Contrary to conventional clich?, there is very little that is "binary" about venture investing outcomes. That is, when it comes to private investing, it is not a choice of either feast or famine. Rather, the investing outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs, or achieve exits at 5X, 10X, 20X multiples or greater on your initial investment.
What does appear to be binary, however, is the manner in which prospective investors in private ventures, and the advisors who recommend such investments, perceive the asymmetric return profile of venture investment outcomes: most either adore it or abhor it.
On the one hand, an investor like the famed Jim Rogers is attracted to what he no doubt views as a positive asymmetric profile of venture investment outcomes.
His venture acumen began developing at the age of five by selling peanuts and getting the deposits back by picking up empty bottles that fans left behind at baseball games. In 1970, he co-founded the Quantum Fund. During the following 10 years the portfolio gained 4,200% while the S&P advanced about 47%. Nice.
In a recent online rant widely covered and distributed in the blogosphere, Rogers opined not only that "diversification was garbage," but went on to say that "you only need four or five good ideas in your life to get really rich." (Rogers says "really" rich, which seems rather elitist, since one or two good ideas can make one simply rich.)
Nevertheless, 90X returns over the S&P implies that he had very little fear of placing losing bets.
But what drives those less adventurous souls to eschew positive asymmetric return scenarios in favor of investments in exclusively binary and symmetric outcomes? Why are there so few angel and venture investors despite the compelling data of the asset class's returns and the proven history of private enterprise as the single greatest creator of family wealth?
Enter the Nobel Prize
Economics psychologist Daniel Kahneman attempted to explain this curious behavior with his 1979 Nobel Prize-winning paper called Prospect Theory (first published in the journal Econometrica). The paper describes the process by which decisions are made when choosing between alternatives with uncertain outcomes but where the probabilities are known.
In prospect theory, Kahneman identified the concept of Loss Aversion. That is the tendency among humans to strongly prefer avoiding losses to acquiring gains. In fact, studies suggest that losses are twice as powerful,, psychologically, as gains.
In their perpetual pursuit to mirror the risk-free rate of return, it would appear that some investment advisors are factoring prospect theory and loss aversion into their asset-allocation schemes. But loss aversion studies opposing symmetrical outcomes, such as either winning $100 or losing $100, provides little insight into an investor's fear of positive asymmetric return profiles.
Inertia and the Status Quo
I prefer the wisdom in David Gal's 2006 study in the Journal of Judgment and Decision Making, A Psychological Law of Inertia and the Illusion of Loss Aversion, (available online at journal.sjdm.org/jdm06002.pdf) which discounted loss aversion as "superfluous" and found instead that risk/return tradeoff decisions were decidedly "influenced by a tradeoff between the status quo and change." Gal calls it inertia, noting that people will tend to remain at the status quo when they have no clear preference between the status quo and an alternative option.
The rigid portfolio allocation to the same old stale asset classes within a strategic asset allocation model is the status quo to which Gal is referring. The results have been far from compelling yet most investors, and their advisors, keep doing the same thing while expecting different results.
Properly allocated, private equity and venture investors can materiality improve their portfolio's risk/return tradeoffs and benefit from the proven superior performance of the asset class. But expanding your repertoire by opening your portfolio to private investment opportunities requires commitment and effort to educate yourself on the rules of the engagement and evaluation.
Achieving superior returns by embracing private investment requires initiative...not inertia.
Jeff Joseph is an investor, financier, CEO of Prescient Advisors, former RIA, and the author of the blog at venturepopulist.com. Send comments, questions and column suggestions to firstname.lastname@example.org.