This article was published on November 13, 2017

Too many investors become a “no machine” — here’s how to avoid it

Too many investors become a “no machine” — here’s how to avoid it
Paul Arnold
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Paul Arnold

Paul Arnold is a venture investor, former startup executive and founder of Switch Ventures, a seed-stage venture capital firm, where he has Paul Arnold is a venture investor, former startup executive and founder of Switch Ventures, a seed-stage venture capital firm, where he has built a high-performing portfolio by identifying the most talented startup entrepreneurs. Paul applies a proprietary, data-driven approach to identifying founders, using a unique dataset to identify those who will outperform the venture industry—proving that investors can make smarter, better investments by taking predictive data seriously. Before becoming a venture investor, Paul was the first senior executive at AppDirect, a leading cloud service platform making software and products accessible globally, helping build it from a small startup into the unicorn ($1B+ valuation) it is today. He also spent four years at McKinsey & Company in its Silicon Valley and San Francisco offices. Paul is an alumnus of the University of Utah, the University of Cambridge, and the University of Michigan Law School and is actively involved in the nonprofit Defy Ventures.

It’s no secret that venture investors hear a lot of pitches. In fact, it is not uncommon for us to see several thousand a year and invest in less than one percent of the startups making them. As you might imagine, we say no — a lot.

You may have heard other investors comment that saying no is one of the hardest parts of the job and it’s true. It often seems as though I have to tell great founders with great ideas “no” when I wish I didn’t have to. Yet, over time, it can become such an inherent part of investing to say “no” that it potentially creates a problem — we become bad at saying “yes.” We can turn into “no machines” and miss out on good opportunities as a result.

There is a dramatic risk in falling victim to this way of thinking as a venture investor. It is a type I error and venture investors cannot make type I errors. Saying no to a Snap, an Uber or an Airbnb is the most serious mistake a venture investor can make. The choice is the difference between a failure and a legendary fund.

This common pitfall led me to think about some of the cognitive traps that can trip venture investors up. Here are a few to watch out for and some tips to guard against them.

Too much information leads to decision-making mistakes

Simply said, venture investors deal with too much information. We are buried in the sheer quantity of it and we screen aggressively to manage the overload. The best investors are often those who screen best — the ones who have developed better, more effective approaches to filtering the signal from the noise. To manage the information overload, we form generalities. We first forget the specifics, and eventually, we overlook them. Some of this is out of necessity, but without correcting for it, it leads to bad investment decision-making.

Compounding the challenge are our own confirmation biases and availability heuristics. We are primed for what we do often — in this case, saying no — and we are drawn to facts that confirm our incoming beliefs. If we already believe that most pitches are going to be a no, our confirmation bias bolsters any reasons we can find.

Here’s my solution: 

Narrow the information flow — Be smart and systematic about filtering investments. A common approach is to keep a tight industry thesis, say, focusing on SaaS or Hardware startups. This drives expertise and narrows the set of what’s attractive. Another example is a data-driven filter similar to what I use, which allows me to narrow the set of startups that I want to be in front of. Narrowing the world has powerful effects, not only for your fund’s strategy, but in countering the cognitive mistakes caused by too much information and too many choices.

Seek out disconfirming evidence — The best way to counteract confirmation bias is to seek out disconfirming evidence. Stay open and consider new futures that you may not have previously. Develop the personal habit of asking yourself what the disconfirming evidence is and build in processes to double-check that you do so.

We create meaning and tell ourselves stories

Betting on what the future will hold is challenging. Almost by definition, venture investors betting on new ideas have only partial information. They don’t know how the specifics will play out.

The brain’s solution is to fill in the gaps—to create a story. Our brains find a narrative that makes it all less confusing. The problem is we are prone to fill in the story with stereotypes, generalities and prior history.  We risk losing the distinction between what we actually know and what we are adding to the story. This can lead to bad investment decisions.

Here’s my solution:

Curate new ways to view the world — We can’t escape the problem of having to fill in the gaps. The best way to deal with it is to have a diverse toolkit of ways to think about the world so that we go in with a fresh perspective.

The best venture investors have a very high density of ideas, structures and frameworks through which they view the world. You will notice a very real difference between how elite investors talk about problems versus how everyone else does. If you don’t believe me, spend time listening to how someone like Peter Fenton or Ray Dalio structure their thoughts about the future. The best investors are voracious learners and rich thinkers. They have a robust set of mental models. A high density of ideas gives them more tools to tackle meaning across the array of possible futures that may unfold.

Seek outside counsel  According to Dr. Cameron Sepah, psychologist and executive coach, one of the most common defense mechanisms is rationalization. What seems like logical reasoning by an investor can sometimes really be a rationalization that justifies a conflicted thought or feeling.

Sometimes you may find a founder to be more likable than their idea, which compels you to want to invest anyway. In cases in which you suspect you’re justifying a decision to yourself, it may be useful to seek outside counsel from a fellow investor or executive that can do diligence on the aspect that is hard to be impartial about.

Scarcity creates FOMO

All this is compounded by the scarcity of time and resources. Even more specifically for venture investors: Fear of missing out (FOMO).

It’s easy to feel that we need to act fast and not risk losing our chance. This compounds our other cognitive challenges: our over-reliance on storytelling, our confirmation bias and our availability heuristics.

Here’s my solution:

Get to know more founders early and watch them over time — The best defense here is a strong offense, meaning to get ahead of the problem. If you are always meeting a company for the first time a few weeks before their round closes, you are doing it wrong. You have to make decisions on short notice sometimes — it’s part of what venture investing is.

However, a meaningful number of investments should be companies and teams you have become familiar with over time. Consider tracking the percentage of investments you’ve made in founders that you have known for a longer period of time. Hold yourself accountable to keep this number high.

Be clear about the investments you want to make — FOMO has the strongest effect when you don’t know what you are looking for. A lack of conviction leaves you vulnerable to thinking “oh man, this might be the next big thing I never knew about. All the big shots are on it. I better act fast!” You don’t want to be that person. Develop your own plan.

Ultimately, VCs need to ensure they aren’t falling victim to biases blinding them from good opportunities. The “no machine” mentality is real and can affect the success of your fund, reputation, and portfolio.

Take the steps to avoid this trap — whether it’s a solid filtering approach, a clear focus, a fresh perspective, or a built-in self check system.

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