Sway and irrational VCs

February 9, 2009

Jeffrey Bussgan— Jeff Bussgang is a General Partner at Flybridge Capital Partners, an early-stage venture capital firm in Boston. This post originally appeared in the Vox Populi section of www.peHUB.com. The views expressed are his own. —

I recently read Malcolm Gladwell’s new book, “Outliers”, with great interest and delight. Gladwell is a fantastic author: always thought-provoking on human behavior and a quick, entertaining read. But I confess this book did not resonate with me or strike me as relevant for the VC-entrepreneur dance in the same way his previous book, “Blink”, did (see: VCs Blink). It was intellectually interesting, but not professionally illuminating.

Instead, I have been even more taken by another book, which also analyzes human behavior in a thought-provoking way called “Sway”. Written by Ori and Rom Brafman, “Sway” was recommended to me by my friend and co-investor Howard Morgan at First Round Capital. It is a fascinating analysis of why human beings naturally fall into irrational behavior. The book has very relevant implications for venture capitalists and entrepreneurs, particularly in today’s environment, as VCs are likely to allow irrational behavior to seep into their portfolio management decisions in the coming years.

“Sway” points to three central psychological tendencies that cause human beings to behave irrationally, despite the preponderance of facts pointing in another direction. The first is loss aversion, defined as our tendency to go to great lengths to avoid possible loss – even when it means taking outsized risks relative to the actual loss impact. The second is value attribution, where we imbue a person with certain qualities based on our initial impressions (or desired impressions!). And the third is the diagnosis bias, where we allow our initial assessment of a person or situation cloud any further judgment and, in effect, cause us to filter out any contradictory data.

As I look back on the good and bad investment decisions that we have made as a partnership, I see each of these three tendencies factoring into our discussions. It is not uncommon for a polished, confident entrepreneur to benefit from value attribution, when in fact a deeper analysis of their skills and previous experiences as a result of exhaustive reference checking will reveal a very different prognosis. We have tried to be more cognizant of identifying these tendencies in the partnership as we contemplate our future investment decisions with our (relatively) new fund.

As I look forward to managing the portfolio during the challenging times that we all face, I can see where loss aversion, in particular, holds sway in a VC partnership. Human beings prefer to avoid a loss, even if that loss is more costly than the price of continuing forward.

One of the dangers in the coming years for the VC business is whether VCs are going to continue supporting companies in order to avoid admitting defeat and taking losses. In many partnerships, the culture may naturally encourage covering things up. Many VC partners are eager to brag about their portfolio successes, but slow to admit when they have made mistakes or when they are in the midst of dealing with a poorly performing portfolio company. Further, partnerships as a whole are going to be loathe to admit problems and failures with their investors, the Limited Partners. Without any malice, portfolio “cover ups” will be common throughout 2009 and 2010.

Loss aversion will thus cause VCs to throw good money after bad in 2009 and 2010. Loss aversion will also cause VCs to report overly optimistic quarterly valuations. I would estimate that many portfolios have valuations that are overstated by 20-30 percent. And, as I have discussed before (see: Why ‘Flat is the New Up’ and VC Funds Are Under-Reserved), it is also the reason why I think many VC firms are grossly under-reserved. These factors will be exacerbated by most portfolio companies failing to attract outside financings in the coming years and VCs, loathe to admit losses, continuing to support them well beyond the length that a rational investor would.

To be clear, it is not only VCs who are induced into irrational behavior due to loss aversion. Entrepreneurs clearly suffer from this tendency as well, particularly when it comes to hiring and firing key executives. How often have you heard an entrepreneur say that they should have acted 6-12 months earlier in firing an employee that was not working out? The reason – loss aversion.

Entrepreneurs are loathed to admit their own hiring mistakes and are fearful of the impact and magnitude of losing even a poorly performing team member. I know I certainly fell into this trap when I was an entrepreneur, and I see it is repeated time and time again.

Thus, I think the lessons of “Sway” are ones that all VCs and entrepreneurs would benefit tremendously from when evaluating how they make decisions. In an upcoming blog I might dive into the question of value attribution and the diagnosis bias, which are also a thought-provoking concepts that drive irrational behavior in VC partnerships. One entrepreneur identified another book for consideration on this topic called “Predictably Irrational” by Dan Ariely, which I have not yet read.

What are other examples can folks think of that fall into these irrational categories?


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Inflation,deflation,recession and then will lead to reverse migration.What I am confused is the falling growth rate of countries.The World Bank,IMF and ILO has kept on downgrading the growth rate of UAE to 2.5% and that to India at 7% in 2009.Expats from India mostly makes the highest population and with the UAE economy declining, do you think the currency exchange rate Dirhams versus INR to remain stable for 2009 or INR to become stronger?Will this not lead to reverse migration for working class,investors or enterprenurs!Can experts solve my layman economical problem?

Posted by Peter Vaz | Report as abusive

It is not just entrepreneurs and VC firms that follow loss aversion with poor performing employees. Working for a major bluechip it is amazing how many poorly performing employees are embedded right the way through the organization.

They are readily reviewed as poor performing or as “needing improvement” but the level of coaching/mentoring required far outweighs any ouput from the individual for the team. However in these instances, it is the Manager that is averse to admitting that their team needs a structural change and that with less people their team will be more productive (even taking into accounts the cost of pay-outs).

Given my organization, I can only assume the cost to the firm is millions of dollars annually.

Posted by Rupert Barnes | Report as abusive

If investors were loss averse, then we would all still invest according to Shariah principles.

If humans were loss averse, there would be no suicide bombers – indeed no wars of any kind, no adultery, no lotteries, and of course, Columbus would have been content to remain Governor of the Azores.

Indeed, where humans behave in ways which other humans describe as”irrational”, it is generally because they face the prospective losses with gay abandon, not because they are artificially inflating them! (The only recent counterexample I can think of from daily life is the MMR vaccine scare.)

How can we square this fairly basic and everyday observation this with all those trendy coffee table books? I think the answer lies in where the behavioural psychologists started out. There were using Victorian parlour tricks and cleverly designed experiments which exposed counterintuitive behaviours in order to understand how some bits of our brains worked. The problem is that, having found some rules for these bits of our brains, they then declared that these rules dictate our NORMAL behaviour, in toto, when in fact they were originally uncovered only in relation to EXCEPTIONAL behaviour.

I can think of nothing worse than a group of politicians or influential businessmen accepting these principles at face value, and it really worries me that, here in the UK at least, our probable next government looks set to use our entire nation to conduct just such a dangerous experiment.

Posted by Ian Kemmish | Report as abusive

Not bad. A good general point is that a lot of the time, what leads you to do something right is knowing many ways to do it wrong.

Posted by Pete Cann | Report as abusive

The most damaging irrational decisions, judgements, opinions and perspective come from a binding personal involvement that cannot be emotionally detached from the subject and always tends to cloud or negate objective and sound rational judgement. This inability for, or even resistance to, rational and objective thought in any circumstance is the most damaging influence on any human behavior that requires total emotional detachment for best results. That involves most of what we do in life and is the primary reason for all life mistakes, yes, including love. That’s why we make so many.

Posted by richard | Report as abusive

Aren’t these venture capitalists being paid very large amounts because they are skilled at avoiding irrational attachments and conclusions? If they fail at that haven’t they failed in their primary mission which is to always be looking at the dynamics and flow within the developing enterprise and the relationship of that development and flow to needs and trends of the outside world.

It is interesting to come up with good descriptions of how failure takes place. But it is unwise to allow that to be an excuse for failure that VCs can then point to and say, “Well, everyone does it.” If VCs and entrepreneurs are making these kinds of mistakes, maybe they are in the wrong business.

Posted by Jonathan Cole | Report as abusive

I just finished the book (kindle version!) and really appreciated it. It’s amazing what people will do on the basis of emotional attachments to an idea, vision, or investment. I include myself in that…

well worth the read.

Posted by Charlie Crystle | Report as abusive

Yes VC’s are short sighted and they are arrogant bunch when the market is going their way. Now it would be eating humble pie for them.
My start up was seeking venture capital and the broker would charge me a fee for creating a biz plan but never want to take the time to listen to a presentation. I could never fathom how a VC could produce a biz plan when they dont even bother to understand the vision or effectiveness of the products.
After setting up a charitable foundation, we are lucky to venture with an international medical device company who would inject substantial capital.
What ired me the most was this broker said he could come out and listen on a pro bono basis! Well that person will kick himself for loosing a potential client especially when it goes for second round funding and when this company goes public in 2012.
The latest development is a well known university will research our supplement to see how effective it is on stem cells because we had 5 cases where the body modulated itself defectives genes were untraceable.
I guess he rolled the dice and it came up 00. Life is great when opportunity knocks however one has to be visionary to seize the moment.

Posted by chao yoong | Report as abusive

Aren’t we really talking about being motivated by “fear”? Isn’t the market based on two main principles, Fear & Greed….It seems pretty clear that since Greed is on a holiday (or under house arrest eg. Madoff), Fear is now in the drivers seat and he ain’t lettin go any time soon… Really the struggle is in not letting Fear gain control, which is much easier said than done.

Posted by L Marceau | Report as abusive

I will do everybody a favor today by posting. There is a direct relationship between me posting and market prices increasing. Survivorship bias tends to result in similarities between those still standing – the same way the best basketball teams often have tall players. VCs that are unsuccessful in making money must nonetheless be successful in obtaining and keeping money. So they have developed a pattern of behaviour that is strengthened by our economic crisis. Good for them.

Posted by Don | Report as abusive

Thanks for all the great comments! Fear and Greed are powerful forces – I still see both at work in the start-up economy, which is a good thing, I think.

Jonathan is right that VCs and entrepreneurs need to be held accountable when they allow “Sway” to compel them to make irrational decisions. LPs are doing this more and more today.

Posted by Jeff Bussgang | Report as abusive