I finally got around to checking out some of the amazing content on iTunes U and came across a talk by Reid Hoffman, founder of LinkedIn and member of the PayPal mafia, addressing the general idea of entrepreneurship and providing a narrative of how he came to build LinkedIn (see link at the end of the post).
In the course of the talk, he made the assertion that there are three approaches to investing:
- “Sure-bets”. This is the style of investing that is attempted by hedge funds and other opportunistic (activists, PE, etc) investors. The ability to generate a sure-thing profit is the goal, usually characterized by having some form of “edge” versus other investors whether that be in the form of access to resources, information, or analysis that others just simply do not have.
- “Diversified, low-risk portfolios”. A former Professor of mine divided the investing world into two camps: wolves and sheep. The wolves were those out there who understood the workings of a security – be it a stock or a bond – and sought to take advantage of those who didn’t: the sheep. However, one can be a sheep and still earn a nice return. The investor who knows what they can’t do (knows the limit of their circle of competence as Buffett would say), can just spread their bets through diversification or buying index tracking vehicles.
- “Accurate contrarian theorists”. This is an interesting term that I hadn’t heard before. Reid posits that an entrepreneur (and therefore venture capitalists who back them) need to pick something others don’t think is viable, that is unique – in other words one needs to have a contrarian theory. It helps if the theory is correct at first (lucky!), but accuracy can be honed through iteration on the idea as the entrepreneur finds product/market fit. This is viewed as the highest risk, highest reward of the three.
I think of these three approaches as the only intelligent ways to earn return on investment. Effectively, they encompass three strategies to systematically lower risk (whether perceived or real) while generating decent returns.
The idea of “accurate contrarian theorists” provides a helpful framework to think about the process, in my opinion. Scientific theories are rarely correct at first. They are tested against the mettle of peer review, re-analyzed, and re-theorized. The peer review system of the “market” can work in a similar way. The low probability of success leads one to conclude that getting the theory out there and shifting hypotheses as feedback comes in increases the chances of success greatly.
Additional note: Reid also makes an interesting comment toward the beginning about how raising money from a top VC is not a sign of success although many act like it is. I once asked the founder of a top East Coast, seed-stage VC firm the same thing and he scoffed saying, “nobody is that blind.” I’m not so sure…