You should focus on the horse and not the jockey when picking your investments, new research has found.
What this means: When deciding the company whose stock you will invest in, focus on the company’s business model and strategy for the future rather than the identity of the founder or CEO. When picking a mutual fund, it means under-emphasizing the education and background of the manager, focusing more on the investment strategy the manager pursues and the patience and discipline with which he does so.
These are the investment lessons I draw from the new research, titled “Predictably Bad Investments: Evidence from Venture Capitalists.” It was conducted by Diag Davenport, a Ph.D. student at the University of Chicago’s Booth School of Business.
To illustrate what this research found, consider two hypothetical ETFs that own the same group of risky stocks in the same proportions. One is managed by a superstar investment adviser, and the other by someone no one has ever heard of before. When presented with this second one, odds are good that you’d dismiss it out of hand. But when considering the first one, the stars in your eyes would blind you to his strategy and lead you to jump at the chance of investing in the risky fund.
We saw something akin to this early last year, when Cathie Wood’s ARK Innovation ETF
ARKK,
was riding high. For the 12 months through Feb. 12, 2021, for example, this ETF produced a 173% gain in contrast to an 18.6% total return for the S&P 500
SPX,
Many investors flocked to this and other ETFs that Wood managed, reasoning that she was playing a hot hand and had a magic touch.
Yet when at the time I presented to clients the list of stocks held by the ARKK ETF, without indicating where the list came from or who was recommending them, most immediately reacted negatively—the portfolio was far too risky. In other words, these clients made different investment choices when focusing on the “horse” — the portfolio itself — rather than the “jockey” — Wood.
As we know now, of course, those in February 2021 who bet on the “horse” are way ahead of those who bet on the “jockey.” Since Feb. 12, 2021, the ARKK ETF has lost a total of 71.7%, in contrast to a loss of just 1.5% for the S&P 500.
What artificial intelligence can teach us
You might object that my example is unfair, amounting to little more than Monday-morning quarterbacking. After the fact it is all too easy to take pot shots.
This is where Davenport’s research is so helpful. He showed that, using information available in real time rather than after the fact, it is clear that investors focusing on the “jockey” are “predictably” making a mistake.
To reach this conclusion, Davenport focused on a sample of venture capital investments in thousands of startups between 2009 and 2016. He specifically wanted to know if, upon relying only on data available at the time those investments were made, it would have been possible to predict which ones would successfully “exit”—such as via an IPO or a merger or acquisition. Companies included in Davenport’s database include such well-known firms as Airbnb
ABNB,
DoorDash
DASH,
Stripe, Dropbox
DBX,
Coinbase
COIN,
Instacart and Uber
UBER,
Davenport divided his database into an earlier and later group, using a type of artificial intelligence known as machine learning (ML) to analyze the factors that led certain startups in the earlier group to ultimately exit successfully. The information available to his ML program was limited to only what was available on the day the venture capital firms invested in the startups.
Davenport took the algorithm that the machine learning program devised and applied it to the startups in the second of his two groups. It successfully was able to predict that around half of the investments in this second group would underperform available alternatives, such as an index fund. Furthermore, Davenport found that the venture capital investors making these predictably bad decisions tended to put inordinate weight on the startups’ founders.
For example, when VC investors knew the founder of a startup, were familiar with where he went to college or business school, or had other positive associations with aspects of his personality or biography, they put inordinate weight on those characteristics and overlooked warning flags that otherwise would have been obvious. “When making good investments, [venture capital] investors appear to bet on the horse, but when making bad investments they appear to be betting on the jockey,” Davenport concludes.
This new research reminds me of an observation that Berkshire Hathaway CEO Warren Buffett made more than four decades ago, in his 1981 shareholder letter: “Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess … [In reality,] we’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses — even after their corporate backyards are knee-deep in unresponsive toads.”
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
