The Best Venture Capitalists Harvest Optionality (Dealing with Risk, Uncertainty and Ignorance)

Venture capitalists must deal with systems which are, in the words of Nassim Taleb, “more like a cat than a washing machine.”  A start up and the markets in which they operate are  quintessential complex adaptive systems. Michael Mauboussin nails the challenge here:

“Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect.  You can’t make predictions in any but the broadest and vaguest terms. … complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.”

People talking about the challenges of being a venture capitalist in this environment will often use a taxonomy created by Frank Knight:

  1. Risk: future states of the world known and probabilities of those future states known.  An example of a something involving risk would be roulette.
  2. Uncertainty: future states of the world known, but probabilities of those future states are not known.
  3. Ignorance:  future states of the world unknown, probabilities therefore not computable.

Nassim Taleb pointed out in The Black Swan that Knight’s category 1 is massively more rare that humans realize.   Nassim Taleb wrote:  “these ‘computable” risks [in category 1] are largely absent from real life! They are laboratory abstractions!”

What happens in real life is that people make decisions assuming category 1 is involved when the reality is that it is category 2 or 3. How then does the Wise VC or entrepreneur operate given this reality?

Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Maubousin provides a summary of what Nassim Taleb has created:

“a two-by-two matrix, where the rows distinguish between activities that have extreme outcomes and those that have more bunched outcomes, and the columns capture simple and complex payoffs. He allows that statistical methods work in the First Quadrant (simple payoffs and bunched outcomes), the Second Quadrant (complex payoffs and bunched outcomes), and the Third Quadrant (simple payoffs and extreme outcomes). But statistical methods fail in the Fourth Quadrant (complex payoffs and extreme outcomes).

The nature of the venture capital business is that what drives financial return comes from what Nassim Taleb calls the Fourth Quadrant. The wise person operates in the Fourth Quadrant by seeking to become “antifragile” rather than trying to predict outcomes that are not computable. My blog post on fragility and optionality is here: In short, the wise venture capitalist seeks optionality. The poseur venture capitalist tries to predict the future by using extrapolation.

Once a venture capitalist recognizes that optionality/antifragility is the objective they understand that there is no formula for being a wise venture capitalist.  Nassim Taleb believes the wise venture capitalist is a flaneur:

“Someone who, unlike a tourist, makes a decision opportunistically at every step to revise his schedule (or his destination) so he can imbibe things based on new information  obtained. In research and entrepreneurship, being a flaneur is called “looking for optionality.”

Acquiring optionality is best accomplished via tinkering and a process that Taleb calls via negativa.

“If you ‘have optionality,’ you don’t have much need for what is commonly called intelligence, knowledge, insight, skills, and these complicated things that take place in our brain cells. For you don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)”

This approach is straight up consistent with the ideas of Charlie Munger. In short, the best way to achieve success is often “to not be stupid.” Wise VCs and entrepreneurs which they invest with engage in tinkering in domains which tend to produce a small down side and potentially massive upside.   One of the best ways I have ever heard the idea behind Charlie Mungers’s philosophy expressed was by the famed investor Sam Zell:

“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.”

Nassim Taleb describes what the smart investor is looking for in this way: “Payoffs [which] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside.” Venture capitalists who are What Nassim Taleb calls “antifragile” benefit from optionality.  Investment bankers, who are “fragile” still are able to do this by being too big to fail and therefore socializing the big downside tail risk (i.e., get the taxpayers to pick up the losses from tail risk). Optionality also explains why there is a power law inside the portfolio of a venture capital investor in addition to the power law that explains the distribution of financial returns between venture capital firms..

Nassim Taleb sums up much of what I have written above in this passage from Antifragile:

“the idea present in California, and voiced by Steve Jobs at a famous speech: “Stay hungry, stay foolish.” He probably meant “Be crazy but retain the rationality of choosing the upper bound when you see it.” Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it…”



5 thoughts on “The Best Venture Capitalists Harvest Optionality (Dealing with Risk, Uncertainty and Ignorance)

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