Why Investors Must Be Contrarians to Outperform The Market

  1. Bill Gurley: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.”

Andy Rachleff elaborates on the point made by Gurley: “What most people don’t realize is if you’re right and consensus you don’t make money.” It is a bit strange that most people don’t realize this truth and yet it is common sense: you simply can’t be part of the crowd and at the same time beat the crowd, especially after fees and costs are imposed. Nobel Laureate William Sharpe famously provided the mathematical proof in a paper entitled “The Arithmetic of Active Management.” As restated by John Bogle the conclusion is: “In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.” Of course, the part about the investors collectively getting the return of the market is key. Being a long term investor in the progress of the economy is a very good thing. As life runs its course, some investors get more of that financial return of the market than others.

A key point in all of this is that you can decide not to try to outperform a market and instead to match it as closely as you can a very low cost. Warren Buffett describes the motivation for this approach well: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

  1. Jeff Bezos: “You just have to remember that contrarians are usually wrong.”

This point made by Bezos is the reason why most people follow the crowd. Michael Mauboussin explains this tendency with a simple example:

“Being a contrarian for the sake of being a contrarian is not a good idea. In other words, when the movie theater’s on fire, run out the door, right? Don’t run in the door…. Successful contrarian investing isn’t about going against the grain per se, it’s about exploiting expectations gaps. If this assertion is true, it leads to an obvious question: how do these expectations gaps arise? Or, more basically, how and why are markets inefficient?”

Mauboussin explains why some investments get mispriced so badly:

“Because if the crowd takes something to an extreme, either on the bullish side or the bearish side, that should show up in your disconnect between fundamentals and expectations. And that is what allows you to make a good investment… Again, the goal is not to be a contrarian just to be a contrarian, but rather to feel comfortable betting against the crowd when the gap between fundamentals and expectations warrants it. This independence is difficult because the widest gap often coincides with the strongest urge to be part of the group. Independence also incorporates the notion of objectivity—an ability to assess the odds without being swayed by outside factors. After all, prices not only inform investors, they also influence investors.”

This blog has repeatedly profiled great investors who have acquired skill in knowing when to be contrarian. Buffett’s famous admonition is: “be greedy when others are fearful and fearful when others are greedy.” One of the best times to invest is when uncertainty is the greatest and fear is the highest. This contrarian admonition is fully consistent with the Mr. Market metaphor. Make the market your servant and not your master. For example, Jeffrey Gundlach puts it this way: “I want fear. I want to buy things when people are afraid of it, not when they think it’s a gift being handed down to them.” There aren’t many people like Charlie Munger: “We have a history when things are really horrible of wading in when no one else will.”

Bucking the crowd’s viewpoint in practice in the real world is not easy since the investor is fighting social proof. Robert Cialdini: social proof is most powerful for those who feel unfamiliar or unsure in a specific situation and who, consequently, must look outside of themselves for evidence of how best to behave there.” I discussed social proof in a recent blog post on Cialdini’s book Influence. In many cases, following the crowd (social proof) makes sense. Sticking with the warmth of the crowd is a natural instinct for most people. Many people would rather fail conventionally than succeed unconventionally. But doing the reverse is easier said that done for most people.

  1. Andy Rachleff: “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”

It is the existence of a gap between expected value and market price that Mauboussin talked about above which should drive investment decision making. If you have views which reflect the consensus of the crowd you are unlikely to outperform a market since a market by definition reflects the consensus view.  Buffett puts it this way: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” Charlie Munger is more direct and colorful is his explanation: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” Sometimes waves of social proof and other dysfunctional heuristics create a significant gap between price and value. This does not happen often in areas within a person’s circle of competence, but it does happen. For some investors, spotting a gap like this happens only once or twice a year and that is just fine with them. In those instances these investors bet big and the rest of the time they do nothing. Some people, like day traders, think they can spot gaps between expected value and market price several times a day and make a profit after fees (this is almost always a triumph of hope over experience).


  1. Howard Marks:To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.”

Being genuinely contrarian means the investor is going to be uncomfortable sometimes. Some people are good at being uncomfortable, and some are not. Peter Lynch said once: “To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.”  Successful investing is the search for the mistakes of other people say Howard Marks that may create a mispriced asset. In other words, one person’s mistake about the value of an asset is what can create an opportunity for another investor to outperform the market. This search is best done by people who are curious and hard working. Great investors hustle, have a huge scuttlebutt network and read constantly. They are constantly trying to learn more about more and know that the more that they know, they more they will know that there is even more that they don’t know. If you are not getting more humble over time, you have a flawed system.

It is Mr. Market’s irrationality that creates the opportunity for investors. Markets are often wise, but they are not always wise. The best returns accrue to investors who are patient and yet aggressive when they are offered an attractive price for an asset. Seth Klarman says: “Successful investing is the marriage of a calculator and a contrarian streak.” The most effective way to get free of social proof when the time is right is to have done the homework in advance and stay within your circle of competence.

5. Jeff Bezos: “Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a 10% chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs.” “In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.” 

It is magnitude of success and not frequency of success that matters for an investor. Bezos is talking about convexity in investments.  All a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment. Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Mauboussin 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).”

Richard Zeckhauser explains why

“The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”

The nature of the venture capital business is that financial returns come from the Fourth Quadrant/the world of ignorance. It is only in this quadrant that optionality will be substantially mis-priced and the type of bargains found that make a venture capital portfolio work financially.

6. Marc Andreessen: “If something is already consensus then money will have already flooded in and the profit opportunity is gone. And so by definition in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment.  And let me translate ‘non-consensus’: in sort of practical terms, it translates to crazy. You are investing in things that look like they are just nuts.” “The entire art of venture capital in our view is the big breakthrough for ideas. The nature of the big idea is that they are not that predictable.” “Most of the big breakthrough technologies/companies seem crazy at first: PCs, the internet, Bitcoin, Airbnb, Uber, 140 characters. It has to be a radical product. It has to be something where, when people look at it, at first they say, ‘I don’t get it, I don’t understand it. I think it’s too weird, I think it’s too unusual.’”

Andy Rachleff elaborates:Being willing to intelligently take this leap of faith is one of the main differences between the venture firms who consistently generate high returns — and everyone else. Unfortunately human nature is not comfortable taking risk; so most venture capital firms want high returns without risk, which doesn’t exist.  As a result they often sit on the sideline while other people make the big money from things that most people initially think are crazy. The vast majority of my colleagues in the venture capital business thought we were crazy at Benchmark to have backed eBay. ‘Beenie babies…really? How can that be a business?’” Marc Andreessen adds: “Breakthrough ideas look crazy, nuts. It’s hard to think this way — I see it in other people’s body language, and I can feel it in my own, where I sometimes feel like I don’t even care if it’s going to work, I can’t take more change. O.K., Google, O.K., Twitter—but Airbnb? People staying in each other’s houses without there being a lot of axe murders?” Most things that sounds crazy are crazy. It is the ability to use pattern recognition developed over time to see the businesses that have massive convexity “if something goes right” that makes for a great venture capitalist. The ideal startup business for a venture capitalist is a combination of half-crazy and great convexity (big upside and small downside).


The Arithmetic of Active Management https://web.stanford.edu/~wfsharpe/art/active/active.htm

Mauboussin: http://wp.nbr.com/your-mind-and-your-money/making-better-investment-decisions-20100215

Mauboussin:  http://www.valuewalk.com/2015/02/michael-mauboussin-contrarian-investing-psychology-going-crowd/

Rachleff: https://blog.wealthfront.com/venture-capital-economics/

Cialdini:    https://25iq.com/2016/10/08/a-half-dozen-things-ive-learned-from-robert-cialdinis-book-influence/

A Dozen Things I’ve Learned about Multi-sided Markets (Platforms)

  1. Multi-sided markets bring together two or more interdependent groups who need each other in some way. Uber, eBay, and Airbnb are all multi-sided markets. A multi-sided market is sometimes called a “platform.” Hundreds of big and small firms fail trying to create multi-sided markets in different categories every year. Since the payoff from creating a significant multi-sided markets is so massive and the financial downside relatively small, founders and venture capital investors are willing to keep experimenting since it is magnitude of correctness and not frequency of correctness that determines financial success. Just one success in creating a multi-sided market can pay for many dozens of failed attempts. Apple, Microsoft, Google, Amazon and Facebook are all platforms. Why don’t firms create more multi-sided markets if they are so profitable? Because getting all of the elements just right at just the right time is very hard to do successfully. Creating a successful multi-sided market requires a lot of skill and luck as will be explained below. 
  1. A critical difference between single and multi-sided market is that the sides interact directly. A single-sided “market maker” buys x, puts x in inventory, and eventually sells x. As an example, a person employee who buys breakfast cereal from a grocery does not deal directly with the manufacturer of the product so that value chain represents a single-sided market. The authors of the book Platform Revolution refer to single sided markets as having a linear value chain. They describe a single-sided market as “a step-by step arrangement for creating and transferring value with producers at one end and consumers at the other.” In contrast, when a recruiter contacts a potential employee directly using the LinkedIn platform that interaction is part of a multi-sided market. Multi-sided markets look like this:


3. Multi-sided markets are not linear. A market that has two or more sides is vastly more financially attractive to create since it has the potential to scale and generate value in a non-linear manner. In other words, the whole of the value created by a multi-sided market can be more than the sum of the parts, if the multi-sided market is correctly structured. What can happen if the right conditions and structure is present is described well by Esko Kilpi as follows: “Network effect-based value can increase exponentially at the same time as costs grow linearly, if at all. If you follow the valuations of firms today, there is an ever-widening gap between the network-economy platforms and incumbents driven by traditional asset leverage models. Investors and markets have voted.” The nature of platforms has changed the value chain in many industries. Tom Goodwin of Havas Media famously said: “Uber owns no vehicles. Facebook creates no content. Alibaba has no inventory. And Airbnb owns no real estate.” When you do not need to own these assets less capital is required and the business scales vastly better both financially and operationally.

  1. A multi-sided market is not valuable if the sides can find each other easily. Solving a hard coordination problem is the key to sustainability for any market, including multi-sided markets. How do many firms and individuals involved in a complex division of labor successfully coordinate their actions so as to optimize the creation of value and profitability, when each possesses different and changing knowledge and expectations about a risky and uncertain future? Coordination is achieved through price discovery and a multi-sided market can provide just that for market participants if the conditions are right. For example, someone may need to find a freelance artist or software programmer and since there are so many potential suppliers with different skills and availability a platform like ProFinder or UpWork will therefore often be useful to them. But sometimes a significant coordination problem does not exist and a multi-sided market is unlikely to succeed. For example, if Boeing needs a supplier of rivets, once it finds that supplier it no longer needs a multi-sided marketplace. Airbnb and Uber are example of businesses that do solve hard coordination problems.
  1. “Demand side economies of scale” (also known as network effects) result when the value of a product or service changes in a positive way as more people use it. Network effects can be positive (for example the benefits of an increasing number of members of a social network) or negative (for example, network congestion; viruses, spam).  What a business seeks in any multi-sided market are network effects since they are increasingly the most important method that can be used by a technology business to create barriers to entry against competitors (a moat). Due to the falling costs of creating a new business, especially technology businesses, network effects are the most significant way to a company to create moat and generate a profit. The famous napkin sketch that illustrates Uber’s network effects is as follows:


Having a moat is essential for any business since otherwise competitors will introduce additional supply to a point where financial returns are equal to the opportunity cost of capital. Anyone who says a moat is not needed is essentially suspending the laws of supply and demand. If a business earns a financial return that exceeds its opportunity cost of capital for a significant period of time it has a moat. The only question open at that point is what the elements are that created that moat (network effects, brand, supply side scale economies, regulation, intellectual property, etc.).

  1.  “Supply side economies of scale” exist when there are reductions in the average cost per unit associated with increasing the scale of production. Sometimes you hear people say that supply-side scale economies of scale no longer matter in an age where network effects are so powerful. This is not true since supply-side scale economies can in some cases still enhance the moat of a business that also enjoys network effect benefits. A moat can never be too strong since it is always under attack by competitors.  As an example, the leading providers of cloud infrastructure  have supply side economies of scale in building web scale services that smaller companies will not be able to match.
  1. Creating a successful multi-sided market requires that the business overcome the “chicken and egg problem.”  The problem can be stated simply: How do you get one side to be interested in a platform until that other side exists, and vice versa. Part of the challenge is to get enough customers on both sides so there is critical mass.  Critical mass is tricky to obtain particularly if the two sides need to show up simultaneously.
  1. The chicken and egg problem is best overcome if one side is clearly made the loss leader. Experience has shown that it does not matter which side gets the free or subsidized offering- what is important is that one or more sides be chosen as the loss leader and one or more sides as the profit pool. The subsidy side tends to: (1) have more elastic demand; (2) be an offering that is harder to get; and (3) is needed more by the other side. The profit generating side tends to be the reverse, obviously. The price of the subsidy side is often below marginal cost and in some cases less than $ zero. For Uber, the subsidy side is drivers since they are relatively scarce. In the real estate business in the United States, buyers are the subsidy side.
  1. The sides of the market should complement each other – if the sides are complements, it not only reduces the customer acquisition cost (CAC) but assembles sides that want to to enter into exchanges.  A “complement” is any product or service that increases the value of another product or service.  Multi-Sided Markets work best when the offering on one side of a market complements an offering on the other side of the market. Some complements are “demand-side complements” like cars and oil, hotdogs and mustard or chips and salsa. Some complements are supply side complements, like beef and leather. Search and advertising are complements as are social networks and advertising.
  1.  Subsidizing the side of the multi-sided market with lower marginal cost/COGS is optimal. Giving away goods that have a high marginal costs is often deadly. The objective is to have zero or very low marginal cost. As an example, it is particularly financially attractive to give away software as your incentive since it has zero marginal cost after fixed costs are recovered. Giving away subsidized hardware or storage is far less attractive, since there are always additional marginal costs no matter the scale of the business.
  1. Businesses that are slow to get to critical mass can run out of cash and momentum. This problem is hard to solve for the same reason the opportunity exists. Getting the balance right and achieving critical mass is an art and not a science. People creating multi-sided markets is relatively is rare at scale. In technology business today there are few areas that do not have existing competition. If you go too slow you may fail just as you can fail if you go too fast. And as I wrote in my recent post on Bill Gurley, you may need to deal with competitors who are not acting rationally or at least are acting extremely aggressively. You need to play the game that is on the field.
  1. Clear profit pools should exist.  Products and services at a given business cannot all be loss leaders. The adoption of a multi-sided market strategy must be considered holistically. If something is a loss leader then there must be a leader that is profitable. Providing one side of a multi-sided maker at a loss cost is a tactic intended to optimize the customer acquisition process and lifetime value for a service that is profitable overall, rather than a standalone strategy.


Invisible Engines: How Software Platforms Drive Innovation and Transform Industries. By David S. Evans, Andrei Hagiu, Richard Schmalensee.   https://www.25iqbooks.com/books/314-invisible-engines-how-software-platforms-drive-innovation-and-transform-industries-mit-press

Platform Revolution: How Networked Markets Are Transforming the Economy–And How to Make Them Work for You.  By Sangeet Paul Choudary and Marshall W. Van Alstyne. https://www.25iqbooks.com/books/315-platform-revolution-how-networked-markets-are-transforming-the-economy-and-how-to-make-them-work-for-you

Matchmakers: The New Economics of Multi-sided Platforms Hardcover – May 24, 2016 by David S. Evans (Author), Richard Schmalensee   https://www.25iqbooks.com/books/133-matchmakers-the-new-economics-of-multisided-platforms

Sangeet Paul Choudary http://platformed.info/twitter-whatsapp-uber-airbnb-network-effects/

David Evans papers: http://www.marketplatforms.com/wp-content/uploads/Downloads/Platform-Economics-Essays-on-Multi-Sided-Businesses.pdf

Van Alstyne: http://ebusiness.mit.edu/research/papers/232_VanAlstyne_NW_as_Platform.pdf

Haigu paper: http://www.hbs.edu/faculty/Publication%20Files/15-037_cb5afe51-6150-4be9-ace2-39c6a8ace6d4.pdf

Hagui interview:  http://hbswk.hbs.edu/item/new-research-explores-multi-sided-markets

Booz: http://www.strategy-business.com/article/03301?gko=16442

Esko Kilpi:  https://workfutures.io/one-theory-to-rule-them-all-c942486e4b30#.gj4wcbxtz

Sam Ghosh: https://www.linkedin.com/pulse/understanding-multi-sided-platforms-social-networks-more-sam-ghosh

A Half Dozen More Things I’ve Learned from Bill Gurley about Investing


I started my friendship with Bill Gurley in the mid-1990s soon after Bill Gates forwarded me a copy of Above the Crowd. I immediately signed up to receive it (by fax!). I then found a way to for us to start talking by phone and the Internet. Gurley was a sell-side analyst living in New York at that time. We kept talking when he moved to Silicon Valley, including the time he spent at Hummer Winblad Venture Partners and then on to Benchmark Capital. As fate would have it, I was sent by Craig McCaw to spend time with Benchmark Capital not soon after Gurley arrived as a partner. It was the late 1990s, the Internet bubble was in full swing and mobile was thought to be “the next big thing” in Silicon Valley. The time I spent co-investing with Benchmark for Eagle River was as much fun as I have ever had in my career. I learned as much from the Benchmark partners during that time as I have from anyone ever. Learning from Gurley, Bruce Dunlevie, Andy Rachleff, Kevin Harvey, Bob Kagle, Steve Spurlock and David Beirne was a dream come true. Unfortunately, the Internet bubble would eventually pop and that would put everyone into firefighting mode for a few years. But I have maintained my friendship with Benchmark over the years and have continued to learn from them. For example, Gurley was the person who pushed me to start using Twitter and from that came my 25IQ blog (my effort to pass along a little of what I have learned before I am dead).

When I wrote my first blog post on Gurley for 25IQ I was limiting myself to 1,000 words per post. I am now up to as much as 4,000 words on some posts since people seem to be actually reading them. So I feel like I owe Gurley and some other people who I wrote about early in this 25IQ series an addendum. As part of my effort to make amends, set out below are a few quotes from a fantastic recent ReCode interview of Gurley by Kara Swisher and my usual commentary. In the notes that are always at the bottom of each post I have assembled a collection of other videos of Gurley, including a particularly insightful interview by Om Malik:

  1. “I think everybody, to a certain extent, has to play the game on the field. I like to use the example of Hortonworks and Cloudera. So we’re in this company HortonWorks, it’s a Hadoop company. Cloudera raises $950 million from Intel. What do you do? You could sit around and say, ‘We’re going to get to profitability,’ but you’re not going to matter. You might as well lock the door and leave the building. So you’re forced into a game of capital warfare that you may have not been ready to play. And so I don’t know that any one person is responsible. Silicon Valley and venture capital have always been cyclical. And so there’s something about human nature that causes us to be increasingly risk-seeking until someone comes along and really punishes everybody.” “I’ve got an unwritten blog post about unit economics. One of the things that Silicon Valley does when it gets risk-seeking, which it did in ’99 and now, is they invest in businesses with lower and lower gross margins. And that’s riskier. And a lot of times those involve consumer products. And then what they do is they start selling them heavily discounted. And there’s this old saying about selling dollars for 85 cents. But there’s a truism to it. You can create infinite revenue if you sell dollars for 85 cents. And if you give consumers more value than you charge them for, they will love you. And I remind entrepreneurs all the time that Webvan had the highest NPS scores of any company I’ve ever known. It wasn’t that the consumer proposition didn’t work, it was that the economics didn’t work. They weren’t charging enough for the service level.”  “When bubbles come along, almost anyone can raise money. And so it creates excessive competition, you get companies that are misbehaving.” Are there any exceptions to the rule that every business needs a moat to generate a sustainable profit?  No. However, this is a trick question since it is the existence of a return on investment that is significantly above a firm’s opportunity cost of capital over a number of years that is the test of a moat’s existence in the first place. In other words, the test of whether a moat exists is fundamentally mathematical (i.e., quantitative). But what causes a moat to exist is mostly qualitative since a nest of complex adaptive systems is involved in any business and the economy in which it operates. The successful creation of a new moat is emergent – you know it when you see it. Moats are created through the interaction of a number of phenomena that I have written about many times on 25IQ series and in my book on Charlie Munger. Because moats are emergent it seems rather obvious how they were created after the fact, but the reality is they are hard to predict before the fact (which explains why venture capital firms invest in a portfolio of businesses hoping for one to three grand slam financial home runs per fund).

In order to moderate the risks associated with this phenomenon of startups and other businesses selling dollars for 85 cents Gurley has been playing the role of an industry leader when he says things like he did above. He has been pushing against the wind to try to benefit not only his own portfolio of businesses, but the industry as a whole. People get easily confused about what Gurley is saying because they tend to be almost totally focused on valuation. Valuation is easy to understand. The general public and many mercenary entrepreneurs like to read and dream about wealth. Wealth sells. But the valuation of a business is a very different issue than the issues that can arise due to risk, uncertainty and ignorance in an industry, value chain or business. In short, there is far too much talking and writing about valuation (especially about whether some company is a unicorn) and far too little focus on the set of issues created by risk, uncertainty and ignorance. In other words, the press likes to say Gurley believes valuations are too high, when he is actually saying that risk, uncertainty and ignorance are too high. Valuation ≠ Risk. Valuation can be a source of risk, but it is not the same thing as risk.

Since Gurley is an athlete and a sports fan he uses sports analogies like “play the game on the field.” Another of these analogies is “muscle memory.” He said in the Kara Swisher’s Recode interview:

[Gurley] “People discount risk slowly. Like they forget about pain and they forget about layoffs and they forget about that this is supposed to be hard, you need to profitable. And the younger generation, they’re taught in very short time windows. So most of the entrepreneurs today weren’t around in ’99.

[Kara] So they’ve forgotten.

[Gurley]They have no muscle memory of it whatsoever.”

It is hard to exaggerate what a shock it was when the Internet bubble popped. The business environment moved from a fund raising climate where you could easily raise billions of dollars for a telecom firm or hundreds of millions for a startup in days to one where you could not raise five cents over any period. Any rational founder should have given thought about what they would do if there was no more cash coming in from investors. Prior to the end of the Internet bubble some founders did and some founder didn’t, and that was a life or death decision for their business. Some founders just got lucky since they had recently done a big financing round (what looked like skill was actually luck). People like Mitch Kapor and Josh Kopelman are in 2016 talking about a Watney rule: “We need to act we’re like Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.” The Watney Rule is intended as insurance, not as an operating plan while money is available as current costs. Fred Wilson thoughtfully argues that times when liquidity is tight can be cathartic:

“As these expansion stage companies struggle to raise capital, they are forced into a cathartic (and at times painful) process of self-reflection. What is their sales process? Is it efficient? What is their unique value proposition? Is it really unique? What kind of company are they building? Will it be large enough to justify all of this investment? And as a result, these companies are coming out of these hard raises with better businesses, better operating models (lower burn rates!!), and bigger visions to go execute against.”

  1. “When I was on Wall Street I was just devouring any book I could on investing philosophy — I think I bring a structured approach. And the way I think about it, which will sound trite, but I’m always looking for some kind of competitive advantage, like some type of unfair ability to compete in the marketplace. I don’t get drawn to the kind of enterprise deals that are just, “Who has the better sales force, knock them down,” kind of thing.” “I remember the OpenTable scenario. We’re meeting with Chuck [Templeton], and he’s in, like, three restaurants, and we’re like, “How could this ever work?” And you’re like, “Well, it can work if we tip it into a network effect and then everyone has to buy it.” And that’s what played out. It’s that kind of thing. We were betting on the existence of a network effect. And people talk about network effects all the time, but you come up with ways to try and analyze whether it’s possible or not. Will more diners lead to more restaurants, and will more restaurants lead to more diners? Are there ways to measure and study that? Or to implement the go-to-market strategy such that it exploits it as much as possible?” One particularly challenging element of a technology-based business is the moats of these businesses have network effects at their core. In a value chain dominated by network effects-based moats it is rare that a business can be fully rational about spending on customer acquisition when their competitor is spending on sales and marketing as if they have a printing press set up in a huge warehouse minting non-sequentially numbered $100 bills at zero cost. Since there is no way to predict when the spigots supplying new cash will be less available or even dry up and since network effects are so critical, a technology startup or business must, as Bill Gurley says: “play the game on the field.” The entrepreneur must trade off: (1) the risk of running out of cash against (2) the risk of not acquiring essential network effects before more free spending competitors do so. There is no scientific method for optimally making this tradeoff.  However, cash in the bank is something that can give the business a margin of safety. A famous investor once called cash “financial Valium.”

All of this is obviously impacted by the availability and cost of capital. More cash means less people are paying attention to having sound unit economics. Gurley notes: “I was fortunate enough this summer to meet Warren Buffett — Chamath [Palihapitiya] was the one that made that happen. But we only had one question each, and I said, “You know, in our industry we’re seeing that low interest rates are leading to overt competition that’s irrational.” And he says, ‘You bet it is.’ And he’s seeing it in his business as well, and I think it’s played out in natural gas and all these other pockets. Real estate in Silicon Valley, right? All these asset prices, because with interest rates so low you just have people looking for yield, so money sloshes around.” There is clearly a lot of capital looking to find higher returns and that impacts the amount of capital invested in the venture capital industry which ends up in the hands of the businesses. This is having a significant impact on behavior to say the least. As Warren Buffett wrote in his February 28, 2001 Chairman’s letter:

“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

  1. “When I first arrived at Benchmark, it was like, ‘Nothing can go wrong.’ There was an IPO every week. And then, wham! Man, the door came down hard.”

Joe Wiesenthal asked this question on Twitter recently:  What caused the end of the Internet bubble.  Here is my answer from a previous post:

“The Internet bubble was literally insane. I’ve never been involved in anything in my life that was more surreal. Fear of missing out (FOMO) caused the bubble to reach unprecedented levels. FOMO is driven by an innate human desire to avoid regret. Daniel Kahneman has counseled financial advisors to “try to prevent people from acting out of regret.” Investors and speculators who are prone to regret are more prone to change their mind at precisely the wrong time. Primarily you want to protect them from regret, you want to protect them from the emotions associated with very big losses.They key takeaway from the Internet bubble, for me, is that when it happens is not predictable. If it is a bubble and it does bust, the day before is like any other day. One key “tell” that can give you a sense that something is up is looking around and seeing lots of companies that are unprofitable paying far too much to acquire customers. What is too much? If the customer over their lifetime is producing a return that is significantly net present value negative the business is paying too much. How much is too much? It depends. If this pattern of acquiring net present value negative customers is persistent and widespread hairs should be standing up on the back of your neck. The bigger the net present value deficit the bigger the risk. Can you predict when a bubble will end? No. “You can’t predict, but you can prepare” says Howard Marks, and I agree. And for the hundredth time: risk is not the same thing as valuation.”

The Internet bubble and its end were nonlinear.  There was no single cause of its creation or its demise. They were what Charlie Munger calls “lollapaloozas.” Michael Mauboussin describes the phenomenon: “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.”

  1. “It’s called asymmetric returns. If you invest in something that doesn’t work, you lose one times your money. If you miss Google, you lose 10,000 times your money. You have to orient yourself toward — Bruce [Dunlevie] uses the phrase, ‘What could go right?” And you have to kind of think that way all the time.” “The learning is that if you have remarkably asymmetric returns, you have to ask yourself, “How high could up be?” And then that “what could go right?” Because it’s not a 50/50 thing on the judgment call. Like, if you thought it was a 20 percent chance at doing it, you should still do it, because the upside is so high.” “You have to be very fortunate to fall on what people sometimes refer to as positive black swans, these break-out plays. And I think you could spend your whole career and do extremely well and never get behind one of the ones: A Facebook, a Google, that kind of thing. And it’s almost impossible to predict ahead of time what’s going to turn into something like that.” “The moment that John Doerr and Mike Moritz closed the Google investment, which was probably all of a week and half, it was the biggest event in both those firms for over a decade. And something had happened in a week and a half. And for a lot of those companies, and I’ll include the ones we’re in, if you worked there it probably would have come out that way anyway. So the seminal event was that closing event that was very quick.”

Convexity (huge upside and small downside) and power laws drive financial returns in venture capital.  Venture capitalists must deal with systems which are, in the words of Nassim Taleb, “more like a cat than a washing machine.” 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).”

Richard Zeckhauser explains why

“The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”

The nature of the venture capital business is that financial returns come from the Fourth Quadrant/the world of ignorance. Standard statistical methods do not work. If you are looking for a career that is more protected from artificial intelligence, the Fourth Quadrant is a place to be. The great venture capitalists person accept this uncertainty and ignorance by seeking to become “antifragile” rather than trying to precisely predict outcomes that are not computable. This is part of the reason why there are venture capital firms. Warren Buffett advises:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

5. “There aren’t that many [rules]. One of the games you play in venture is to know which rules to break at the right time. And so we constantly challenge ourselves. Like, “Should we maybe be dropping this rule at this moment in time because things are changing?” “In the venture rule book there’s: “Don’t back academics who insist on being CEO.” So [when Google pitched to us] there was a number of things that said, “Don’t do it.” But two of the smartest investors ever [Sequoia and Kleiner] stepped up and did it. They also wanted a price that was seemingly ridiculous, obviously a very good investment. We failed to pursue it. It’s always important to state it that way. Because to say ‘pass’ made it sound like we had a chance. I don’t know if we had a chance. They presented to us and we failed to pursue it. And if we had, we would have had to compete with two of the best.” When venture capitalists make a decision on an investment they must think about a range of issues. One of these issues is valuation. If the investor pays too much for an investment it can become very hard to hit the targeted potential return. Another issue is the ownership level. You need to own at significant stake in a business to justify diverting the time and energy of the venture capitalist and not investing in a business that may be viewed to create a conflict.  The venture capital business is about tape measure financial home runs and those returns come from exceptions to what people thought was a rule before or things no one knew. It is worth repeating what Zeckhauser said above: there is no way that one can sensibly assign probabilities to the unknown states of the world.  So for the venture capitalist the question is always: what rule it it wise to break in the case of this investment?

6. “Venture’s really hard. And there’s a lot of luck involved. And mistakes that you make — especially missing ideas.” “Most big startup breakouts are where people aren’t paying attention. As opposed to where everybody’s got their guns lined up.” “Between the time we looked at the [Uber] seed and when we did the A, Travis had moved into the CEO position. At the beginning we were just studying him as an angel investor in the thing, and probably by the time the A came around he was the CEO. It was hard. Like I said, we had a theory that it could be like OpenTable. So you know, OpenTable was sold for like $3 billion or something. So I’d be inaccurate if I suggested we had a vision that it could one day cause people to question car ownership. I never had considered that.” The best venture capitalists are open and aware of the role that luck played in their lives and in their portfolio.When you listen to a Gurley interview he always takes time to thank the people who helped him along the way and to point out the good fortune he has experienced in his career. In a Quora AMA, Gurley gave a great answer to this question: What are the top pieces of advice you would give to your younger self?  I can’t think of a better way to end this post than Gurley’s answer:

1) Read even more than you did.
2)  Thank the people (more) that helped you along the way.
3) When Larry and Sergey ask for $110 pre-money, say “yes, we would be  very excited about that.”


Previous 25IQ on Bill Gurley: https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/

Above the Crowd:  http://abovethecrowd.com/

ReCode: http://www.recode.net/2016/9/28/13095682/bill-gurley-benchmark-bubble-uber-recode-decode-podcast-transcript

Quora AMA: https://www.quora.com/session/Bill-Gurley/1#!n=30

McCombs Interview: http://www.today.mccombs.utexas.edu/2016/05/high-stakes

Om Malik:  https://www.youtube.com/watch?v=dBaYsK_62EY

Pando: https://www.youtube.com/watch?v=nUfkK2xcwnY

TechCrunch: https://www.youtube.com/watch?v=FTGQb32DCDE

GeekWire: https://www.youtube.com/watch?v=VVbK5LCpuWk

Gurley on Coach Campbell:  https://www.youtube.com/watch?v=Lfrbn4tH-NY

Bloomberg:  https://www.youtube.com/watch?v=PwuAYyhfuMs

WSJ: http://www.wsj.com/video/bill-gurley-weve-become-comfortable-with-high-burn-rates/1A3324C6-40BF-4B64-BAD2-D2864F891AB3.html

CNBC:  http://www.cnbc.com/2016/06/01/bill-gurleys-warning-for-start-up-investors.html

TechCrunch: https://techcrunch.com/2015/10/20/bill-gurley-surprises-with-a-positive-note-on-seed-stage-startups/

Techcrunch: https://techcrunch.com/2015/09/15/bill-gurley-on-some-high-flying-startups-and-their-economics-its-the-same-shit-as-in-99/

Fred Wilson: http://avc.com/2016/10/the-hard-raise/

A Half Dozen Things I’ve Learned from Robert Cialdini’s book “Influence”


Professor Robert Cialdini first published his best-selling book Influence in 1984. Charlie Munger liked the book so much he sent Cialdini a thank you note and a share of Berkshire A stock then worth $75,000. Munger said in his famous The Psychology of Human Misjudgment speech at Harvard: “Cialdini does a magnificent job and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.” It should not be a surprise that Influence is in the top ten on my book discovery web site 25IQ books.

Cialdini has a new book out that is at the top of my reading list called Pre-Suasion, which I will write a post about at some point. Cialdini’s describes the subject of his new book as follows: “Pre-suasion is the practice of getting people sympathetic to your message before they experience it.”

In his book Influence Cialdini identifies six important principles often used by what he calls “compliance professionals.” Do you know any “compliance professionals” who have been in the news lately? How do they use principles like authority to try to manipulate you? Influence also discusses a range of additional biases and type of dysfunctional thinking that can cause people to make mistakes. Ironically, we often act as compliance professionals with respect to ourselves to our own detriment. Unfortunately, just being aware of these tendencies is not sufficient to keep them from adversely impacting our judgment and decisions. But a tendency is not destiny, so we can learn to be less adversely impacted by these techniques. None of us will ever be perfectly rational, but we can become incrementally better at making rational decisions.

1. “The [reciprocity] rule says that we should try to repay, in kind, what another person has provided us.” “The obligation to receive reduces our ability to choose whom we wish to be indebted to and puts that power in the hands of others.” The need for reciprocity is a powerful human emotion. Compliance professionals know how to exploit this tendency. For example, when the stock broker gives away the “free” salmon dinner he or she is expecting you to reciprocate by allowing them to manage your wealth. The salesman who wants you to buy his goods in return for the football tickets is no different in his or her motivation. One weird thing about the reciprocity tendency is that you are so influenced by this tendency that what is asked for by the compliance professional can be of far greater value that what is given to you. For example, the Hare Krishna member in the airport who gives away the flower can ask for something much more valuable and yet the people being solicited will still feel the compulsion created by reciprocity. The key defensive move against reciprocity is to not accept the gift in the first place. I would rather stab myself in the thigh with a sharp fork than accept a free weekend condominium stay offered by a time share salesperson. One technique that is useful when engaging in a negotiation is to politely refuse to accept or at least immediately reciprocate when hospitality is offered. Lavish hospitality given to the employees of a business is often intended to create obligation at a personal level, which they hope will cause the employee to offer reciprocal benefits to the generous compliance professional. One problem, however, is that some studies have shown that there is also a bias toward receiving a gift: “Although the obligation to repay constitutes the essence of the reciprocity rule, it is the obligation to receive that makes the rule so easy to exploit.” I’m not so sure about this conclusion as I have an easy time saying no to giftsCialdini points to an additional factor that compliance professionals may use to generate the behavior they desire: “A well-known principle of human behavior says that when we ask someone to do us a favor we will be more successful if we provide a reason. People simply like to have reasons for what they do.” Charlie Munger has said: “the practice of laying out various claptrap reasons is much used by commercial and cult ‘compliance practitioners’ to help them get what they don’t deserve.” The sales person may say something like: “Well yes, we are charging you a 3% sales load on this index fund, but we need to do that because our costs are high.”

The “reason” cited by the compliance professional creates a tendency by the customer accept the fee, even though it is unreasonably high. Similarly an internet scammer may claim that they need to know your social security number because it is required by a state government regulation. How can this reciprocity principle be used in a positive way? One example would be someone who wants to find a career mentor. The best way to do that is often to do favors for the person you want to be a mentor first.  Cialdini talks about an important idea he calls prework:

“People will help if they owe you for something you did in the past to advance their goals. That’s the rule of reciprocity. Get in the habit of helping people out, and—this part’s really important—don’t wave it away when people thank you. Don’t say, “Oh, no big deal.” We’re given serious persuasive power immediately after someone thanks us. So say something like “Of course; it’s what partners do for each other”—label what happened an act of partnership. With that prework done, a manager who subsequently needs support, who needs staffing, who maybe even needs a budget, will have significantly elevated the probability of success.”

Cialdini believes the exchanges can:

“increase both the social value of the giver and that person’s productivity. It wasn’t the number of favors done. It was the number of favors exchanged. If the initial giver creates a sense of reciprocity—a sense that there’s a network of partners who are not just willing but eager to help—he will get a lot in return. He can increase the likelihood of a big ROI by characterizing his assistance as a two-way partnership.”

2. “We all fool ourselves from time to time in order to keep our thoughts and beliefs consistent with what we have already done or decided.” Charlie Munger believes:

“The brain of man conserves programing spaces by being reluctant to change.” He describes the relationship between the human brain and an ideas as being like a human egg with a sperm. Once an idea gets in to the brain, other ideas are prevented from entering by a shut off valve, just like what an egg does to additional sperm once one gets in.”

Commitment and consistency are a very powerful forces that kick in with particularly strong force when people do things like making a public statement about something like a stock price or a political issue. Once that public statement is made (e.g., climate change is X), the tendency is for the person who made the statement to ignore or deny dis-confirming evidence. The best antidote to this bias is arguably an outlook often described as : “Strong opinions, weakly held.” To effectively adopt this antidote a person should do enough research so their opinions are strongly believed, but be open to new dis-confirming evidence (weakly held). As an example, when you publicly state that you believe X stock is going up you are setting in place a potential bias that may cause faulty thinking. By keeping your view on that stock weakly held you can remain open to new evidence if it appears. Value investor Guy Spier writes: “I try to avoid walking into the trap of making statements about any stocks that we currently own, since the situation might later change or I might discover that I was wrong. This is why I prefer not to discuss our current investments in public settings such as annual meetings, shareholder letters, and media interviews.” Sunk cost bias is part of this bias. Munger notes:

“Failure to handle psychological denial is a common way for people to go broke. You’ve made an enormous commitment to something. You’ve poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think,” Now it has to work. If I put in just a little more, then it ’all work…. People go broke that way —because they can ’t stop, rethink, and say,” I can afford to write this one off and live to fight again. I don’t have to pursue this thing as an obsession —in a way that will break me.”

How can this principle be used in a positive way? Cialdini once used this story in an interview to make the point: 

“There was a study done on college students, as freshman, were having trouble in their first year with their study habits.  They weren’t doing very well in their classes.  And they went into a particular program that was scheduled to help their study habits.  One group of them made a commitment to study regularly and specific times, in a systematic way every night.  And they kept that commitment in their heads. Another group wrote it down and kept it private.  Another group wrote it down, and showed it to everybody else in the room.  “Here’s what I promise that I’m going to do.” The first 2 groups didn’t improve at all on their next test.  But that group that showed their public commitment to everybody else in the room, 86 percent of them got one full grade better and moved from a C to a B or a D to a C on the next exam.”

3. “First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information.”We will use the actions of others to decide on proper behavior for ourselves, especially when we view those others as similar to ourselves.”  Social proof is powerful and someone who knew that well was Bernie Madoff. The list of his famous victims is long. Sandy Koufax, Kevin Bacon,  Henry Kauffman, Steven Spielberg, Kyra Sedgwick, John Malkovich… The list of famous victims goes on and on. Cialdini writes: “One means we use to determine what is correct is to find out what other people think is correct. We view a behavior as more correct in a given situation to the degree that we see others performing it.” Restaurants often seat the first patrons near the front window since it is harder to get people to enter if no customers are already inside. As Ben Graham once said: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” Munger talked about how business executives makes errors based on social proof in his famous Harvard speech on human misjudgement: “Big-shot businessmen get into these waves of social proof.  Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company?  And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa.  I think they’re all gone now, but it was a total disaster.” In order for investors to beat the performance of an index fund they must have a view that is different than the crowd and they must be right about that different view. Cialdini points out: “Daniel Kahneman won a Nobel Prize for showing that if you’re trying to mobilize people under conditions of uncertainty, notions of loss are psychologically more powerful than notions of gain. Managers can take the wind in their faces and make it wind in their sails by speaking not just of what will be gained by moving but also of what will be lost or forgone if people fail to move. A second thing that happens when people are uncertain is that they don’t look inside themselves for answers—all they see is ambiguity and their own lack of confidence. Instead, they look outside for sources of information that can reduce their uncertainty. The first thing they look to is authority.” An example Cialdini cites is changing the action line in an infomercial from “Operators are waiting, please call now,” to “If operators are busy, please call again.” Cialidni describes why the call in rates went way up when this change was put in place: “home viewers followed their perceptions of others’ actions, even though those others were completely anonymous. After all, if the phone lines are busy, then other people like me who are also watching this infomercial are calling, too.”

Social proof, like the other tendencies discussed in this post, can be uses for good as well as bad purposes. For example, an advocate of greener practices writes:

“Cialdini, a professor at Arizona State University, conducted a study in several Phoenix hotels comparing the effects of those ubiquitous hotel-bathroom placards that ask guests to reuse towels, testing four slightly different messages. The first sign had the traditional message, asking guests to “do it for the environment.” The second asked guests to “cooperate with the hotel” and “be our partner in this cause” (12 percent less effective than the first). The third stated that the majority of guests in the hotel reused towels at least once during their stay (18 percent more effective). The last message was even more specific: it said that the majority of guests “in this room” had reused their towels. It produced a 33 percent increase in response behavior over the traditional message.”

Cialdini gives this other example from an area of the United States close to where he lives:

“We’ve done some research in the petrified forest in Arizona where I live, there’s a big sign: ‘So many people have stolen pieces of wood from the forest that it’s undermining the integrity of the forest’. That sign tripled theft! But if we said ‘If even one person steals, it undermines the integrity of the forest’, that cut theft in half compared to no sign. Well, it turns out that the managers of the park made a mistake, because only 2% of people steal. So actually they made two mistakes: First of all, they didn’t use the real Social Proof: the 98% of the people who don’t steal. Secondly, they made stealing seem like the norm when it wasn’t! So it’s all about the norm. Norm is essentially Social Proof.”

4. “People prefer to say yes to individuals they know and like.” Finding examples of dysfunction based on liking is like shooting fish in a barrel with a spear gun. For example, an actor who knows nothing about finance is put in a commercial and talks in the advertisement about how you can “make money” doing X.  People know that the person is just an actor and yet statistics show they are motivated into the reverse mortgage or buy the expensive insurance or trade commodities. The sales person who wants to close the sale may want to learn the favorite sports team or hobby of the customer for the same reason. People are also more likely comply with requests of people who are physically attractive or who have similar backgrounds and interests.” Again, the liking tendency can be used for good as well as bad purposes. For example, a study concluded: “newcomers feel motivated to come back to Alcoholics Anonymous because they felt cared for, felt similar to other alcoholics, and found hope in others’ recounted experiences with the program. Findings also argue for an extension of Cialdini’s theory by augmenting the ‘liking’ peripheral cue to include social support and similarity.” Munger says Alcoholics Anonymous uses many of the same techniques as a cult like the Moonies, but for what he believes is a positive outcome. It is interesting to note that just because someone is “family” does not mean they fall outside of the liking/hating tendency.  Munger quotes Buffett as saying: “a major difference between rich and poor people is that the rich people can spend more of their time suing their relatives.”  On a more positive note, Cialdini advise salespeople as follows:

“People don’t buy from because they like you, as much as they buy from you because they perceive that you like them.  If I know that you like me, I know you’re going to give me a good deal. You’re not going to exploit my interests.  You’re not going to take me.  If you genuinely like me, I can exhale.  I can listen to what you have to tell me with confidence. So here’s the implication.  Instead of trying to find a way to get your clients to like you, you find a way to come to like your clients, and show them that you like them. That’s your secret.”

5. “We are trained from birth to believe that obedience to proper authority is right and disobedience is wrong.” “Abraham’s willingness to plunge a dagger through the heart of his young son because God, without any explanation, ordered it. We learn in this story that the correctness of an action was not judged by such considerations as apparent senselessness, harmfulness, injustice, or usual moral standards, but by the mere command of a higher authority.” Authority is often used by “compliance professionals since it is so easy to put into play. Often all is needed is an expert, who can be just about anyone with a fancy title, particularly if they are from out of town. The good news is that if someone’s expertise is shown to be fake the spell can be broken. Charlie Munger describes the problem with authority bias: “[Researchers] don’t do this in airplanes, but they’ve done it in simulators. They have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. Twenty-five percent of the time, the plane crashes. I mean this is a very powerful psychological tendency.” Cialdini explains: “Someone who is in authority has a title, ranking, or the trappings of authority. But, someone who is an authority is more persuasive because they have superior knowledge, experience or expertise in a specific area.” A crook trying to steal your Internet password may claim that they are from the security department of your network services provider, bank or credit card company. The Nigerian scammer may say they are a prince, senior government official or tribal leader for the same reason. Scammers who claim to be from the IRS are also trying to exploit authority bias. Ciadini has said in an interview:

“Authority is more important, impactful and more influential on topics of fact. If you are an expert on the matters of fact then you should emphasize your authority when you are presenting that information.” How has the Internet charged this authority principle. Cialdini points out: “Social media have allowed us to access other sources of information than in the past, but I don’t think they’ve changed our responses to influence appeals. One thing we’re seeing, though, is that people are beginning to be influenced by their peers more than by experts.”

6. “Our typical reaction to scarcity hinders our ability to think.” Scarcity is often used by salespeople and other compliance professionals to motivate buyers. Bernard Madoff when approaching new marks liked to make a big show out of telling people in public that they would not be allowed to invest in his fund. The more he told them he was not willing to manage their money, the more they wanted to do so since he created a false sense of scarcity. Palm Beach accountant Richard Rampell said of Madoff: “It was almost like you were getting let into the club of investors, and everybody wanted to be in. ‘Oh, wow! You’ve got a Madoff account.'” The phrase “limited time offer” or available for the first ten customers is all about invoking scarcity bias. A limited edition Ferrari is all about creating an image of scarcity. Cialdini points out: “The scarcity principal trades on our weakness for shortcuts.” If the Yeezy sneaker is relatively scarce, is must be valuable is the message intended by the compliance professional. If there is a line outside a store to buy the latest phone it must be scarce and therefore valuable in the thinking the vendor wants to generate. If the salesperson says you need to act now, but you are not ready to act since you have not done the due diligence, just say no. As Warren Buffett says: “Investing is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch.” Addendum: It is important to note that more than one principle may be involved and that there are many more biases, tendencies and heuristics than the six discussed in this post on Influence. They can all interact to create what Charlie Munger calls a lollapalooza. Munger:

“A [decision] frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect. Often results are not linear.” Munger relays this story: A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners, and they started acting out roles as people expected.  He had to stop the experiment after about five days.  He was getting into human misery and breakdown and pathological behavior.  However, Zimbardo is greatly misinterpreted.  It’s not just reciprocation tendency and role theory that caused that, it’s consistency and commitment tendency.  Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea.” Wherever you turn, this consistency and commitment tendency is affecting you.  In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think.  And you can say, “Everybody knows that.”  I want to tell you I didn’t know it well enough early enough.”


Cialdini’s book Influence: https://www.25iqbooks.com/books/8-influence-science-and-practice-5th-edition 

Munger’s The Psychology of Human Misjudgment speech:  http://www.rbcpa.com/mungerspeech_june_95.pdf

Influence at Work  http://www.influenceatwork.com/wp-content/uploads/2012/02/E_Brand_principles.pdf

Atlantic article:   http://www.theatlantic.com/magazine/archive/2009/07/greening-with-envy/307498/

HBS Interview: https://hbr.org/2013/07/the-uses-and-abuses-of-influence

NPR Interview: http://www.pbs.org/newshour/bb/psychological-trick-behind-getting-people-say-yes/

Interview: http://www.mischacoster.com/2010-10/psychology/interview-dr-robert-cialdini-on-social-media-influence-with-audio/

Interview: http://www.geniusnetwork.com/robertcialdini/Genius-Network-Robert-Cialdini-Interviewed-by-Joe-Polish.pdf

A Dozen Things You can Learn by Reading “The Success Equation” by Michael Mauboussin

Asking me to select my favorite book written by Michael Mauboussin is like asking me to pick my favorite child. I love them all the same. But if I had to choose one book it would probably be The Success Equation. There are lot of reviews of this book, all of them glowingly positive. The world doesn’t need another review of this great book so I will try to write mostly about how the ideas in the book might be applied in the real world.

Anyone who has been reading this blog should know a lot about Michael Mauboussin. He is one of the clearest business thinkers ever in my view. When he writes and speaks it is in complete thoughts to an extent that astounds me. Read his books and essays. Then read them again. He is a wonderful teacher and very generous with his ideas and time.

It is rare that a post on this blog does not have a notes section identifying further resources to read, but this one is particularly long since Mauboussin’s written work is voluminous. He is a reading and writing machine.

One of the many things I like about Mauboussin is that he thinks about thinking. That is not only valuable, but fun. I am lucky to count him as a friend. His ideas have shaped mine about as much as anyone. Let’s get started.

1. “There’s a quick and easy way to test whether an activity involves skill: ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally, but when playing roulette or the lottery you can’t lose on purpose.” Luck is easier to describe than skill. Luck is best thought of in terms of an activity like roulette. With roulette you know the all potential future states and the probability distribution. Because the house takes a rake in roulette, there are no professional roulette players. Very few things in life involve just luck. The probability distribution of outcomes in the real world is rarely known. Mauboussin writes that luck has three core elements: 1) it operates on an individual or an organizational basis; 2) it can be positive or negative; and 3) it is reasonable to expect that a different outcome could have occurred.

Skill is harder to define, but Mauboussin believes a dictionary definition works well. Skill is: “The ability to apply one’s knowledge readily in execution or performance.” Mauboussin writes that activities like chess rely almost wholly on a player’s skill. Mauboussin explains that each sport has a different mix of skill versus luck and if you want to understand this point better read the book! You will note that in this picture below investing finds its home closer to luck than skill (see the placement of chart icon).


2. “Much of what we experience in life results from a combination of skill and luck.” The mix between skill and luck in a given business or investing activity is always different and is constantly changing. Exactly where investing falls on that continuum depends on the style of investing involved and the business environment at the time. Investing in the stock market is an interesting case to consider when thinking about the mix between luck and skill since it is hard to do better than an index and it is also hard to do worse, especially if you are diversified. Venture capital investing is a more a skill driven activity since it involves things like coaching founders and significantly more uncertainty. Starting a business also involves more skill than investing in pubic equities. When Mauboussin was writing The Success Equation we had an email conversation about the role of luck in the success of Microsoft. I recall that we did not agree completely about the mix in that case. I recall that saw less luck that Mauboussin did. But I am too close to the story perhaps to be objective. Mauboussin includes writes in the book: “When asked how much of his success he would attribute to luck, Gates allowed that it played ‘an immense role.’ In particular, Microsoft was launched at an ideal time: ‘Our timing in setting up the first software company aimed at personal computers was essential to our success,’ he noted. ‘The timing wasn’t entirely luck, but without great luck it wouldn’t have happened.’

3. “Great success combines skill with a lot of luck. You can’t get there by relying on either skill or luck alone. You need both.” Sometimes you will hear people say things like: “the harder I work, the luckier I become.” Mauboussin easily demonstrates these statements to be a non sequitur with a few well-chosen words: “there is no way to improve your luck, because anything you do to improve a result can reasonably be considered skill.” This Mauboussin turn of phrase reminds me a lot of the classic Howard Marks line: if risky investments could be counted on to deliver high returns, then they wouldn’t be risky.

4. “So here’s the distinction between activities in which luck plays a small role and activities in which luck plays a large role: when luck has little influence, a good process will always have a good outcome. When a measure of luck is involved, a good process will have a good outcome but only over time.” Mauboussin believes a wise investing process has three elements: 1) you must find something the market does not believe and you must be right about that belief; 2) you must have control over your behavioral biases; and 3) you must not have organization issues that get in the way of a sound decisions. One way to find things that are true that the market does not believe is to find areas of the market that are less well known and popular. In other words, what you want to do is find a game where the competition is weak. This is exactly what investors Warren Buffett and Howard Marks recommend. What you want to do is find a bet where the other bettors are making decisions based on things that are the equivalent of the patterns made by sheep guts at a slaughterhouse or a Keynesian Beauty Contest. Munger says: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” Warren Buffett makes the point that the way to beat a chess master is to play them at something other than chess. Buffett adds: The important thing is to keep playing, to play against weak opponents and to play for big stakes.” If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

There is no substitute for a sound process in an activity like investing. Mauboussin writes:

“If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome. Think of playing blackjack at a casino. Basic strategy says that you should stand— not ask for a hit—if you are dealt a 17. That’s the proper process, and ensures that you’ll do the best over the long haul. But if you ask for a hit and the dealer flips a 4, you’ll have won the hand despite a poor process. The point is that the outcome didn’t reveal the skill of the player, only the process did. So focus on process.”

5. “When everyone in business, sports, and investing copies the best practices of others, luck plays a greater role in how well they do.” “It’s not that investors lack skill. As investors have become more sophisticated and the dissemination of information has gotten cheaper and quicker over time, the variation in skill has narrowed, and luck has become more important.” Mauboussin calls this idea the paradox of skill. For example, as the skill levels of portfolio managers rise the greater the role of luck becomes in the outcome. The classic example of this idea that Mauboussin cites is the .400 batting average of Ted Williams. One of the many joys of this book is how easily he conveys ideas that involve statistics. Mauboussin points out: “The average of all batting averages in Major League Baseball is generally in the range of .260 to .270. In 1941, when Williams achieved his feat, the standard deviation was .032. Today it is about .028. Saying this differently, Ted Williams had an average that was 4 standard deviations away from the average, getting him to .406. If a player were to be 4 standard deviations away from average in 2011, he would have hit .380. Awesome, but nowhere near .400.” Charlie Munger once said, “If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You’re giving a huge advantage to everybody else.”


As investors increasingly move toward buying index funds, unskilled investors are removed from the game which makes the task of a manager trying to earn alpha harder. In their book The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin argue that active managers are increasingly competing for a shrinking pool of alpha. So as investment skill levels rise, luck gets more important.

6. “If you take concrete steps toward attempting to measure [the contributions of skill and luck to any success or failure], you will make better decisions than people who think improperly about those issues or who don’t think about them at all. That will give you an enormous advantage over them.” The more data you have on your processes and outcomes the more you will be able to improve those processes and outcomes. What data is valuable?  I would rather have data and not need it, than need it and not have it. This quote makes me think of a quality that Mauboussin and I share. We both want to know why something is true. It is not enough to know that x is true. Why is X true? One way to know more about why something is true is to measure it. Of course people tend to ignore or hide data they do not like, which reminds me of an old joke told by Kieran Healy:

A soldier is captured during a long-running war and thrown into the most stereotypical prison cell imaginable. Inside the cell is another solider. He has an enormous, disgusting-smelling beard and has clearly been there a long time. The young solider immediately sets about trying to escape. He is resourceful and possessed of great willpower. He bribes a guard with his emergency supply of cash. The guard gets him into a supply truck and he makes it to the prison garage, but is found during a routine vehicle search while exiting the compound. He is returned to his cell. His mangy companion says nothing about his departure or return. Undeterred, the young soldier works on the bars of the cell for weeks, filing them down with a shim made from a toothbrush. The whole time the old soldier looks on, silently. The young soldier finally breaks the bars, slips out the window and makes it to the outer wall, where he is spotted and recaptured. He is thrown back in the cell. He glowers at his grizzled companion, who still remains silent. Calming himself and mastering his despair, he tries yet again, this time digging a tunnel with the narrow end of a broken plastic coffee spoon. After about two years of work he succeeds in escaping under the wall and making it to the nearest town, only to be captured again at the train station. He is delivered, once again, back to his cell and its taciturn occupant. At the end of his wits, the young soldier finally confronts the old soldier, shouting, “Couldn’t you at least offer to help me with this?! I mean, I’ve come up with all these great plans—you could have joined me in executing them! What’s wrong with you?” The old soldier looks at him and says, “Oh I tried all these methods years ago—bribery, the bars, a tunnel, and a few others besides—none of them work.” The young soldier looks at him, incredulous, and screams “Well if you knew they didn’t work, WHY THE FUCK DIDN’T YOU TELL ME BEFORE I TRIED THEM, YOU BASTARD?!” The old soldier scratches his filthy beard and says, “Hey, who publishes negative results?”

7.“Not everything that matters can be measured, and not everything that can be measured matters.” People want to be able to predict the future. To satisfy that desire, humans have a tendency to grab what data can be measured and assume that what can’t be measured does not exist or does not matter. People who are mathematically gifted are particularly prone to this tendency. For example, if you just assume that the human world works like the world of physics you can use this assumption make beautiful mathematical formulas. But there may or may not be any tie of that mathematics to reality, which can create a host of major problems. As an example, one of my biggest problems with a lot of economic discussions today related to the fact that it is very hard to measure consumer surplus. Just ignoring consumer surplus because you can’t measure it well is a bad idea that can lead to unhelpful policy conclusions. Just as unhelpful are people who say that it can be accurately measured, based on a bunch of assumptions that are essentially guesses. Sometimes we need to accept that we do not or cannot fully know something. The policy choices must deal with that uncertainty.

8. “Even if we acknowledge ahead of time that an event will combine skill and luck in some measure, once we know how things turned out, we have a tendency to forget about luck.” Survivor bias is a huge problem in human cognition. The tendency is for people to conclude: what I achieve is skill and what I fail at is luck. Too often recollections of events we see in life is best categorized as fiction. People love to tell stories, particularly about their successes. Sometimes we get lucky and sometimes we are skillful. Usually the result is some mix of both. Charlie Munger has said on this topic: “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” What is particularly bothersome to me is when people ascribe luck to themselves in a way that they bestow themselves some moral measure superiority. As Warren Buffett points out, he won the ovarian lottery: “I was born in the United States. I had all kinds of luck.”

9. “One of the main reasons we are poor at untangling skill and luck is that we have a natural tendency to assume that success and failure are caused by skill on the one hand and a lack of skill on the other. But in activities where luck plays a role, such thinking is deeply misguided and leads to faulty conclusions.” One of the aspects of life that bothers me the most is when I encounter someone who attributes all their success to skill, and as a result of that they assign a higher moral standing to themselves than people who have been less successful. Mauboussin illustrates this point with a story:

“For almost two centuries, Spain has hosted an enormously popular Christmas lottery. Based on payout, it is the biggest lottery in the world and nearly all Spaniards play. In the mid-1970s, a man sought a ticket with the last two digits ending in 48. He found a ticket, bought it, and then won the lottery. When asked why he was so intent on finding that number, he replied “I dreamed of the number seven for seven straight nights. And 7 times 7 is 48.”

10. “The trouble is that the performance of a company always depends on both skill and luck, which means that a given strategy will succeed only part of the time. So attributing success to any strategy may be wrong simply because you’re sampling only the winners. The more important question is: How many of the companies that tried that strategy actually succeeded?” Once up a time long ago I read a book called In Search of Excellence. The authors analyzed leading companies are sorted out the secrets of success in a way that suggested that it was a replicable formula. The best companies do X, Y and Z was the claim. What was missing of course were all the companies that did X, Y and Z and failed. Mauboussin writes:

“There are numerous books that purport to guide management toward success. Most of the research in these books follows a common method: find successful businesses, identify the common practices of those businesses, and recommend that the manager imitate them. Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of companies and selected 11 that experienced an improvement from good to great results. He then identified the common attributes that he believed caused those companies to improve and recommended that other companies embrace those attributes. Among the traits were leadership, people, focus, and discipline. While Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because performance always depends on both skill and luck, a given strategy will succeed only part of the time.

Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of business success fail to answer a critical question: How many of the companies that adopted a particular strategy actually succeeded?”

As an example, I knew someone once who though that since X successful founder yelled at people that he must yell at people to succeed. People do things like see fictional accounts of Facebook in a movie and think that all they need to do is replicate that formula. Hoodies or black turtlenecks are not highly correlated with startup success. If enough people wear hoodies sure one of them will succeed to, but there is no causation involved. Free Kind bars and colorful plastic slides between floors of an office do not cause startups to succeed financially.


11. “The process of social influence and cumulative advantage frequently generates a distribution that is best described by a power law. … One of the key features of distributions that follow a power law is that there are very few large values and lots of small values. As a result, the idea of an “average” has no meaning.” I call this the paradox of luck as a riff on Mauboussin’s “paradox of skill.” My thesis is that the luckier you get, the more skill you can get if the conditions are right. This happens because of what is known as “cumulative advantage.” As an example, the more financial success someone like a venture capitalist gets, the more skilled people they get to work with since they are attracted to that success, which makes the venture capitalist more skilled, which makes them more financially successful [repeat]. My thesis is: financial success caused by luck begets not only greater financial success, but greater skill. A good example on this point is a statement made by Michael Moritz years ago.  He said: I know there are millions of people around the world have worked as hard and diligently as I have and weirdly enough, like [former US President] Jimmy Carter said years and years ago, ‘life’s unfair’. I just happen to have been very fortunate.” “A chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” The key point about what Moritz describes is that luck did not just make him richer, it made him more skilled since he was exposed to opportunities and teachers that he would not otherwise have encountered. Being lucky made him more skilled and that process fed back on itself. Luck and skill are different but one can lead to the other in a way that create a virtuous circle.

12. “Knowing what you can know and knowing what you can’t know are both essential ingredients of deciding well.” The best investors are certain of just about nothing and spend a lot of time trying to learn more about what they do not know and cannot know. Mauboussin is chairman of the board of trustees of the Santa Fe Institute, a leading center for multi-disciplinary research in complex systems theory. Perhaps the greatest things I have learned about complex adaptive systems is to more aware of what I do not know.

There is a difference between knowing what you do not know and not knowing very the basics necessary to do a job. As an example, I’m of the view that a US President should know what Aleppo is or be able to name a few foreign leaders. And you want you investment managers to understand things like, well, compound interest and capital gains. Call me a stickler on this point if you want. A positive example would be an investor who candidly says, “I don’t understand biotech investments.”

If you ever attend a meeting at Sante Fe Institute meeting you will see famous investors in the audience who are hungry for information on what they do not know or can’t know. Great investors are humble but yet aggressive when they see a significant opportunity within their circle of competence. Munger is a good person to give the closing statement:

“Even bright people are going to have limited, really valuable insights in a very competitive world when they’re fighting against other very bright, hardworking people. And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times.”


The Success Equation (the book): https://www.25iqbooks.com/books/3-the-success-equation-untangling-skill-and-luck-in-business-sports-and-investing

My previous post on Mauboussin on 25IQ: https://25iq.com/2013/07/11/a-dozen-things-ive-learned-from-michael-mauboussin-about-investing/

My list of Mauboussin Essays: https://25iq.com/2013/02/17/mauboussin/

More than You Know:  https://www.25iqbooks.com/books/5-more-more-than-you-know-finding-financial-wisdom-in-unconventional-places-updated-and-expanded-columbia-business-school-publishing

Think Twice: https://www.25iqbooks.com/books/4-think-twice-harnessing-the-power-of-counterintuition

Expectations Investing: https://www.25iqbooks.com/books/24-expectations-investing-reading-stock-prices-for-better-returns

Mauboussin’s bio/CV:  http://www.santafe.edu/about/people/profile/Michael%20Mauboussin

Mauboussin’s Web site http://www.michaelmauboussin.com/

Fast Company Interview: https://www.fastcompany.com/3002729/facts-luck

CNBC post: http://www.cnbc.com/id/49791755

Strategy-Business: http://www.strategy-business.com/article/13202a?gko=50b64

Bloomberg: https://www.bloomberg.com/view/articles/2016-08-16/michael-mauboussin-on-skill-and-luck

Talk at Google: https://www.youtube.com/watch?v=1JLfqBsX5Lc

Ritholtz MIB Podcast:  https://www.bloomberg.com/view/articles/2016-08-16/michael-mauboussin-on-skill-and-luck

Economist: http://www.economist.com/blogs/buttonwood/2012/12/investing

Wharton: http://knowledge.wharton.upenn.edu/article/michael-mauboussin-on-the-success-equation/

Wealth of Common Sense:  http://awealthofcommonsense.com/2013/07/do-you-feel-lucky/

Essay on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf

Essay on the Skill Paradox:  http://changethis.com/manifesto/100.03.SuccessEquation/pdf/100.03.SuccessEquation.pdf

Essay: https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&source_id=csplusresearchcp&document_id=1051045621&serialid=CFuLyFE%2BEXHlo12BGWMqq8fSzI8Xcj0miB1nOa39p9U%3D

Wired Interview: https://www.wired.com/2012/11/luck-and-skill-untangled-qa-with-michael-mauboussin/

Forbes interview:  http://www.forbes.com/sites/investor/2013/11/05/the-role-of-luck-and-skill-in-investing/#7368a94e3e4c

Slide Deck http://www.sloansportsconference.com/wp-content/uploads/2013/Slides/EOS/Why%20You%20Don’t%20Understand%20Luck.pdf

Prisoner Joke: http://crookedtimber.org/2011/04/23/i-predict-the-gifted-will-foresee-the-punchline/

A Dozen Ways You Can Use Seth Klarman’s “Margin of Safety” Approach When Voting

When you cast a vote you are making an investment. You should vote using a sound process, just as you should use a sound process when investing. Having a sound decision making process means reading a lot and talking to people you trust who have good judgment before making a decision. When it comes to a decision about a particular candidate in an election I would frankly rather read a transcript of a speech than listen to it. But if you like listening to speeches, do that. In general, I prefer an interview to a scripted speech anyway since you get a better sense of whether the candidate has any sense when they are not scripted. Yes, I would rather read a transcript of the interview. Reading any policy papers that are available is also helpful but few people will actually do that. Of course, more than just getting the facts is required. As Charlie Munger has said: “I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.” As an aside, if you don’t like reading about Munger’s ideas, this may not be a good blog for you to read.

In writing blog posts about what people like Bill Murray, Rza and Louis CK can teach about investing, I am trying to make a point about sound decision-making principles being universally applicable. Investing is about making good decisions. For example, someone like Charlie Munger does not use a different decision making methodology when voting than he does when he is investing or making a charitable donation. A key point about making decisions of any kind is stated simply by Munger: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” This applies both to the way you vote and how you analyze a candidate. The best way to be smart, is to not be stupid.

I have previously written a blog post on Seth Klarman that included some quotes from his excellent book Margin of Safety. Few people reading this post will be willing to pay the $1,000 that a used copy of that book sells for on Amazon. I suggest that you instead borrow a copy of Margin of Safety from a friend or somehow find another way to read it. As an aside, I’m hoping that Klarman allows someone to republish this book soon since the world needs books like this now more than ever. Any sane publisher would do so in a heartbeat. “Hey Seth. The investing world needs you! Please republish the book!”

The quotes from Margin of Safety in the text below are in bold as is usual, but in this post I have substituted the words “voter” for “investor” and “candidate” for “investment” to make my points.

1. “Rather than targeting a desired rate of return, even an eminently reasonable one, [voters] should target risk.”  Klarman is using the term “risk” in the broadest sense. He knows that very few things in life involve just “risk” if you use Richard Zeckhauser’s definitions. Almost everything in life involves decisions that have outcomes which will be determined by “uncertainty and ignorance” rather than “risk” since it is rare that the probability distribution of future outcomes is known. In other words, life is almost never like roulette, where you know the odds and the probability distribution. The way Howard Marks puts it is that there is no definitive future at any given point in time and instead what we all face when looking forward in time can only be represented by probability distributions.


Given the inevitable risk, uncertainty and ignorance that you face in life, one thing you want to avoid is a candidate who will often create “concave” situations (small upside and big downside). Stated differently, what you want to avoid is a candidate who is what Taleb calls a fragilista. Taleb’s fragilistas develop and promote concave propositions that promise low or modest upside gains, but ignore the possibility of catastrophic risks. Does the candidate understand this concept? Do they have a sound decision-making process? Or are they oblivious to actions which exhibit negative outcome asymmetry?  Nassim Taleb elaborates:  When you inject uncertainty and errors into airplane ride (the fragile or concave case) the result is worsened, as errors invariably lead to plane delays and increased costs —not counting a potential plane crash.” Taleb continues by saying that The fragilista “defaults to thinking that what he doesn’t see is not there, or what he does not understand does not exist. At the core, he tends to mistake the unknown for the nonexistent.”

2. “Smart [voters] stick to [candidates who stay] within their circle of competence, within which … they have the capability to understand.” This is the only quote of Klarman’s in bold in this post that wasn’t in Margin of Safety, but it is something Klarman believes in as evidenced by this bolded quote from another source. The book Margin of Safety has a great index but I can’t find the “circle of competence” in the index or text. This is a bit odd, but it is what it is. I would say that in general that Margin of Safety is not a book that digs into investor psychology like Thinking Fast, and Slow or Influence. In any event, the circle of competence idea when applied to an election decision is simple:  Does the candidate know what they do not know? Do they understand what a circle of competence is? Do they stay within that circle?  Do they seek experts when they are outside their circle of competence? Do they avoid getting advice from poseur faux experts who don’t know what they don’t know and stray from their circle of completence?

3. “One of the recurrent themes of this book is that the future is unpredictable.”  “[A nation] must be prepared for any eventuality.” If a country has done its preparation correctly it has this thing called a constitution that prevents an idiot who somehow gets elected to office from ruining a nation and its way of life. Every nation needs a constitution that is structured so well that an idiot could be elected to the highest office in the land and the nations will get through that difficult time, “because sooner or later, one will” to paraphrase Warren Buffett. There is a separation of powers and checks and balances in the US Constitution for very good reasons. The people who wrote the US Constitution were aware that someone might someday end up being president who was unwise or had a lousy temperament. So they wrote it carefully to limit the power of  a single person by making sure political power was distributed. Not only is there a constitution that provides protection in the case of the United States but there is also the extraordinary people of the nation itself as a buffer against idiocy.

4. “An irresolvable contradiction exists: to [vote intelligently], you must predict the future, yet the future is not reliably predictable.” If the candidate for elected office believes they have an IQ that is greater than t actually is that is a red flag on their suitability to perform the duties of an elected official. Munger again:

“A [elected official] with an IQ of 160 and thinks it’s 180 will kill you,” he said. “Going with a [candidate for office] with an IQ of 130 who thinks its 125 could serve you well.” “Smart people aren’t exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.” “You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have the cast of mind, you’re destined for failure even if you have a high IQ.”

5. “A margin of safety is [is intended to] allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” As Charlie Munger has said: “Proper [voting] is like engineering. You need a margin of safety. Thank God we don’t design bridges and airplanes the way we [vote for political candidates].” When choosing who to vote for it is wise to ask yourself questions like: Do the candidate’s previous actions reflect margin of safety principles?  Do they leave a margin for error, bad luck or extreme volatility?  Are they thoughtful in making decisions using a sound process or are they quick to make judgments before they think through an issue? Do they make decisions like an engineer designs a bridge? Does the candidate have a temperament that will allow them to make the right decisions in a crisis? Will they conduct themselves in a way that does not precipitate crisis after crisis?

6. “The river may overflow its banks only once or twice in a century, but you still buy flood insurance.” Black swans are highly unlikely but very impactful events that have causes which are explainable, but only after the fact. We know Black Swans happen. Does the political candidate in the election understand that you must invest to capture the benefits of positive Black Swans and also invest to prepare for unpredictable negative Black Swans? Do they know that you can’t predict when negative Black Swans will arrive but that you can prepare?

7. “Think for yourself.” If you consider yourself a member of a political party and it nominates candidate X, why would you vote for that candidate if you have actually done your own research and drawn you own conclusions?  Why would you not do your own research and draw your own conclusions? Think! The power of thinking for yourself has been a consistent message on this blog.

8.“[Smart voters] pay attention to financial reality in making their decisions.” Does the candidate make promises that are grounded in financial reality? Do they make proposals that are achievable? In making a decision a voter should use an opportunity cost approach as described by Munger: “If you take the best text in economics by Mankinaw, he says intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.  In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics.”

9.“Successful [voters] tend to be unemotional, have confidence in their own analysis and  judgment.” Here’s Charlie Munger again on the importance of avoiding mistakes that can be made due to emotional or psychological factors. Increasing rationality and improving as much as you can no matter your age or experience is a moral duty. Too many people graduate from [college] today and think they know how to do everything. It’s a considerable mistake.” Be rational. Decide carefully, but do decide.

10. “A [candidate for office] should be inspected and re-inspected for possible flaws.” Who should I quote now? Yep, Munger: “The best single way to teach ethics is by example: take in people who demonstrate in all their daily conduct a good ethical framework. But if your ethics slip and people are rewarded it cascades downward. Ethics are terribly important, but best taught indirectly by example. If you just learn a few rules [by having ethics taught in school] so they can pass the test, it doesn’t do much. But if you see people you respect behaving in a certain way, especially under stress, [that has a real impact].” “I think we have lost our way when people …fail to realize they have a duty to the rest of us to act as exemplars. You do not want your do not want your [public officials] to be setting the wrong moral example.”

11. “What appears  to be new and improved today may prove to be flawed or even fallacious tomorrow.” Sometimes an electorate is hoping for “a change” from the status quo. This is understandable. But it is wise to make sure that the change is for the better. Sometimes people jump out of what they think is a frying pan and into a fire. Munger again: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other. And that’s the way we filter opportunities.”

12. “[Voting] is serious business, not entertainment.” When you vote you are making decisions that can have a major impact on something that is precious. Your voting decision should not be decided on the basis of a talk show performance or other events with entertainment value. Do the research. Think.  Select wisely.  And do actually make a selection. Not voting is voting. Protest votes have no place in elections, especially in 2016. Make your vote count.

I will have attempted to be relatively apolitical in this post. I have also tried to make the explanation of a sound decision making process applicable to any election, not just the US Presidential election that will take place soon. Reuters reports that Klarman himself: “is registered as an independent voter and has given money to candidates from both parties in the past.” In the United States presidential election Klarman has said: “I will continue to find ways to support Hillary Clinton and defeat Donald Trump. He is completely unqualified for the highest office in the land.” The views of Klarman are similar to Munger’s statement on the  election: “The last person, almost, I’d want to be president of the United States is Donald Trump.”

My intent in writing these blog posts is to teach people how to make better decisions and making this post partisan interferes too much with that mission in this case. I would rather teach someone to fish than hand them one.  I’ve set out my decision making process many times. It should not be hard to figure out who I will vote for in a given case. What I hope that you do is think for yourself after doing the research, just as you should do in investing. Be rational rather than emotional. Decide based on facts. Be smart by not being stupid, stay in your circle of competence and find candidates who think the same way.

One of my favorite recent stories took place at the recent Rio Olympics: “The U.S. boat was in third place halfway through the race when coxswain Katelin Snyder shouted the magic words: ‘This is the U.S. women’s eight!’ In the bow seat, Emily Regan could feel her end of the boat rise, as if the whole shell were taking flight. ‘It was like I wasn’t even touching the water,’ she said.” For an American citizen it is helpful right now to remind yourself that: “This is the United States of America!” We will get through this year, the next four years, or anything else that is thrown at us. Despite the existence of that buffer, every American who is eligible needs to vote. Get the hell out and vote. Your country needs you.


25iq on Seth Klarman https://25iq.com/2013/07/15/a-dozen-things-ive-learned-from-seth-klarman/

Margin of Safety: https://www.25iqbooks.com/books/109-margin-of-safety-risk-averse-value-investing-strategies-for-the-thoughtful-investor

Klarman on the US presidential election: http://www.politico.com/story/2016/08/seth-klarman-supports-clinton-226663

Munger on the US presidential election: https://www.youtube.com/watch?v=1Bb3cvrxdVs

Antifragile:  https://www.25iqbooks.com/books/12-antifragile-things-that-gain-from-disorder-incerto

Poor Charlie’s Almanack: https://www.25iqbooks.com/books/215-poor-charlie-s-almanack-the-wit-and-wisdom-of-charles-t-munger-expanded-third-edition

Charlie Munger: https://www.25iqbooks.com/books/54-charlie-munger-the-complete-investor-columbia-business-school-publishing

Michael Mauboussin: http://www.michaelmauboussin.com/excerpts/MTYKexcerpt.pdf

A Dozen Ways to Apply the Lessons Taught in the Book “The Most Important Thing” by Howard Marks

When I am asked by someone what book they should read first to learn about investing  I often suggest Howard Marks’ The Most Important Thing https://www.25iqbooks.com/books/207-the-most-important-thing-illuminated-uncommon-sense-for-the-thoughtful-investor-columbia-business-school-publishing

The book does not take too long to read and the points Marks makes are simple and understandable.  The Most Important Thing is currently a top five rated book on my book discovery web site https://www.25iqbooks.com/. Warren Buffett has said about this book: “This is that rarity, a useful book. When I see memos from Howard Marks they’re the first things I read. I always learn something and that goes double for this book.” The only reason I might hesitate in making The Most Important Thing my first recommendation is that some people may need to read a survey book on investing first to learn some terminology and basic concepts. For that primal level and survey type introduction to investing I usually chose one of the books by the Bogleheads or John Bogle himself.

This post is not a book review. What I will do in this post is explain how to identify situations where you can apply the ideas in the book.. The key skill you need to acquire to do this well is pattern recognition. The more you work at applying these ideas, the better you will get at applying these principles, the more fun you will have with the process, the more you investing skill you will acquire [repeat]. What I just described is an example of a positive feedback loop. As Mae West once said: “Too much of a good thing can be wonderful.” Improving your investing results is a very good thing indeed.

Howard Marks is a value investor. Someone might say: “What does value investing have to do with other investing systems?” The answer to that question is: “All intelligent investing is value investing.” Who said that? Charlie Munger. Why did he say that?  Because the foundational principles of value investing are universal. The need for a margin of safety, a business valuation process and phenomena like moats are universally applicable to any style of investing. These principles do not apply to speculation, but that is a subject for another post.

To convey my points in this post I decided to take an investing style that many would consider to be very different from value investing and show that they are in fact based on the same principles applied in different ways to different types of assets. That other investing system I will discuss here is venture capital. Venture capitalist and entrepreneur Andy Rachleff has said: “My investment idol is a guy named Howard Marks, who runs a hedge fund in LA., you might know called Oaktree. He’s as well known for his writings as he is his returns, which are very, very good. He once wrote an article about investing which I think relates well to entrepreneurship as well.”

As always on this blog, the words written or spoken by the subject of the post (in this case what Howard Marks wrote in his book The Most Important Thing) are in bold.

1. “The expected result is calculated by weighing each outcome by its probability of occurring.” Once upon a time in 1999, Sergei and Larry were looking to raise some capital for a business they were calling Google. One of the venture capital firms the Google founders pitched in seeking an investment was Kleiner Perkins, which saw hundreds of other pitches that year, just like they do every year. Out of all of the firms Kleiner considered that year they made 85 investments. One of those 85 was an investment of $12.5 million in Google (another venture capital firm named Sequoia made the same bet). This Kleiner IX fund also invested in AutoTrader and Martha Stewart Living Omnimedia Inc. in 1999 but it is not much of an exaggeration to say that the Google investment was all that mattered in that venture capital fund and in Silicon Valley in general that year.

In making a decisions like Kleiner did in 1999, the venture capital firm performs an “expected value” analysis which is: the weighted-average value for a distribution of possible outcomes. In other words, expected value is calculated by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes. As Buffett likes to say: “take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.” Venture capital firms have a hard problem in that it is not easy to make the expected value calculation since there is a great deal of risk, uncertainty and ignorance related to the decision. You will sometimes hear venture capitalists say that they make decisions based on their gut instinct, but this really is an investor making an expected value calculation using rough inputs determined in many cases in their head based on pattern recognition skills. Precise inputs are not required to make an expected value calculation and the math can be done in your head if you know it well and you are seeing a substantial bargain that more than covers any mistakes on your part. Michael Mauboussin lays out a key part of the task for any investor in his usual clarifying manner in his essay “Ruminations on Risk”:

“Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur.  As Robert Hagstrom notes, the textbooks on Bayesian analysis suggest that if you believe that your assumptions are reasonable, it is perfectly acceptable to make your subjective probability of a particular event equal to a frequency probability. Thinking about the investing world probabilistically is critical to the margin of safety concept.”

2. “Many futures are possible, to paraphrase Dimson, but only one future occurs.  The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.  The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.” They key point is this is that Kleiner and Sequoia did not know that Google would be a tape measure financial home run. It was enough that they thought it had a significant chance to do so and that the potential payoff was massive. So how does a venture capitalist deal with this uncertainty about the future? Warren Buffett describes the approach:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

This approach employed by venture capitalists outlined by Buffett is essential given the nature of convex bets. As I have written in previous blog posts, the value that is uncovered by venture capital is achieved through a process that is based on trial and error by the entrepreneurs. There is no absolute certainty in investing. Ever. There is no future. What exists now and in the past is what we have and when we look forward all we should think about is a probability distribution. What this means is that when it comes to the future, there is no “there there” yet. For this reason investing of all kinds is inherently a probabilistic activity. In any form of investing you can be wrong even though you made the right decisions based on probability. And vice versa. Venture capital investing is unique in that the bargains being discovered are convex and outcomes that result in financial success being determined by very few winners. Startups are not the sort of undervalued asset that a traditional value investor seeks. But both types of assets should be considered using the same basic principles.

3. “Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have.  You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won’t be sufficient.  You must be more right than others… which by definition means your thinking has to be different.” “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate.  That’s not easy.” It is provable mathematically that you cannot beat the market if you are the market. To outperform the market you must take positions that are at odds with consensus and be right about that decision. As an example, in the spring on 1995 Tom Alberg was asked to be an investor in a startup created by Jeff Bezos by the name of Amazon. Alberg wasn’t sure whether to make that investment:

“Bezos hadn’t launched the site yet. He had a good business plan that was solely focused on books. It was going to break even in year two. Sounded attractive. The other thing, I loved bookstores…. I met with him, and I thought he was a very smart guy and intrigued. I said: Well, I am potentially interested but let me think about it. The next week I went to Barnes & Noble bookstore. I was trying to buy a book for my son, who was starting a business. And I had that sort of bookstore frustration where the salespeople didn’t know. I finally figured out the book I wanted and they didn’t have it. So, I said maybe there is room for online. Then, every month for the next couple months, they launched it in June, I think, Jeff would send me an email and say: ‘Gee, we’ve now sold books in eleven states.’ And then I get an email and it said: ‘Revenues are up to $70,000 a week.’ And: ‘We just sold our first book to a European customer.’ I met with him a couple more times, and invested.”

Lots of people turned Jeff Bezos down that year. I know one such person and it impacts his investing to this day since it causes him in my view to write too many checks. For better or worse I was not asked to invest. But I know seven people who said yes.How did it workout for the people who invested?

Jeff Bezos: “The riskiest moment for Amazon, was at the very, very beginning. I needed to raise $1 million at a certain point, and I ended up giving away 20 percent of the company for a million dollars.”

Charlie Rose: “A helluva a deal for somebody.”

Jeff Bezos: “A lot of people did very well on that deal (laughs). But they also took a risk, so they deserve to do very well on that deal. But I had to take 60 meetings to raise $1 million, and I raised it from 22 people at approximately $50,000 a person. And it was nip and tuck whether I was going to be able to raise that money. So, the whole thing could have ended before the whole thing started. That was 1995, and the first question every investor asked me was: ‘What’s the Internet?’”

4. “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.  That means the best opportunities are usually found among things most others won’t do.  After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.” “A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.” “The most profitable investment actions are by definition contrarian:  you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).  These actions are lonely and… uncomfortable.”  “The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.” To find something that is undervalued you need to be looking where others are not looking. It has been said that the best venture capitalists are looking for something that is half crazy. Why? Well, people are generally fearful of investments that are even part crazy and that fear on the part of others can create some bargains due to mis-pricing. Something that others do not believe is valuable, or better yet, is not yet on anyone’s radar, can be offered to a venture capital investor at a bargain price. A venture capitalist is just looking for a different type of asset available at a bargain than a typical value investor. Venture capitalists are looking for a chance to purchase an asset that is highly “convex,” which means there is a huge upside and a relatively small downside. For example, a venture capitalist is not buying something like a well-known consumer product brand at less than intrinsic value. They are instead is looking for convex bets that can be bought at less than their true value. As is the case with any other financial asset a venture capitalist can pay too much for an asset that has convexity. But there were some people in the venture capital business who though the valuation of Google in 1999 was too high and passed. The 1999 investment in Google by Kleiner and Sequoia had tremendous convexity (massive upside and relatively small downside). The most these two venture firms who invested in Google in that round could lose is what they invested. Similarly, early seed round investors in Amazon could only loose what they invested. If they still owned those Amazon shares, the total gain would greater than ~38,000%.


5. “I’ve said for years that risky assets can make for good investments if they’re cheap enough.  The essential element is knowing when that’s the case.  That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.” To discuss risk you must first start with a definition. My favorite definition is from the work of Richard Zeckhauser who teaches at Harvard:


Zeckhauser explains an important take away from those chart:

“The returns to UUU investments can be extreme.  We are all familiar with the Bell Curve (or Normal Distribution), which nicely describes the number of flips of a fair coin that will come up heads in a large number of trials.  But such a mechanical and controlled problem is extremely rare.  The standard model often does not apply to observations in the tails. So too with most disturbances to investments. More generally, movements in financial markets and of investments in general appear to have much thicker tails than would be predicted by Brownian motion, the instantaneous source of Bell Curve outcomes.  That may be because the fundamental underlying factors produce thicker tails, or because there are rarely occurring anomalous or weird causes that produce extreme results, or both. Nassim Taleb and Benoit Mandelbrot posit that many financial phenomena are distributed according to a power law, implying that the relative likelihood of movements of different sizes depends only on their ratio. Power distributions have fat tails.  In their empirical studies, economists frequently assume that deviations from predicted values have normal distributions. That makes computations tractable, but evidence suggests that tails are often much thicker than with the normal.”

The key point is that venture capital is all about exceptions and phenomenon that express themselves in power laws. It is not an investing discipline that is ruled by a Bell curve, but it is still a probabilistic activity. I have written a blog post on what I believe is another style of venture capital investing by Dave McClure which I believe harvests a different type of alpha which is important if the style is to spread to more cities and grow in size.

6. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.” “Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.” Risk comes from not knowing what you are doing. The best way to lower risk is to know what you are doing. It’s that simple. If riskier investments could be counted on to generate higher returns than they would not be riskier is the applicable famous Howard Marks quip on this point.

7. “First-level thinking says, ‘It is a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’ First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’ First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’” Second level thinking is about finding value that others don’t appreciate. You can’t beat the crowd if you are the crowd. Here’s Howard Marks writing in one of his wonderful essays:

“Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.”

The matrix that describes the outcomes is:


8. “Cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control.  Thus we must recognize, accept, cope and respond.  Isn’t that the essence of investing?” “Processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.  The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical. Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions.  But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.” “Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” “In January 2000, Yahoo sold at $237.  In April 2001 it was $11.  Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.  But that doesn’t mean many investors were able to detect and act on the market’s error.” “A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.” “It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.  And there are few assets so bad that they can’t be a good investment when bought cheaply enough.” Howard Marks believes that almost everything is cyclical. And venture capital is no exception to this rule. Other people agree the venture industry is cyclical. Bill Gurley once put it this way: “Venture Capital has long been a trailing indicator to the NASDAQ.  Venture capital is a cyclical business.” “Moreover, deep down most LPs know that performance in the VC sector is counter cyclical to the amount of money raised by VCs.” Andy Rachleff has similarly said: “[Venture capital is] a very cyclical business. So there was a cycle from 1980-1983 that looked a lot like 1996-1999. Only an order of magnitude smaller on every dimension.”  “I don’t think a bubble is an environment where things are valued highly, I think it’s an environment where crappy companies are valued highly.” Sometimes growth is valued more than profitability by markets and sometimes it isn’t. Sometimes cash is relatively easy to raise if you have a good business and sometimes you can’t raise five cents even if you have a good or even great business. Howard Marks likes to say you can’t predict but you can prepare. Having enough cash on hand to survive an inability to raise new cash for a significant period of time helps prepare a company for adverse turns in a cycle which can’t be fully predicted.

9. “Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing.  Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.” “The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.  My ‘I don’t know’ school thinks of future events in terms of a probability distribution.  That’s a big difference.  In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.”  This is the “circle of competence” idea in all of its glory.  Risk comes from not knowing what you are doing. The best way to avoid risk is to stick to situations where you know what you are doing and to work hard to expand the areas where you do know what you are doing by learning. One thing I have seen again and again in great investors is that they spend most of their time trying to determine what they don’t know. They would much rather read a book or attend a lecture on what we don’t know than listen to crackpot theories that try to predict what can’t be predicted. This “tell me what I don’t or can’t know” approach is very different from academia since there are few people who get academic tenure for proving what we don’t know or that we can’t know something. The key point is illustrated by Charlie Munger’s desire to know where he is going to die so he can just not go there. Munger’s quip is humorous because it is so true for an investor. If you just know where you are going to lose money, you can just not go there. If only that was always true.

10. “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies.  Thus, I suggest people try to ‘know the knowable.’”  This is the Howard Marks version of the Charlie Munger principle that “the best way to be smart is to not be stupid.” The best venture capitalists are aware of the cycle because of its impact on valuation of individual businesses but stay focused on microeconomics. They value the convexity of each business in the portfolio and give only occasional thought to Federal Reserve interest rate policy when making investments. Like Marks, a smart venture capitalist understands that they know a lot about today but nothing certain about tomorrow and the days after that. The future is not only risky and uncertain but contains the potential to reveal ignorance. By adopting a margin of safety approach one can be wrong, make a mistake and still have an acceptable result.

11. “No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.” Venture capital is interesting in many ways, but perhaps most interesting is that it involves people who break rules. At least one key rule is broken by each entrepreneur who hits a financial home run. If you don’t do make a decision to be different in some way and are right about that decision you are unlikely to generate convex financial returns. Operational excellence is a great thing, but to generate a 10-100X financial return you can’t be doing what everyone else is doing, only better. Every time an entrepreneur breaks a rule the risk of failure rises so they don’t want to break too many rules at once. As was the case in the story in Goldilocks and the Three Bears, the founders of a startup want the “rule breaking” to be at a “just right” level. 

12. “Where does an investment philosophy come from?  The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed.  A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources.  One cannot develop an effective philosophy without having been exposed to life’s lessons.” There is no way to get through life and learn without making mistakes. You can certainly learn a lot and avoid a lot of pain by watching and reading about the mistakes of other people. Learning vicariously not only scales better but can be far less painful. That is why I love books so much and created my book discovery site https://www.25iqbooks.com/. But there is a big difference between knowledge and skill. Acquiring skill requires at least some real world practice. In the end, to acquire skill you need to sometimes make mistakes yourself to really learn the most powerful lessons. You can only learn so much just by watching others.


Howard Marks: https://www.25iqbooks.com/books/207-the-most-important-thing-illuminated-uncommon-sense-for-the-thoughtful-investor-columbia-business-school-publishing

My previous blog post on Howard Marks:  https://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/

Alberg invests in Amazon:  http://www.geekwire.com/2015/qa-madronas-tom-alberg-on-the-changing-winds-of-venture-capital-tech-bubbles-and-bankrolling-a-young-jeff-bezos/

Kleiner’s IX fund: http://www.wsj.com/articles/SB108328387230498204

Zeckhauser: https://www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf

Mauboussin’s Ruminations on Risk: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf

Buffett’s 1993 Chairman’s letter:   http://www.berkshirehathaway.com/letters/1993.html

Geekwire Charlie Rose: http://www.geekwire.com/2013/jeff-bezos-60-meetings-raise-1m-amazoncom-giving-20-early-investors/

A Dozen Things I’ve Learned About the Music Business (and Businesses Like It)


  1. “I wish there had been a music business 101 course I could have taken.” Kurt Cobain. There are many musicians like Cobain who are thrust into situations without financial help they can trust. Every musician should take a lesson from the comedian and actress Tina Fey: “I came to New York in 1997 to work on Saturday Night Live. I realized I have no head for business. And it would have been very easy for me to let someone take control of my money – for me to say, ‘Here, sign my checks…whatever.’ But… as much as it makes me super sleepy, I have to pay a lot of attention when my business manager talks to me about money. He talks to me about taxes, and I get really, really sleepy. But I listen.” Most people get bored quickly learning about business topics. I’ve thought a lot about how to fix this problem, but I really don’t have a great solution. Warren Buffett tries to make business entertaining in his own way and that helps. But the unfortunate fact is: few people are willing to do the necessary work to learn business concepts. I fear the situation will get worse with time and not better. Once upon a time people learned about business when they joined a big company and went through what was effectively an apprenticeship. Today companies are smaller and fewer people receive that training. I wrote about many of the basic business principles that apply to the entertainment business in my blog post on Louis CK. I supplement what I said in that post in my usual format below.
  1. “At the end of the day, there’s only a few major stars in the music business, and then there’s all these people that are aspiring to be that.” John Legend.  One of my favorite articles on the music business was written by Duncan Watts and is entitled: “Is Justin Timberlake a Product of Cumulative Advantage?” This article by Watts (the link is in the notes) makes important points that must be understood if you want to understand modern economics generally. The key insight is simple: People don’t make decisions independently. Something called “preferential attachment” happens in some situations and this phenomenon produces the “power law distributions that rule everything around the music industry.” This power law phenomenon is not new but as Nassim Taleb points out, it has received an accelerating boost from digitization and the internet. A writer of a story about Nassim Taleb put it this way: “We live in Extremistan, where black swans proliferate, winners tend to take all and the rest get nothing –there’s Domingo and a thousand opera singers working in Starbucks.” In an article entitled The Music Industry’s New Math New York Magazine  points out: “Since 2008, there have been 66 No. 1 songs, and six artists are behind almost half of them. (In 1986, there were 31 No. 1 songs by 29 different people).”

    The distribution of financial success in the music looks like this:

Long tail

As an example of a power law distribution in the music business: The share of concert revenue taken home by the top 1% of performers has more than doubled, rising from 26 percent in 1982 to 56 percent in 2003.


As another example, the top 5 percent of musicians take home almost 90 percent of all concert revenues.


  1. “The TV business is uglier than most things. It is normally perceived as some sort of cruel and shallow money trench through the heart of the journalism industry, a long plastic hallway where thieves and pimps run free and good men die like dogs, for no good reason.” Hunter Thompson. You will see versions of this quotation by Hunter Thompson that substitute the word “music” for “TV.”  the reality is that Thompson wasn’t writing about the music business although he could have been since they share attributes. You may also sometimes see the following tag line attached to this quote: “There’s also a negative side.” While it is a clever addition, it is fake. Sorry. But that does not mean that the quote is not directionally correct. And it does make for a good quote (I love a good quote as you probably know). Anyway, “payola” in all its forms has always been a part of the music business. The word is combination of “pay” and “Victrola” (i.e. record player). At first, payola was mostly  about cash, which lead to a major scandal in the 50s that lead to a law prohibiting payments for airplay in certain situations where there wasn’t full disclosure. Payola is messy, cruel and shallow money trench, which is a shame since it can block the rise of talented people.
  1. “[Any money I make] goes straight into my bank account, where it turns all moldy and smelly.” “I didn’t go and buy a Lamborghini because I had a million dollars.” “I drive a family car—not a monster SUV but a family car that fits five people. I’ve got a house that is just big enough, too.” Dave Grohl.  This musician’s statement reminds me of something Warren Buffett once said: “There’s nothing material I want very much.” Wanting too much can make you  really miserable.  This point was made well in a line of dialogue of a fictional character in Charles Dickens’s 1850 novel, David Copperfield: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.” While there is no formula to get rich, staying rich is a bit easier if you can get control of your emotions.
  1. “I just don’t agree with perpetuating the perception that music has no value and should be free.” Taylor Swift.  Music is a public good, which can be a danger zone for profitability. What is a public good? Well, public goods are both non-rival and non-excludable. If I make a digital copy of your digital music, you still have your music (the music is non-rival). If I steal your phone you will no longer have a phone (a phone is rival). Music becomes “excludable” if you move the musician’s performance into a theater, since you can exclude people from hearing the performance who do not pay. Lots of important industries like journalism have this public good problem. It is not a new problem and applies to things like lighthouses and national defense.


Excludable Non-excludable
Rivalrous Private goods
food, clothing, cars, parking spaces
Common-pool resources
fish stocks, timber, coal
Non-rivalrous Club goods
cinemas, private parks, satellite television
Public goods
free-to-air television, air, national defense

The music business has responded to this public problem by shifting to complementary products that are excludable like concerts and merchandise sales. This works for musicians but is not enough to save the newspaper business since people will attend only so many conferences.



This public goods problem combined with other points that I have described above above place real and uncomfortable pressure on some people who trying to earn a living from music and similar professions. Neil Howe writes:



“Data from the Bureau of Labor Statistics on specific professions point to a similar conclusion. While the incomes of the creative class have generally kept pace with inflation, their ranks have shrunk—in some cases, drastically. From 1999 to 2015, the number of musicians and singers slipped 20%; photographers, 24%; news analysts, reporters and correspondents, 29%; dancers and choreographers, 42%. (Though these numbers don’t include the self-employed, freelancers tend to earn less than their counterparts with conventional jobs.)”



  1. “When the Rolling Stones started out they didn’t make any money out of records because record companies didn’t pay you. Nobody got paid. I always wonder if Frank Sinatra got paid. Your royalty was so low. If you sold a million records you got a million pennies. It was all very nice, but not what you imagined you were going to get.” “There was a small period from 1970 to 1997, where people did get paid, and they got paid very handsomely and everyone made money. But now that period has gone. So if you look at the history of recorded music from 1900 to now, there was a 25 year period where artists did very well, but the rest of the time they didn’t.”  Mick Jagger. That the economics of the music business are worse than they have been at some times in the past in not controversial. This unfortunate reality means that people need to be more creative in finding solutions. My blog post on Rza of Wu-Tang clan is about a musician who figured out how to change the rules so his share of the business is better. Just selling digital music is no longer enough.



  1. “People who cost too much: manager, lawyer, publicist, label, music publisher.” Roger McNamee. Every business has a “value chain.” Some portions of that value chain is not necessary and yet they may take a big a slice of the profits. What is going on in the value chain today is a battle over “wholesale transfer pricing” between the layers. Set out below is one depiction of some of the different types of people who are trying to get a slice of the profit from the music industry.


value chain

  1. “I’m not a businessman, I’m a business, man.” Jay-Z.  In the modern world of the music business much of the profit must come from complementary goods. That means concerts and merchandise and other services. The entertainer is a business. If they are not thinking  about different kinds of revenues related to the business they may not make enough money to stay in the business. One interesting thing Hip-Hop did was make it OK for a musician to sponsor goods again without being a sellout. That helps musicians work around the “public good” problem. This writer raises the idea of complementary goods as a partial solution:

“One interesting thing about this market is there are two major sets of players: Those who make their money solely from these music services and those who make the vast majority of their money elsewhere. Spotify and Pandora can’t afford to keep losing money in this business because it’s the only business they have. Amazon, Apple, Google and others, however, can afford to subsidize these offerings or run them at low margins because they feed the other parts of their businesses and generate additional revenue indirectly. Apple may be in the strongest position of all here, because it has a user base willing to pay for content and it can afford to run the music business at a relatively low margin, while Amazon’s customer base is highly driven by saving money, and Google’s true customer base is its advertisers, not its users. Much has been made of Spotify’s lead over Apple in on-demand streaming, but Apple offers the flavor of streaming the labels like and has already signed up half as many paid subs as Spotify.”

  1. “Grateful Dead Fans are like people who like licorice. Not everyone likes licorice, but the people who like licorice REALLY like licorice.” Jerry Garcia. I was never a Dead Head. But I know people who are. And I know people who love to hate Dead Heads. Frankly people who spend their lives talking about what “real music is” bores me. But I like a lot of things other people find boring so I should not complain. In any event, music is not an exception to the rule that there can be significant be benefits when a business differentiates. Being unique can create a moat. Professor Michael Porter writes: “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.”  If you deliver the same product or service as your competitor you by definition don’t have a moat.  Competition will be based on price and price-based competition inevitably degrades to a point where profit disappears. Porter teaches: “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”  He adds: “Producing]the highest-quality products at the lowest cost or consolidating their industry is trying to improve on best practices. That’s not a strategy.”
  1. “I don’t waste my time thinking about how I could make more when I already got enough. I’m not a banker, I’m a musician.” “[Money] buys me freedom. It allows me to do what I want to do and not have to worry about anything at all.” Dave Grohl.  This famous musician seems to have a very firm grasp on the “circle of competence” idea. Grohl seems to recognize that risk comes from not knowing what you are doing. If you do not understand much about investing and finance, it is very wise to keep your approaches simple. Know your limitations. Be smart, by not being stupid.
  1. “To me, music was an escape from working in a furniture warehouse.” “I was a manual-labor worker, doing masonry and working at a furniture warehouse. I worked at a nursery breaking fucking rocks. There were not a lot of career opportunities for me. At one point, I thought, ‘I know how to play drums. I’ll learn to read music, become a session drummer and from that money, I’ll put myself back through school.” “I wanted to have a kickass job downtown, in Washington, D.C. But that wasn’t going to happen. In Washington, D.C., you’re either in the Army or the government. I was too skinny to be in the Army and too stupid to be in the government – or too smart.” Dave Grohl.  Many musicians are one hit wonders who therefore have short careers. They may need to live for a lifetime mostly based on the income from that one hit. Sports stars are similar. Yes, they can get another job after the music career ends but it may not pay nearly what they generated from a brief period of time creating music.  Since income can be very lumpy it pays to save. Grohl is far from a one  hit wonder, but he is financially careful nevertheless.
  1. “The reward of playing music should be playing music.” Dave Grohl. Enjoy what you do and you will not only be happier, but will be much more likely to be successful since you can adopt the attitude of a missionary not a mercenary. Missionaries survive through the tough times, which is usually what success in the music business requires. Many people work for many years in order to become an overnight sensation. It is important to note that what you love will likely change substantially over your lifetime. This is natural.  Tastes and desires evolve over the years, which is a good thing, since otherwise life can get boring.


Duncan Watts: http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html

Generation of Swine: https://books.google.com/books?id=hysRM1imbJ0C&lpg=PA43&pg=PA43#v=onepage&q&f=false

BBC: http://www.bbc.com/news/10581280

The Music Business:  https://www.budivoogt.com/understanding-music-industry-record-labels-ars-distribution-pluggers-pr/

Quartz:   http://qz.com/383109/the-music-industry-has-hit-its-rock-bottom/

Nesta: http://www.nesta.org.uk/blog/artistic-inequality-industry-or-human-nature

Recode: http://www.recode.net/2016/8/26/12645066/music-streaming-services-pandora-spotify-amazon-pandora

Rza: https://25iq.com/2016/01/02/a-dozen-things-i-have-learned-about-business-from-rza-the-founder-of-wu-tang-clan/

John Bersin:  http://www.forbes.com/sites/joshbersin/2014/02/19/the-myth-of-the-bell-curve-look-for-the-hyper-performers/#7ae8019d13fc

Neil Howe: http://www.forbes.com/sites/neilhowe/2016/08/31/the-new-rules-of-the-creative-economy/#695d7cc259f0

Pollstar:  http://www.pollstarpro.com/files/charts2015/2015YearEndBusinessAnalysis.pdf

New Math: http://nymag.com/arts/popmusic/features/grizzly-bear-2012-10/

A Dozen Things I’ve Learned from Michael Dell about Business (Pre-2002 edition)

If you have been reading this blog for a while you have probably figured out by now that my posts are a scheme on my part to write about topics that interest me in a way that is more interesting for readers. This blog post about Dell founder Michael Dell is no different. I try to work within a 4,000 word count on each blog post. For this post both for brevity and due to the nature of what I do for a living, I’m going to limit the discussion mostly to pre-2002 events.

As is usual, the Michael Dell quotes are in bold text:

1. “I believe that you have to understand the economics of a business before you have a strategy, and you have to understand your strategy before you have a structure. If you get these in the wrong order, you will probably fail.” Dell’s statement about economics is a reference to microeconomics and not macroeconomics. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Understanding microeconomics is essential if you want to be successful in business since as Munger went on to say business is essentially microeconomics. In his “Five Minute University” bit on Saturday Night Live, Father Guido Sarducci explained business simply: “You buy something and you sell it for more.” It is really quite simple. The math that determines whether you can “sell it for more” is called “unit economics.” How much can you profit from the sale of each unit of what your business produces?

Dell said in the quote above that once you have an understanding of the economics you need a strategy. What is a strategy? My most complete post on strategy is about Michael Porter, who has said: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. The essence of strategy is choosing what not to do. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.” After you have a strategy then you can create a structure says Dell. The original structure at Dell was three people assembling PCs working at a six foot table and two more people answering the phone with Dell performing the rest of the necessary functions at the company. The structure of Dell’s business has evolved many times, but always in relation to the underlying economics and the strategy of the business.

2. “When I was 19, I saw what I thought was a huge opportunity to change the way personal computers were made and sold. In high school I purchased and took apart one of the very first IBM PCs. I made two interesting discoveries: 1) none of the parts were made by IBM 2) the system that retailed for $3,000 actually cost IBM about $600. I immediately saw this as an opportunity. I started upgrading my own systems, using the same components as IBM, and selling them. The idea grew from there.” What a 19 year old Michael Dell saw in the PC business was “unit economics” that were quite favorable. Dell saw the opportunity to take $600 in components and transform that into a product that people would pay $3,000 for. Even better, none of the parts were made by IBM so there was no real barrier to entry and as a result IBM did not have wholesale transfer pricing power over his business. Dell was able to find favorable unit economics because Bill Gates also had a favorable strategy with respect to IBM. The most important business decision that took place in the earliest days of Microsoft was Gates’ decision to license Microsoft Basic to MITs (the manufacturer of very first PC known as the Altair) on a non-exclusive basis. This decision by Gates was enabled by the fact that multiple people and businesses can possess the same software at the same time at essentially no incremental cost (software is non-rival). Gates understood the difference between a license and an outright sale which was an essential enabler for both Microsoft and companies like Dell. Gates explained the history of one of the most important deals in business in this way: “The contract with IBM called for us to do all this work on the design of the machine and all this software. We didn’t get paid that much–the total was something like $186,000–but we knew there were going to be clones of the IBM PC. We structured that original contract to allow them. It was a key point in our negotiations.” Paul Allen elaborated: “We already had seen the clone phenomenon in the MITS Altair days. Other companies made machines that succeeded because they were similar to the Altair. For us it had been easy to modify our software so it worked on those machines too.” Not only was Dell able to surf on the phenomenon created by Gates and Allen, he was also able to create his own moat by making some key decisions as will be explained below.

3. “We started the company by building to the customer’s order. And interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” “While that was a great way to start the business, it turned out there was a lot more we could do with it, in terms of building relationships with suppliers, reducing inventories and receiving direct input from customers.”’ Most important, the direct model has allowed us to leverage our relationships with both suppliers and customers to such an extent that I believe it’s fair to think of our companies as being virtually integrated. That allows us to focus on where we add value and to build a much larger firm much more quickly. I don’t think we could have created a $12 billion business in 13 years if we had tried to be vertically integrated.” Dell started his business at a very auspicious time. Powerful forces were transforming the economy and that created massive opportunity for many business. In his 1999 essay Michael Mauboussin pointed out “source of value creation is shifting from physical capital to intellectual capital— from atoms to bits.” Better information technology systems (i.e., bits) allowed Dell to create a vertically integrated solutions with only a fraction of the capital that would have been needed in the traditional business world. Professor Gerald Davis describes this phenomenon:

“In 1950 it might have made economic sense to assemble cars in giant vertically integrated factories in Detroit and ship them from there to the rest of the world. Today, the parts of a business are like interlocking plastic bricks that can be snapped together temporarily and snapped apart when they are no longer needed. Information and communication technologies (ICTs) make starting an enterprise trivially easy, from creating a legal structure to hiring temporary employees to contracting out for production and distribution. Coordinating activities used to be the corporation’s strong suit. Now the corporation is increasingly out-maneuvered by alternative forms of enterprise that are more flexible and less costly. The barriers to entry are falling across a wide swathe of industries. In his famous 1937 article “The Nature of the Firm,” Nobel Prizewinning economist Ronald Coase explained, “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price system. The most obvious cost of ‘organising’ production through the price mechanism is that of discovering what the relevant prices are.” But what if discovering the relevant prices becomes trivial? What if the inputs of a firm, including labor, can be priced and ordered as they are needed? What if, in place of long-term employees, firms were able to contract for workers if and when they were needed for specific tasks—the way that customers can use the Uber app to order a ride?”

4. “Inventory velocity is one of a handful of key performance measures we watch very closely. It focuses us on working with our suppliers to keep reducing inventory and increasing speed.” “We tell our suppliers exactly what our daily production requirements are. So it’s not, “Well, every two weeks deliver 5,000 to this warehouse, and we’ll put them on the shelf, and then we’ll take them off the shelf.” It’s, ‘Tomorrow morning we need 8,562, and deliver them to door number seven by 7 a.m.’” “Because we build to our customers’ order, typically, with just five or six days of lead time, suppliers don’t have to worry about sell-through. We only maintain a few days—in some cases a few hours—of raw materials on hand. We communicate inventory levels and replenishment needs regularly—with some vendors, hourly.” Dell did not have much capital when he started so he turned a weakness into a strength. Bill Gurley and Jane Hodges described the Dell strategy in a classic article from 1998:

“From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive. To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let’s divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital…. companies that lack competitive information technology will be in serious trouble. They will resemble a 40-year-old trying to win Wimbledon with a small wooden racquet. Their business models may no longer be economically sustainable. Companies like Dell have reached an interesting new stage in the evolution of business–negative working capital. They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.”

Gurley elaborated on Dell’s advantage in another article: “Dell’s incredible five days of inventory allows it to pass on component price declines faster than anyone else in the industry. But perhaps the unique aspect of Dell’s business advantage is its negative cash conversion cycle. Because it keeps only five days of inventories, manages receivables to 30 days, and pushes payables out to 59 days, the Dell model will generate cash–even if the company were to report no profit whatsoever.” Michael Mauboussin describes the results in his essay Atoms, Bits and Cash in November of 1999.


5. “We’re free cash flow people.” Dell shares this attribute with many great operators like Costco’s Jim Sinegal. One of my post popular blog posts was on Jeff Bezos. One focus of that post is on his views on the right financial drivers of his business. Bezos is quite clear about what he seeks:

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

Justin Fox explains:

With free cash flow what counts is when the money actually changes hands. So if you have a business where your customers pay you quickly, you manage your inventory well, and you’re able to take your time in paying your suppliers, your free cash flow can be consistently positive even when your net income is not. Which is exactly the kind of business that Jeff Bezos and his colleagues have constructed at Amazon over the past decade. According to my instructor in such matters, Harvard Business School finance professor Mihir Desai, the key metric of a company’s cash-generating prowess is the cash conversion cycle, which is days of inventory plus days sales outstanding (how long it takes your customers to pay you, basically), minus how many days it takes you to pay your suppliers. Super-efficient retailers such as Walmart and Costco have been able to bring their CCC down to the single digits. That’s impressive. But at Amazon last year, the CCC was negative 30.6 days.

6. “The computer industry when [we] entered it had gross margins of 40 percent plus. On top of that, you had dealers with margins of 20 to 30 percent. So the end user was paying a pretty incredible premium over the cost of goods for the product.” “The basic idea was to eliminate the middleman.” “Every breakthrough business idea begins with solving a common problem. The bigger the problem, the bigger the opportunity.” Jeff Bezos famously said that the profit margins of his competitors are Amazon’s opportunity and Dell was an early believer in that approach to business. The longer I am involved the business the more I appreciate the value of being in a business with high gross margins. Life is just better when gross margins are high since you have headroom for sales and marketing as well as profit. By contrast, businesses with low gross margins tend to be soul crushing slogs where every penny spent is another way to go out business. Of course, high gross margins alone are not enough to make a business attractive. You also need a large market. And a moat. At one point I changed the focus of my career from the communications business to the software business and I must admit that a major motivation for the shift was the high gross margins available in software. There were other reason that attracted me like better scalability, but high gross margins are a wonderful thing to have in a business. As Warren Buffett has said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

7. “If we can buy something that’s very similar to something we can create ourselves, we believe it might not be valuable for us to create it. On the other hand, if we’re thinking about creating something that nobody else has, that’s worth doing.” “Dell Computer came along and said, “Now wait a second. If I understand this correctly, the companies that do nothing but put chips on motherboards don’t actually earn tremendous profit doing it. If we want to earn higher returns, shouldn’t we be more selective and put our capital into activities where we can add value for our customers, not just into activities that need to get done?” I’m not saying those activities are unimportant. They need to get done very, very well. But they’re not sources of value that Dell is going to create. When the company started, I don’t think we knew how far the direct model could take us. It has provided a consistent underlying strategy for Dell despite a lot of change in our industry. Along the way, we have learned a lot, and the model has evolved.” Dell is talking about a point made by Andy Grove, who said once: “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and focus resources on it with passion. Businesses that try to do everything, often end up doing close to nothing.

8. “The consumer has better information, you have transparency of pricing. You can’t trick the consumer anymore. The businesses that had an advantage because they sold things in a geographic area where people had limited information, and they couldn’t travel to go buy something else. Those folks are in real trouble. The Net kind of destroys that business model.” “At the root of any economic system is the cost of transactions. You have something you want to sell, I want to buy it, and what that transaction ultimately costs is tied to the cost of communicating information. The Internet is the latest evolution of communication technology-tremendously powerful because it enhances the flow of information. So basically it’s like a big vacuum that sucks friction out of the economy.” Simply increasing product advertising is often not a solution to increasing sales due to higher levels of transparency enabled by Internet. When customers are as well informed as they are today the best way to acquire customers cost effectively is almost always with an organic customer acquisition strategy, meaning they are attracted to the service because it is a great service. Businesses that must sell their products with huge advertising budgets are losing their edge in the Internet era. Jeff Bezos of Amazon puts it this way: “In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts. Your brand is formed primarily, not by what your company says about itself, but what the company does.”

9. “Ideas are commodity. Execution of them is not.” “Coming up with the ideas is not the hard part for us. We got more ideas than we know what to do with. The hard part for us is prioritizing the best ones, picking them, and fielding teams to go after them all. We’ve gotta be careful. Because if we go after too many of them, well then we’ll fail to execute, because we won’t have the people, the resources. It’s sort of one foot in front of the other.” “People look at Dell and they see the customer-facing aspects of the direct-business model, the one-to-one relation-ships. What is not really understood is that behind these relationships lies the entire value chain: invention, development, design, manufacturing, logistics, service, delivery, sales. The value created for our customers is a function of integrating all those things.” “If you want to sustain excellence over a long time, you’d better come up with a system that works well. Anyone can sprint for a little while, but you can’t sprint for forty years.” In my blog post on John Doerr I quoted John Doerr as saying “We believe that ideas are easy, execution is everything.” A good idea or invention is necessary, but it is far from sufficient to achieve success in business. It takes an entrepreneur to take an idea or innovation and turn into genuinely scalable business. That means a “roll up your sleeves” and a “make the trains run on time” effort from a team of people. Bill Gates said once: “Being a visionary is trivial. Being a CEO is hard. All you have to do to be a visionary is to give the old ‘MIPS to the moon’ speech — everything will be everywhere, everything will be converged. Everybody knows that. Which is different from being the CEO of a company and seeing where the profits are.” The great CEOs I have seen over the years like John Stanton and Jim Barksdale are masters of execution.

10. “The inspiration initially was my own curiosity about technology and what it could do for people. But I had a sense of urgency about it in 1984. Like all windows of opportunity, they eventually close.” “You have to focus on the point of impact where you can really make a difference in something in a meaningful way. That’s going to evolve. Where you might have had an impact on something three years ago. If you did that same thing now, you wouldn’t have enough of an impact to matter.” Sometimes an opportunity comes along and it has a time stamp. You either grab that opportunity right then and bet big or it is gone. As an example, Bill Gates famously dropped out of Harvard to move to Albuquerque, joining Paul Allen in writing software for the Micro Instrumentation and Telemetry Systems Altair computer they first saw in a Popular Electronics magazine at a newsstand in Harvard Square. The price of the MITS computer in 1975 was $397. It was primitive and lacked easy-to-use software, but even then they could see the potential for this device since they experienced how valuable having access to a computer could be. Despite being their youth, especially in the context of how business was conducted at that time, Gates and Allen realized that if their business was not formed immediately they would miss the opportunity. Gates recalls: “When we saw [the Altair], panic set in. ‘Oh no! It’s happening without us! People are going to write real software for this chip!’” Dell saw his own opportunity and grabbed it. Charlie Munger’s advice is that a person needs a combination of patience and yet aggressiveness when the opportunity is right.

11. “Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk. In our case—with 70% of our sales going to large corporate customers—accounts receivable isn’t hard to manage because companies like Goldman Sachs and Microsoft and Oracle tend to be able to pay their bills. But in the computer industry, inventory can actually be a pretty massive risk because if the cost of materials goes down 50% a year and you have two or three months of inventory versus 11 days, you’ve got a big cost disadvantage. And you’re vulnerable to product transitions, when you can get stuck with obsolete inventory.” “Consider what to do with the investment that could be freed up by shedding inventory and other assets now on the balance sheet.” “One of the big changes that is brought about by information technology is that the cost of those connections and those linkages has gone down dramatically. So if you’ve got an operation that builds a component, the cost to communicate worth that operation in an information sense, if it is done electronically goes to zero. That means you can build a linkage between that components supplier and a manufacturer and make it very, very efficient. That enables you to scale more quickly, gives you more flexibility, you can manage supplier networks in a more dynamic fashion, and get things off your balance sheet that aren’t your specialty, and companies can really hone in on something that they’re really great at.” The many ways in which Dell grew by having great financial strategies and tactics is underappreciated. Dell had a succession of great CFOs over the years and it shows. Combine a great CFO and a great information technology infrastructure and that is rocket fuel for success. CFOs take a lot of criticism from engineers since they often put limits on spending. Which reminds me of a story. A CEO I knew took the company’s leadership team on a retreat to a resort that had a large swimming pool filled with hungry alligators. One night the CEO said to the executives: “A person should be measured by courage. Courage is what made me CEO. This is my challenge to each of you: if anyone has enough courage to dive into the pool, swim through those alligators, and make it to the other side, you will be my successor.” While everyone was laughing at the CEO’s crazy offer, they suddenly heard a loud splash. When they turned to look at the source of the splash they saw the CFO of the company in the pool, swimming for his life. Amazingly he swam so fast that he avoided the alligators and was able to make an exit using a ladder at the other side the pool with only a fraction of a second to spare. The shocked CEO approached the CFO and said, “You are amazing. I’ve never seen such courage in my life. You are clearly the right person to be my successor. Tell me what I can do for you.” The CFO, panting for breath, looked up and said, “Well, first of all, you can tell me who the hell pushed me into the pool!”

12. “Try never to be the smartest person in the room. And if you are, I suggest you invite smarter people… or find a different room.” Dell has always had a range of talented people working with him. One example is Thomas J. Meredith, who was at one time Dell’s chief financial officer. There are many other people who have contributed to the success of Dell over the years, many of which are mentioned in this article: entitled: Inside Dell Computer Corporation: Managing Working Capital http://www.strategy-business.com/article/9571?gko=d8c29  As Charlie Munger has said: “Acknowledging what you don’t know is the dawning of wisdom. I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”


Dell on Going Private: http://www.cnbc.com/2014/09/23/after-going-private-dell-isnt-looking-back.html

HBR Interview: https://hbr.org/1998/03/the-power-of-virtual-integration-an-interview-with-dell-computers-michael-dell

Justin Fox: https://hbr.org/2014/10/at-amazon-its-all-about-cash-flow/

Gurley and Hodges Fortune Article: http://archive.fortune.com/magazines/fortune/fortune_archive/1998/10/12/249302/index.htm

WSJ on the Dell Model: http://www.wsj.com/articles/SB944003985432882680

Technology Review Article on Dell: https://www.technologyreview.com/s/401105/direct-from-dell/

Mauboussin on CAP: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/cap.pdf

Mauboussin on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf

Mauboussin on Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

Professor Davis: http://vanishingcorporation.com/wp-content/uploads/sites/62/2016/02/Davis-Booksite-Excerpt.pdf

Mauboussin: Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

A Dozen Things I’ve Learned from Naval Ravikant about Investing, Business and Startups

“[Naval Ravikant] is an entrepreneur and angel investor, a co-author of Venture Hacks, and a co-maintainer of AngelList. Previously he]was a co-founder at Genoa Corp (acquired by Finisar), Epinions.com (IPO via Shopping.com), and Vast.com (white-label classifieds marketplace).”

1. “The cost of starting a company has collapsed.” “As the cost of running a startup experiment is coming down, more experiments are being run.” “Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.” A capitalist economy is an evolutionary system. Innovation and best practices are discovered by the experimentation of entrepreneurs who try to establish the evolutionary fitness of their business. Products and services created as part of this experimentation which have greater fitness survive and other less fit products and services die. Entrepreneurs are essentially running experiments in this evolutionary system when they create or alter a business.  Entrepreneurs are engaged in “deductive tinkering” as they search for better products and services. Eric Ries describes the process in this way: “Learning how to build a sustainable business is the outcome of experiments [which follow] a three step process. Build, measure, learn.”

Why is experimentation so important in an economy? The answer is that experimentation is the best way to deal with one of nature’s solutions to dealing with risk, uncertainty and ignorance: a complex adaptive system. An economy is a complex system in that it is networked and therefore adaptive in ways that a simple formalism, such as used in physics, will fail to predict. Michael Mauboussin explains:

“A complex adaptive system has three characteristics. The first is that the system consists of a number of heterogeneous agents, and each of those agents makes decisions about how to behave. The most important dimension here is that those decisions will evolve over time. The second characteristic is that the agents interact with one another. That interaction leads to the third—something that scientists call emergence: In a very real way, the whole becomes greater than the sum of the parts. The key issue is that you can’t really understand the whole system by simply looking at its individual parts.”

In the case of complex adaptive systems like an economy or a business, the correct approach is to discover solutions via trial and error rather than try to predict. Nassim Taleb describes why the experimentation approach works well: “it is in complex systems, ones in which we have little visibility of the chains of cause-consequences, that tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform the teleological—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative…. Critically [what is desired is to] have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.” What Taleb is talking about is “convexity” which is something I have written a lot about recently. As an example of convex financial proposition, all a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment. People will inevitably say when the topic of complex adaptive systems comes up that nothing has emerged from research in this area that allows you to predict the future, which ignores the point that knowing what you can’t predict is one of the most valuable things you can know. Discovery which happens via experimentation via trial and error is a vastly superior way to deal with unpredictability than trying to predict what can’t be predicted.

It is important to note that Ravikant in the quotes above is talking about a specific type of business experiment. One way to look at the impact of business startups is to group them into two categories:

  1. Some startups are an attempt to create entirely new categories of businesses at global scale (e.g., Uber, Salesforce.com or Airbnb).
  1. Some startups are about incremental or local innovation, such as a new frozen yogurt shop or sushi restaurant.

The number of businesses trying to create value in category 1 through business experiments has substantially increased. Comparing a category 1 startup (e.g., a business that will try to achieve a level of success similar to Uber or Airbnb) to a category 2 startup (e.g., new frozen yogurt store on main street) is apples and oranges. As an aside, I believe anyone doing something like opening up a new restaurant or main street retailer deserves a medal for bravery. The competition they face on a daily basis is brutal. These category 2 entrepreneurs are vitally important parts of the what makes capitalism work..

It is also important to understand how much bigger category 2 is than category 1. The number of startups that obtain venture finance for the first time in a given year is relatively small. There are ~ 700-800 firms per quarter in the US which raise venture capital for the first time.  This data is from PitchBook:


In addition to firms that actually obtain professional venture capital funding there are also a much larger number of startups that are able to conduct experiments based on the personal capital of founders even before seed. I’m not aware of anyone who has compiled a reliable estimate of how many category 1 startup experiments fail to raise seed capital or bootstrap the business to success, but it is a significant number.  The same problem exists for anyone trying to estimate how many startups raise some “friends and family” money. This activity is just to diffuse and distributed to be accurately estimated. Nevertheless, the lower cost of conducting a startup experiments has increased the number of experiments and the level of innovation is higher as a result.

Comparing category 1 to category 2 shows how much bigger the latter category actually is in terms of absolute numbers:

“Firms are individual businesses, while establishments include multiple outlets for existing firms. The Brookings report specifically discussed entrepreneurship, which is why it used the numbers for firms. “The distinction between a new Chase Bank branch opening in your neighborhood versus a brand new community bank is critical — particularly when studying entrepreneurship”…. The  most recent data from Census, released in September 2014, that showed firm deaths in 2012 (424,864) still outnumbered births (410,001). That’s a difference of 14,863, and the figures showed that the gap had been narrowing each year since deaths first outnumbered births by 90,670 in 2009. But, it turns out, Census had released new numbers for 2013 in September of this year. And in doing so, it revised its figures for past years. The latest statistics now show that in 2012, firm births (411,252) were higher than firm deaths (375,192) by 36,060. And the same held true for 2013, when births outnumbered deaths by 5,666. We can expect that figure to be revised, too, when Census releases new figures in the future. …the latest numbers show that more firms are opening than closing.

Firm births


My trip to Omaha for the Berkshire shareholder meeting this year was interesting for many reasons but one fact that struck me was how many business, especially in West Omaha, are franchises.

A paper prepared for the Federal Reserve Bank of Cleveland, in August 2014 said there had been a shift away from brand-new businesses toward new outlets of existing businesses, a trend that many Americans may have seen in their own communities. “The Shifting Source of New Business Establishments and New Jobs,” Aug. 21, 2014: We find that while new firms have been forming at a slower pace over the past 33 years and creating fewer jobs, there has been a simultaneous rise in the number of new establishments opened by existing businesses (which we will call new outlets). … Markets that used to be served by independent entrepreneurs creating businesses are now increasingly being served by the expansion of existing businesses.

There are a lot more business in 2 category in absolute numbers but it is category 1 that generates the most fundamental innovation. Do I wish there was more business entry in category 2 and that they were more successful more often?  Definitely. Lots of jobs are created and taxes paid by businesses in category 2.

The additional point that must be considered is that innovation in category 1 can cause both more business failure and more new business starts in category 2. The outcome of this process varies since any given innovation can increase profit or not. Whether profit is generated by any given innovation is determined by the presence of a moat. Am I saying that some innovation at an aggregate level produces no profit or even less overall profit? Yes. Charlie Munger explains the phenomenon best:

“When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead—you’re destroyed. It happens again and again and again. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”

2. “Success rates are definitely coming down but that is because the cost of running a startup experiment is coming down…so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1-2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost a half of what they used to, you are actually saving money, it is a more efficient market.More experiments inevitably means more failures on an absolute basis. In addition, as the rate of business experimentation rises there will inevitably be an increase in the number of poseurs trying to create new businesses and that will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive tradeoff overall since society benefits from the increased level of innovation. This net benefit for society is created even though most experiments fail and some experiments are being conducted on the margin by poseurs who have little or no idea what they are doing. Success is found by any given business via negativa. For this reason, some failure is essential to the capitalist process since it is what fuels success. What the collapse of the cost of running business experiments has done is radically increased the pace of the discovery process that creates innovation. Because the creative destruction process is now operating as if it has taken steroids, the rate at which profit is turned into consumer surplus has never been greater, especially in the technology sector.

A real economy is messy and there is lots of failure. Failure is in fact an essential part of the process of creating innovation and a healthy economy. A fantasy economy in which fully informed and perfectly rational agents interact with perfect efficiency is believed to reflect reality only by a few people suffering from extreme forms of psychological denial. A child of ten knows humans are not perfectly informed and rational.  Failure is literally everywhere and is essential to making capitalism work given the economy is a nest of complex adaptive systems.

Despite the fact that experimentation is beneficial, it is interesting to think about whether there can be too much failure. Does the existence of too many startups in a given area like a city lower the overall benefit by diluting the talent available for startups of higher quality? I have argued previously that there is a Goldilocks “just right” level of startups that is unique for each city. That city A has a huge number of startups should not be the test of success but rather: what is the outcome of that activity? As many startups as are created in the Bay Area of California may not be optimal for a city like Seattle or New York. How big is the city? How much supporting infrastructure exists? What alternative employment opportunities exist? Does the city’s culture reward or punish failure? Is the culture in that city most supportive of missionaries or mercenaries? Does the city have a major research university?

At some level, the ability of an economy to grow is a brake on the overall level of success that can be created in a given time frame like a year or decade. To illustrate, Warren Buffett made a comment once that could be applied to unicorns waiting to go public as a group:

“Think about a [bunch of unicorns with a combined private valuation of] $500 billion. To justify paying this price, [they] would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the [businesses don’t] begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years, $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that [valuation].”

Regarding the amount that has been invested in breakthrough innovation, Mattermark calculates: “we found that 75% of the approximately $108 billion that investors deployed into these [software] companies is still locked up in private coffers.”


I am conformable in predicting that I do not know who the outcome will be. Lots of unicorns may go public in the next year or two with an IPO, but perhaps in many cases only with a down round. That company A can’t go public at a valuation greater than $1 billion does not mean that it can’t go public at some price. Or maybe large numbers of unicorns will go public at flat or even higher levels. Of course some unicorns may be bought by large already profitable firms for defensive reasons, which allows financial exits by startups to exceed aggregate GDP growth by some amount. We will see what happens soon enough. That’s part of the uncertainty and fun of this process.

3. “The funding market is so bifurcated because outcomes are so bifurcated.” “Startup outcomes fall on a power law distribution. So startup financings look the same way. You’re un-fundable until you’re oversubscribed.” The financial returns from a tiny number of startups have always driven venture capital returns due the inherent convexity of technological innovation. This distribution of financial returns inevitably takes the form of a power law for the best venture capital firms. As just one example to illustrate, the ten biggest exits from 2014 look like this:


2005 looks like this:


Ravikant explains: “The nature of the markets have in many cases become more consumerized. People have caught on to how network effects work.” Network effects are increasingly driving financial success which phenomenon causes investors to put more investment into a smaller number of startups and firms that are deemed to have momentum. As a result, some firms can easily raise billions of dollars if investors see potential network effects, while other firms can’t raise even small amounts of capital.

I recently had a discussion on Twitter with Dave McClure (who I respect a lot) about the power laws in venture capital and my view is that a firm like 500 Startups that makes over 150-200 investments a year has a fundamentally different portfolio that a venture capital firm in the top decile of historical performance that makes < 10 investments a year. One recent survey survey reported that the average venture capital firm looks at 400 business a year and invests in only 5 businesses on average during that year. That data would means that these venture capitalists are investing in about 1% of the businesses they consider. McClure says that his financial return data does not look like a power law, but my view is that this does not mean other venture capital firms that embrace more convexity and make fewer investments do not have a return distribution that looks like a power law. All the data I have seen over the years indicates that top venture capital firms have a return distribution that reflect a power law. My thesis is that these views can be reconciled by looking at the composition of the two different portfolios. When financial exits reflect a power law and the head of the distribution is only a handful of companies, investing at a very high rate in any given year inevitably means you are in the tail for more investments.


My thesis is that the 500 Startups portfolio is fundamentally different than the portfolio of a firm that Peter Thiel talks about below. This is from a blog post by Jerry Neumann linked to in the notes below:

“At a given alpha, the more investments you make, the better, because your mean return multiple increases with the number of investments, as does the likeliest highest multiple. Dave McClure makes this case:

‘Most VC funds are far too concentrated in a small number (<20–40) of companies. The industry would be better served by doubling or tripling the average # of investments in a portfolio, particularly for early-stage investors where startup attrition is even greater. If unicorns happen only 1–2% of the time, it logically follows that portfolio size should include a minimum of 50–100+ companies in order to have a reasonable shot at capturing these elusive and mythical creatures.’

Peter Thiel flatly contradicts this:

‘Given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about.’

McClure believes he can find hundreds of companies with high enough growth to maintain his requisite alpha. Thiel thinks this is not possible. Venture capitalists have always faced this tension: the average growth rate of all small businesses in the US is closer to 7.5% than 30%. The pool of companies that can grow fast enough is limited.”


My view is that both McClure’s and Thiel’s approaches to venture capital can be successful just as Warren Buffett and Ray Dalio can be successful with different investing approaches. The financial out-performance can come from different sources of mis-pricing for each of the two approaches. One interesting point: would venture capital  firms in the lower two quartiles improve performance by investing more like 500 Startups? The old joke is that all VC firms are in the top quartile, or at least that is what they say to their limited partners. Do you know any limited partners who have been pitched by a venture capital firms that says it is in the bottom quartile?

The discussion in this blog post to this point has not addressed more than a few questions: Why are financial outcomes in venture capital and business in general so bifurcated? What explains the presence of power law distributions? This topic is worthy of its own blog post, but in my view the simplest explanation is that there are many forms of feedback in a world that is a nest of adaptive complex systems and that feedback in all its forms creates the power law distributions. I have always loved this statement by Richard Feynman: “Imagine how much harder physics would be if electrons had feelings!” Duncan Watts describes how this manifests itself in this way: “individuals do not make decisions independently, but rather are influenced by behavior of others.” Humans are not like electrons- they have emotions, do things like herd and otherwise copy each other. That behavior can cause success and failure to feed back on itself, which produces outcomes that under the right conditions reflect a power law.

4.“The Internet is very efficiently arbitraged. Anything you can think of has been thought of and tried. The only way you’re going to find something is if you stick to it, at an irrational level and try a whole bunch of things.” The number of business experiments being conducted is increasing so quickly that the more obvious opportunity spaces for entrepreneurs are being exhausted with unprecedented efficiency and speed. There is no place to hide from the relentless pace of competition if the business person’s plan is to do something conventional. This places a premium on genuine product breakthroughs, often resulting from original research and development. In other words, convexity as a source of out performance is more important than ever.

5. “You get paid for being right first, and to be first, you can’t wait for consensus.” An investor can’t beat the market if they are the market. This is the point made so well by investors like Howard Marks. It is mathematically provable that being right will not lead to outperformance if the consensus forecast is also right. Howard Marks puts is this way: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Ravikant is saying that you also need to do it first. If you are not first, the bet will probably become consensus before you can capitalize on that bet.

6. “The market has to be huge because everyone makes mistakes. You never quite get it right the first time. Companies that don’t do giant pivots are always doing micro pivots. You need a large enough market that you can pivot in and you still have a customer base.” The convexity of a business investment (potentially massive upside and small potential downside) has never been so important. Having a huge addressable market increases the convexity of the potential financial outcome since it increases optionality. Small addressable markets provide entrepreneurs with fewer options and are not as likely to be convex.

7. “[A $1 billion seed fund would] destroy the entire market and put prices up 20% overnight.” “We don’t think we can allocate that kind of capital without distorting the market.” “Even the $400 million [we raised] will be spread out over six to eight years. Maybe the first year, we’ll deploy $20 or 30 million as we figure out the model, and then scale it out.” The market for venture capital is top down constrained by the potential for financial exits. This scalability problem in the venture capital business that Fred Wilson and others have written about means that in a country like the US only about 800 startups per quarter raised venture capital for the first time. If seed stage valuations get too high, the market can become distorted since it can become hard to raise funds in later rounds. Angel and seed considered together is only slightly higher as this chart indicates:



As I noted above the economy is limited in its ability to generate exists at some level. Yes it can rise more over time with the right environment in place but number of financial exits doesn’t just suddenly jump 10x when overall GDP is increasing only at low single digit levels. One thing that may take the possible exit total higher is that some startup firms are purchased even though only consumers benefit from their existence and there is no net increase in GDP. This creates a weird asymmetry where startups can win without ever making a profit in some cases. The idea that sometimes only consumers benefit from innovation escapes many people. Some innovations have a moat and create profit and some innovations do not have a moat and create no profit.





8. “It’s just as hard to build a large company as it is a small company, so you might as well build a big company. It’s roughly the same effort.” This is yet another point related to convexity. The bigger the upside the greater the convexity.

9. “I use Warren Buffett’s criteria for assessing the Team: Intelligence, Integrity and Energy. You want someone who is really smart, very hard working and trustworthy. A lot of people forget the integrity part, because if you don’t have that, then you have a really hard working crook and they will find a way to cheat you.” “Intelligence and energy are easier to measure. Integrity is the most important factor.” An honest colleague or partners with integrity increases the convexity of an investment since trust gives you more options. Decisions can get made faster and with greater confidence. The work is fun. Life is better. People have actually does research to prove that people who life in high trust societies are happier.  A lot of research has also been done on how trust is a key enabler of an economy. The studies show that “high-trust societies achieve higher economic growth due to lower transaction costs. Since trust protects property and contractual rights, it is not necessary to divert resources from production to protection.” These same ideas about the value of trust are fractal and exist at a company and personal level.

10. “Companies only fail for two reasons: The founder gives up or they run out money.” “Don’t be proud. Get the cash wherever you can. Cash is everything.” “Raise twice as much and make it last four times as long. Pretend that you don’t have the money in the bank, run lean. Assuming your unit economics are at least breakeven, keep your headcount low, raise money and stay in it for the long haul. It takes a decade to build a great company. There’s no shortcuts.” The only unforgivable sin in business is to run out of cash. What does cash give a business? Options. What do options create? Convexity! By now you have probably figured out that convexity is everywhere if you know how to look. “There is a whole set of companies that are not financeable by the venture community; service businesses, markets that are heavily played out, if you are fighting a war that has already been won…you better have some really core differentiation and traction. [Other disqualifiers include] not enough technical people on the team…if you are completely out of market… pre-launch companies tend to not do well…teams that have no credibility. The companies that fail to raise funding are the ones who use too many words and too few actions. Your biography is a record of your past actions. Your execution on your current business is a record of your current actions. Talking about what you are going to do in the future is almost pointless. Talking about what you can become is almost pointless. People want evidence. There is a lot of talk out there.” Most startups will not be able to raise venture capital. That is not the end of the world for those businesses. There are many ways to finance a business that do not involve venture capital.

11. “When building a startup, microeconomics is fundamental, macroeconomics is entertainment.” “Getting real traction is hard. Raising millions of dollars is hard. Building a sustainable, long-term company is hard. Your pre-traction company has not  achieved product/market fit and so it has a hard time hiring.” “There isn’t a shortage of developers and designers. There’s a surplus of founders.” Understanding microeconomics is essential if you want to be successful in business. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Munger and Buffett elaborated on that point during this interchange:

BUFFETT: “Charlie and I read a lot and we’re interested in economic matters and political matters for that matter and so we’re familiar with almost all of that macroeconomic factors. That doesn’t mean we know where they’re going to lead. For example, where zero interest rates are going to lead.”

MUNGER: “We pay a lot of attention to microeconomic factors. If you’re talking about macro we don’t know anything more than anybody else.”

BUFFETT: “Yes, he summed it up. In terms of the businesses we buy – and when we buy stocks we look at it as buying businesses, so they’re very similar decisions – we try to know all or as many as we can know of the microeconomic factors. I like looking at the details of a business whether we buy it or not. I just find it interesting to study the species.”

MUNGER: “Well there hardly could be anything more important that the microeconomics, that is business. Business and microeconomics are sort of the same term.”

12. “Desire is a contract you make with yourself to be unhappy until you get what you want.” “Seems like too many people, public and private sector, are making a living slicing the pie rather than baking it.” “Figure out what you’re good at and start helping other people with it; give it away. Pay it forward. Karma sort of works because people are very consistent. On a long enough timescale, you will attract what you project.”  “If you are young, one of the best things you can do is build a brand around yourself.” Yeah, this last set of quotes is a grab bag of ideas but there is a lot to grab in what he says! This post is already at 4,000 words, so I will let his words speak for themselves.



Anatomy of a Fundable Startup https://vimeo.com/25392719

Business Insider Interview:  http://www.businessinsider.com/interview-naval-ravikant-co-founder-angellist-and-co-maintainer-venture-hacks-2011-8

Nextweb: http://thenextweb.com/entrepreneur/2011/02/22/naval-ravikant-talks-in-depth-on-twitter-bubbles-new-york-and-start-fund-interview-part-2/#gref

Pando: https://pando.com/2015/05/08/naval-ravikant-to-vcs-you-can-lie-to-your-lps-but-dont-lie-to-yourselves/

Profile: http://dartmouthalumnimagazine.com/articles/avenging-angel

SJBJ: http://www.bizjournals.com/sanjose/blog/techflash/2015/06/angellist-chief-ravikant-its-a-bubble-but-not-just.html

CNBC: http://www.cnbc.com/2015/10/13/

CB Insights:   http://www.forbes.com/sites/niallmccarthy/2015/01/21/the-10-biggest-u-s-venture-capital-exits-of-2014-infographic/#660ae6322917

WSO http://www.wallstreetoasis.com/blog/the-current-state-of-startups-from-naval-ravikant

Power Laws in Venture http://reactionwheel.net/2015/06/power-laws-in-venture.html

Embracing Complexity  https://hbr.org/2011/09/embracing-complexity

Firm deaths and births:  http://www.factcheck.org/2015/11/a-gop-talking-point-turned-false/

Mattermark: https://mattermark.com/75-capital-invested-unicorns-still-locked-private-coffers/?utm_campaign=Mattermark%20Daily&utm_source=hs_email&utm_medium=email&utm_content=33087858&_hsenc=p2ANqtz-_oxddUidtX8i2-IRVA-CTZo5zp4YHD4joHvSJxGTvMmW_BIsyQ-oOi0eEEA3MTIfMS4Ur31j6mG9d1UDAHF9tJgcgkNw&_hsmi=33087858