My friend Fred Wilson has a post up about active vs passive investing. It really got me thinking because I am seeing trends in the angel investing/early stage world that I don’t agree with. Crowdfunding has really allowed people to put capital to work in different ways. I am a big proponent of crowdfunding. But, at the same time people should understand there is no portfolio effect, or diversification effect from making lots of individual bets on startup companies.
Each new investment doesn’t diversify risk, it adds to risk. My friend Albert Wenger told me that years ago. It makes total sense and blows apart the theory that you can diversify your early stage portfolio.
There is a lot of variance in early stage investing. Each investment is independent and identically distributed. When you have the statistical condition of iid, it means you cannot pick which investment will do better than the other at an early stage. Brad Feld has said you cannot pick a billion dollar company at seed. But there are no portfolio effects under classic efficient market theory in an early stage portfolio either.
Eugene Fama wrote a paper on the Theory of Efficient Markets. His theory works. Dr. Cliff Asness studied under Fama at Chicago Booth before he went to work for Goldman, and then start his own successful hedge fund. Here is what he has to say about the theory.
Why am I so interested in this? As a floor trader I could continually beat the market. I had an artificial edge outside of my internal risk parameters. I could react faster than almost anyone else. It was a huge edge.
When I was exposed to Efficient Market Theory, I didn’t believe it at first. My friend Steve Surdell told me my eyes would be opened when I conjugated beta. In my finance class at Chicago Booth, we did just that as we learned about the Capital Asset Pricing Model (CAPM). I worked at length with my friend Michael Gibbs to really understand Fama’s theory.
Today, there is a challenge to the efficient market hypothesis. Behavior Economics challenges some of the assumptions. I blogged about that here. My feeling about Behavior Economics is very mixed. I see a lot of value in it. But, at the same time it misses the mark when it comes to investing. It makes you feel smarter than you probably are.
Today, when I actively invest, I do it when I think I have an edge. I do it when I figure out if I have some unfair advantage. That unfair advantage can manifest itself in different ways. The best unfair advantages are always investing in great people where I also have a network and expertise to help them. You cannot be more successful active investing simply by throwing money at the problem.
It has been a long journey intellectually for me to figure all these things out.