“There are only 3 people in the world who know whether there is a property bubble in China. I am one of them and the other two people work for me.”
– CEO of a Chinese real estate company, 2015
Let’s start with a question. What do you estimate the share price of Amazon to be in 2 years’ time? How many of you are now currently looking for the current Amazon share price? This is, of course the method employed by many when asking such questions, but how relevant are the questions. Find the current value, apply some growth factor and this will be the estimated future price. The current price used in this forecast could be labelled an anchor which is the tendency to make a future decision based upon a reference point which is frequently irrelevant to the decision. Why do we do this? Under conditions of uncertainty humans rely on anchors to drive their decisions.
If anchoring is such a pervasive bias, then it is likely to create sub optimal outcomes within investment decision making and venture capital is not precluded from this. At Kavedon Kapital the behavioural science team works with founders and our own portfolio managers to create frameworks which insulate them from behavioural biases such as anchoring as we believe it produces superior investment outcomes.
There are many examples to cite where anchoring could be problematic from both the founder perspective and the investor viewpoint. However, two of the more pertinent ones are as follows and this behaviour is also mimicked in public markets too.
1. Pitch meetings
Pitch meetings, whether that is pre-seed, seed or series A are central to the capital raising process. However, from a portfolio management perspective we need to be aware of anchoring our beliefs. My concern is that investors form a view of a company/founder before they enter the room, which therefore jeopardises the value of that event. The beliefs will be anchored against a historical, independent event which is now driving a premeditated view on this meeting. If you have received positive experiences in a business or industry you will be anchored to favouring a similar business before you have even met with a founder, questions are likely to be more benign. Conversely, if you have a negative experience with a business/industry you will likely be skeptical and more questioning of the founder.
On the negative side this creates unintended consequences as the VC is unintentionally reducing their opportunity set. For example, a US health fund may theoretically be able to invest in a broad spectrum of startups within the healthcare nexus however, the reality maybe that the fund only invests in 60% of available names because of negative experiences associated with specific technologies and treatments. Once we are anchored on a negative view/belief it is very difficult to turn back. If you assume that 25–30% of VC backed businesses fail, over a period of years portfolio mangers and VCs are significantly reducing their opportunity set which is likely to yield inferior returns to the VC which is operating with a much more complete universe of bonds.
Our proposal would be for all meeting attendees to document what they would need to see for a favourable/negative view on the founder(s) and to also state whether they have invested in similar businesses in the past and what was the conclusion. Once you have created essentially a checklist it is emotionally easier to change/challenge your beliefs.
2. A problem for founders too
We once worked with a group of founders who were expanding their sales overseas. Senior leaders of the business would fly to countries to assess their eligibility. The concern here was to what extent they were exhibiting anchoring. More specifically, does the startup know the answer before they even make the trip? What surprised us when we reviewed previous trips and referenced them with their sales expansion plans ex post, the individuals concerned always expanded into the countries they had just visited. It is difficult to countenance that there was never an occurrence where the founders would report back with negative conclusions versus the initial expectation, therefore deciding not to expand into that particular country. If you know you are always going to expand then you actually don’t need to make the trip and can reduce your carbon footprint.
Essentially founders should prepare guidelines which outline the positives and negatives associated with the trip. Mostly, (I suspect) if these are drawn up at all then they focus almost exclusively on the positives and not on the negatives, so unsurprisingly we are therefore conditioned to seek positive aspects of the countries. So, always ask the question: what would dissuade me from increasing my exposure? Equally important, meet companies, government figures, and economists who offer a conflicting view on the visiting country.
Of course, similar investment behaviour can be observed in public markets too and we used this approach when helping a fund manager understand whether there was a property bubble in China. The fund manager’s view was no bubble existed so were keen to engage with the gentleman who had a strong view on whether there was a property bubble in China.
Like all the biases we have touched upon in this series, this bias is pervasive and far from exclusive to investment decision making. However, it can be extremely damaging to the latter if investors and founders are not constantly questioning what the drivers are for their underlying decisions.