC firms bias the outcome. Getting investment from Andreessen Horowitz or being a graduate of Y Combinator helps you get attention and money, and increases your odds. So perhaps you need to add a fourth question. Who else has bet on this jockey and this horse?
2- But there is another way in which it could be fixed. It could be that the system pays out more than it takes in. That if you were able to place a bet on every horse in every race that you would come out ahead. In this case while it's nice to assess jockey quality it may be more important to just place a lot of bets. I do think that VC's do some of this as well.