The topic of luck has always fascinated me. In particular, I find it interesting that people don’t seem to want to explain outcomes as being influenced (heavily) by luck even though we all know that luck plays a big role in outcomes in business, investing, sports and other activities. In his 2012 Princeton commencement speech (topic: luck), Michael Lewis said:
People really don’t like to hear success explained away as luck — especially successful people. As they age, and succeed, people feel their success was somehow inevitable. They don’t want to acknowledge the role played by accident in their lives. There is a reason for this: the world does not want to acknowledge it either…
… don’t be deceived by life’s outcomes. Life’s outcomes, while not entirely random, have a huge amount of luck baked into them.
Another of my favorite writers and thinkers, Nassim Taleb, has also tackled the role of luck and its implications in decision making, policy and the macroeconomy in his books the Black Swan, Fooled by Randomness and others (these are must read books in my opinion). However, I had yet to find someone who tackled the luck versus skill problem in a practical way until very recently when I came across a book called The Success Equation by Michael J. Mauboussin (this book was recommended in another of my favorite recent reads: The Second Machine Age).
In The Success Equation, Mauboussin lays out some basic frameworks that help to place activities on the Luck/Skill continuum. He then goes on to discuss ways to operate in activities that are more skill based (e.g. practice, practice, practice – 10,000 hours rule holds true) and those that are more luck based (e.g. use a consistent process).
I have a particular interest in how to operate within a luck based profession given that investing in general, and venture capital investing specifically, lean more toward luck on the luck/skill spectrum.
One thing I learned early on at Cambridge Associates, both in speaking with colleagues and seeing the data, was that sticking to a process and a focus area was important to achieving good returns in the venture capital business. Honestly, I didn’t spend much time thinking about it then, or since then, because it just made sense. The corollary, undisciplined investing, just didn’t sit well with my personal philosophy. Being a disciplined investor was something my father taught me early in my life and it was also reinforced in my internship role at Eaton Vance. I just took discipline and process as a given to achieving good investment returns.
But why is that the case? Why does being disciplined and focusing on a consistent process make sense in investing?
Mauboussin argues in The Success Equation that when activities are determined more on luck than on skill process is crucial. One reason for this is that we can more readily accept the outcomes of our decisions with equanimity if we stick to a good decision making process. I’ll admit, that is not a satisfying answer. Not to worry, Mauboussin expands on the idea by saying; “when a measure of luck is involved, a good process will have a good outcome but only over time.” When luck exerts more force than skill, cause and effect are linked in the short run, but only very loosely.
Therefore, if you stick to a process over a long period of time, statistically speaking you should run across some good luck. If your process is always changing, you are changing the probability that luck will find you over time and making a big bet that luck finds you in the extremely variable short run.
You can see this play out in blackjack, a game with a lot of luck involved but where a good process – “basic strategy” in this case – if employed yields better expected outcomes (relative to no strategy, poor strategy or an inconsistent strategy), but over a large sample size. It is easy to get wiped out in blackjack, even when employing basic strategy, if you only start with $100 (even if the hands are $5 each). You’ll have a much better chance of winning, or at least attaining the house odds, if you start with a larger sum and, thus, give yourself a larger sample size.
Nassim Taleb gets at this idea from a different angle but ends up at the same endpoint – stick to a process for the long run. Taleb suggests that in the realm of black swans – and venture capital investing is very much in that realm – investors “should seek payoffs that are roughly equivalent to buying options, even though they have a small but steady cost and you don’t know when or if you will get a big payoff. [See graph below - x axis is time - y is outcome/payoff]
Source: “Antifragility, Robustness, and Fragility Inside the “Black Swan” Domain.
SSRN working paper, February 2011
Author: Nassim Nicholas Taleb
Hopefully this post provides some insight into why following a consistent process is important in venture investing. I also hope that this post provides some helpful insight to entrepreneurs into how VCs think.
Additional notes: Venture investing takes place in a complex system and one where positive (and negative) feedback loops can take hold (i.e. you make a good investment and that yields more great entrepreneurs seeking you out as an investing parter, which tilts luck more in your favor, and so on). I’ll leave that for a future post and I look forward to receiving feedback on this post via email, twitter and in the comments section.