Thursday, March 30, 2017

On VCs, Clairvoyants, and Magicians

The guy at the next table looks out at the amber sunset, puffs up with gravitas, and announces to his wide-eyed friend “soon all things will be connected seamlessly to the ubiquitous network." Time to change tables. I grab my drink and set off to find an area outside of Houdini’s vocal range. The bar at the Rosewood is cursed by its reputation as the place where VCs from Sand Hill Road meet, so it attracts posers playing the prophet like LA attracts actors.

Coincidentally, on my way over to the Rosewood, I saw along El Camino Real a hand-painted sign saying “clairvoyant conference” with an arrow pointing to a hotel. Imagine a conference for clairvoyants! You would not need to have sessions on “future trends,” since they would already know. But wait: Why the sign giving directions, for that matter?

Since time began, it seems people want to believe that some of us have a special knowledge of what is to come. So we’re vulnerable to those who claim such knowledge - albeit that different people fall for different images of the prophet. You might mock the trappings of the village shaman, the tarot reader, and the astrologist – but I bet you’d clear your calendar to hear the latest word from the valley’s richest VCs.

I’m not just waxing cynical. It turns out that venture capitalists typically are bad at telling the future. As an industry, VCs don’t perform that well financially. To find VCs who outperform the market, you have to selectively sample only the most successful ones - but that is true for slot machines, too. OK, a minority of VCs do tend to appear repeatedly on the winning side, so perhaps they are the real Houdinis. Maybe. Or maybe having been successful they end up getting preferential access to things that continue to make them successful. (I appreciate that advantage, working at Stanford.)

Whatever the reason, the fact that at least some VCs are repeatedly successful has created the mystique that there does exist, somewhere along Sand Hill Road, somebody who does know what’s next. Hence all the puffery at the Rosewood. How are we to know that he’s not really a visionary?

Professor Elizabeth Pontikes and I took a careful look at this question. We collected data on thousands of firms in the software business and looked at their fates over time – including both successes and failures in the data. We found that these firms herd into “hot” markets that have been blessed by the VCs. But we also found that the VCs herd into markets too, following each other in financing frenzies. The resulting hype cycles lead to bad outcomes for companies; firms getting funded in these waves are the least likely to ultimately succeed by going public. So much for Houdini.

Perhaps even more interesting, the VCs themselves seem to be aware of this problem. While VCs herd into hot markets, at the same time they try to avoid investing in firms that do so. The VCs prefer instead to invest in those who pioneered what is now a hot market (and survived). As a kid I had a precocious classmate who would jump to the front when he saw a trend, pointing resolutely forward in Napoleonic fashion, proclaiming “follow me!” I’ll have to check; perhaps he grew up to be a VC.

Remember, the most disruptive changes are not predicted by our experts. They are pioneered by those foolish enough to ignore the consensus. Be skeptical of those who claim to know what's next.

For the research behind this article, see my paper with Elizabeth Pontikes.

Wednesday, March 15, 2017

Define the Game

"Change the game" you'll hear people say. In fact, we often define the game we play when we choose how to play it. But only some of us realize this fact. I was reminded of this lesson in Moscow by the French chess master, Joel Lautier.

Joel and the rest of the team had to solve the problem before morning. Vladimir Kramnik would sleep, of course. He would need to be rested fully, and even then it would be a long shot to beat Garry Kasparov. The dominant world chess champion was unlikely to lose. But the team had an idea. Even if it worked just once - there were many games in the match - it might open up the smallest of chances.

The team were all wiz kids, each a chess master in his own right. No one person could fully prepare alone for the many possibilities of a match at this level. So each of the grand masters had his team of trainers assigned to work out the best solution to a particular situation that might arise. By morning, each team member needed to have solved his problem and prepared the result of his analysis for presentation to Kramnik himself, who would scan the analysis and commit it to his marvelous mind. Few words were needed.

Joel Lautier was on the team because he is one of the few to ever beat Kasparov. Lautier’s job was key: Formulate Kramnik’s best “black” opening. Many readers will know about the most well-known chess openings. But, in fact, there are many more possible openings than the common ones, and by its nature chess allows for the invention of new openings to this day. But in such an old and storied game, the chances of inventing an effective new opening are not great. That was Lautier’s task.

What made Lautier’s job especially important was that Kasparov was especially good at the attack. Key for Kramnik would be to find a way to improve his chances in the games where he started as “black”- second - since those games would favor Kasparov’s attacking ability. And he would need to be able to repeat the opening over several games as black, a tough job once the opening was revealed.

Working into the night, Lautier formulated a risky approach for Kramnik. The opening was not ideal, but it might work given Kasparov’s strengths relative to Kramnik. It involved an odd series of moves, quickly leading to the trading of queens. When complete, the strategy - which has come to be known as the "Berlin" opening - left Kasparov, as white, with a slight positional advantage (with his players in slightly better places on the board). But the opening hurt Kasparov too, by skipping the complicated “mid game” where Kasparov famously had an advantage. The strategy worked. The opening shifted the edge enough for Kramnik to draw games that he would have otherwise lost.

Several years later, when I was lecturing in Moscow, Joel Lautier was in the audience and he asked me this question: “There may be many possible winning business strategies. How do we know which is best?” The answer comes from Mr. Lautier's example. The best strategy plays to your strengths, and away from the other’s. Don't just play the game as defined; define the game you play.

Research on "metacompetition," defining the game you play, appears in my book on Red Queen competition.