Fire Your Public-Equity Fund Manager, But Find A Good One For Venture Capital
Public equity and venture-capital-oriented stock are different vehicles for different kinds of investors. Public equity is liquid and heavily regulated. Venture capital (VC) is often less liquid and subject to fewer regulations. Many publicly traded companies are large and well-known, whereas a startup can be just an inventor in his garage. This also implies that the market usually has more information about public companies, whereas good VC investments are harder to find and more opaque. While gains and losses are possible with both, VC is often riskier (and more rewarding).
For public stocks, go with what you know.
So who are the “target audiences” for both kinds, and how should investors choose? Simply put, public equity is for everyone. Even $1,000 is a good start in a long-term index fund, and stock markets exist to connect investors with investments. Choosing publicly traded winners is easy (read on) but harder in the VC world. And VC funds require more capital to get started. So let’s think about how to choose in each market and what advice is worth heeding.
When it comes to the stock market, individuals — especially experts — are easily fooled. Large groups, however, are astute. Crowds outperform professionals: index-tracking funds consistently beat managed funds. Evidence indicates that lower management fees — implying less intervention by individuals — improve returns.
Why? Markets are recursive. A market’s future depends on its present, and its present depends on what each participant thinks every other participant is thinking. Prediction is impossible because any valid prediction would affect the parameters that led to the prediction being accurate in the first place. Not only is the target moving, but every time it moves, the hunter’s gun transforms into a piece of modern art.
Recursivity is why algorithms can spot and exploit minuscule arbitrage positions before the market catches up, but they can’t pick which stocks will win next year. Humans have no hope of keeping up.
Heuristics — conditional rules that facilitate decisions made with limited data — are a novice investor’s best friend. Index-tracking is one useful heuristic for investing in public markets. Just follow the crowd: take advantage of the market’s free analysis and go with the flow. This strategy is already better than a fund manager and his or her crystal ball.
Simpler heuristics can perform even better. Stocks with names, or even with ticker codes, that are easy to pronounce performed up to 11% better than those with awkward names. The fluency heuristic reveals promising stocks just by skimming names on an exchange and seeing what rolls off the tongue.
Novice investors don’t even have to read stock names out loud; they can simply scan for familiarity. Merely having heard of a stock can indicate its future performance. In one study (paywall) on the recognition heuristic, portfolios containing stocks that non-experts recognized outperformed portfolios containing unrecognized stocks by 300%. They also outperformed market indices. And German laypeople picked better stocks in the U.S. by recognition than American experts did by analysis. In fact, randomly selected female pedestrians, who recognized the fewest stocks of all, managed to double the returns of the men who claimed to know more.
VC investing is different and requires guidance.
In short, when investing in equities, entrust your money to the market or, better yet, to a proven heuristic, not to any huckster who claims to have a secret winning formula.
It’s no surprise that the recognition heuristic works. After all, recognition and profile are major components of “blue-chip stocks.” It makes sense for strangers to converge on high-profile, high-value equities. When many people converge and buy famous stocks, their prices go up and stay up.
But neither index-tracking or recognition works for VC investing.
Startups aren’t traded on public exchanges, so there is no index that reflects the market. No secondary exchange captures the breadth of an entire market like the NYSE or the NASDAQ. Further, the VC market changes too rapidly. Exits, whether by acquisition or IPO, happen all the time. The whole point of index tracking is to buy and hold, but rapid shifts in the VC market turn that strategy into a farce.
The recognition heuristic fails because some of the biggest opportunities in the VC market are deeply under the public radar. Yes, unicorns might be the “blue-chip” stocks of the VC market, but that’s not saying much.
For example, Snowflake was founded in 2012, and it rose to a post-money valuation of $12.4 billion as of Q1 2020. It should have been a household name. But it wasn’t. Until a few weeks ago, it was practically unknown. Measured by search frequency, Microsoft was around 60 times more recognized than Snowflake in February 2020. It wasn’t even a “blue-chip” unicorn. Airbnb was around 90 times more popular in February. Snowflake was virtually invisible until its IPO on Sept. 16, when its value at the market close was $70.4 billion. But by then, it was too late. An attentive expert might have had a chance to win on the secondary market months prior, but non-experts had no hope.
“Set it and forget it” works for an index-tracking fund, but monitoring and moving on the VC market is a full-time job best left to shrewd professionals.
What are the lessons? Public equity is for millionaires and cops, billionaires and teachers — it’s for everyone. It’s the relatively low-stress, long-term, “easy” way to invest. Novices don’t even need an advisor. Good investment apps are out there. Just download your favorite and follow the crowd.
Venture capital is for those with deep pockets and large appetites. But such investors still need expert guides. Professionals’ vast knowledge of what’s out there is perhaps the best approximation of an index, and their experience helps them to recognize what everyone else is missing.
Originally published at https://www.forbes.com.