A lot of VC investing is driven by cognitive bias. The bad news is that it’s a drag on return. The good news is there’s a solution. Embedding this one protocol in your portfolio monitoring framework will help the VC investor avoid the gnarliest cognitive bias traps: the Monthly Portfolio Review.
Systems Save Us From Ourselves
If you’ve ever read Atul Gawande’s The Checklist Manifesto, you’ll be familiar with the idea that a list (a system in its simplest form) provides some defense against failure — whether it be faulty memories, or human limitation stacked up against ever-increasing complexity. Or perhaps you’re a James Clear aficionado. (Who isn’t?) If so, then you’ll know: “You do not rise to the level of your goals. You fall to the level of your systems.”
“Combating Cognitive Bias Drives Alpha? Go on…”
Specific protocols within portfolio monitoring (automated data collection systems [i.e. creating a Single Source of Truth], scheduled periodic engagement, consistent analytical modeling, etc.) provide guardrails against bias. In VC as in life, cognitive bias is a problem because it distorts reality. Regular access to an accurate lens on the world gets you a steady supply of higher quality information, which gives you a shot at making better decisions. The “dispassionate investor” is receiving better, unbiased information, therefore sees the landscape more clearly, and can more efficiently capitalize upon it (a.k.a. drive alpha).
The Top 5 Offenders
- Confirmation Bias: tendency to put more weight on data that agrees with what you already believe, and to discount opinions and data that disagree.
- The Dunning-Kruger Effect: tendency in which people with low ability in a certain area overestimate their ability, while people with high ability in the same area underestimate their ability.
- The Anchoring Bias: tendency to rely too heavily on the first piece of information encountered when making decisions.
- The Halo Effect: tendency to perceive one aspect of something as being representative of the entire thing.
- Affinity Bias: tendency to prefer or attribute more value to people who are most like you. I’ll leave this chart here.
Add an MPR to Your Portfolio Monitoring Toolkit
The Monthly Portfolio Review is a must-have element of a VC’s portfolio monitoring framework. Call it whatever you like, but here are the features it needs to be impactful:
- Consistent. Don’t let busy calendars, meeting fatigue, or an overemphasis on sourcing allow this meeting to fall by the wayside.
- Diverse. The only way to combat affinity bias is to skirt it by having all kinds of people deciding.
- Data-driven. Accurate and up-to-date data on the fund, portfolio companies, and IPO/M&A market activity.
- Technical. Meaningful analyses of the high-quality data in #3, presented simply. Most important ones: scenario analysis and in-depth review of KPIs/thresholds.
- Expert. Recruit a cadre of technical (and neutral) experts in your fund’s sectors and have them attend.
- Brutally Honest. This meeting is centered around risk mitigation, and its tone should reflect that. The team should be challenged to systematically poke holes in assumptions and the fund’s thesis, using the biases as prompts. Then, craft a response to these downside risks.