When to Duck and When to Catch

After Google I/O, my wife and I visited my eldest, Rich, who is a graduate student at Stanford, and he suggested that we sit in on one of his lectures.  It was a treat, and not just because Professor Mehran Sahami throws candy to his students.  The class was on probability theory.  So here I was sitting at the back of a lecture hall, which I have not done for 27 years, being taught about “Modeling Uncertainty and Utility” – so, why was it such a treat?

Well, first of all, Sahami is a great teacher.  He keeps his students involved and awake, and not just from a sugar high.  He tied the subject back to the real world, talking about betting games, and micromorts, an idea core to life insurance.  It was his discussion of the behavioral aspects of utility that grabbed my attention.  Why would one person make a bet (or an investment) where the long-term average outcome (the “certain equivalent”)  makes it a “bad” bet.  Part of the answer lies in the relative amount of the bet vs. the person’s net worth and well being.  Sizing up/down the size of the bet changes the attractiveness of the bet in a way not immediately apparent from the numbers.  A billionaire is more willing than a multi-millionaire to bet $1mm for the fun of it, even if the odds do not make sense.  Psychology and Maslow’s Hierarchy need to be factored in.

The lecture made me think about the outcome of an investment in a private company.  Say that you invested $1mm 10 years ago at $1 per share and the company just had a successful IPO.  You also believe that it is capable of growing 50%  a year for next few years.  For sake of argument assume that there was no dilution and the company went public at $10 per share and traded to $15.  Assuming the market is rational (Okay, bad assumption) the stock could rise 75% a year for the next few years, if multiples do not contract.  You $1mm investment is worth $15mm today, $26mm in one year, $46mm in two year and $80mm in three years.  What is the utility value of profit?  When do you take money off the table?  Situations like this are are the subject of bar discussion by angel investors.

Sahami’s lecture helped me solve this problem.  It all depends how rich you are.  If you are just getting by, then $15mm today is very valuable to you, you can’t risk losing it (the market being irrational and all that) and so you probably sell a lot of it so that you can have money to live on.  If you are worth $100mm, you probably let it ride, not because you need it, but because of what a great story turning $1mm into $80mm would be.

This perspective helps solve another question I have been pondering as well.  If early stage venture capital and angel investor returns CAGR north of 15% (and there are a number of studies that support this view, but let’s just take it as a given) then why do more people not invest in this space?  Well, part of the answer is that if they did then the returns would not be as strong – which I wholly agree with, but part of the answer is that there is a small group of people to draw from that both have enough money to make such an investment and tie up their money for 3-8 years, but do not have so much money that the investment is too small to be worth their time.  Thus the space is left to a subset of rich angels and the handful of early stage venture capital firms such as ff Asset Management.

I was attentive throughout the class, and gained a lot from it.  We had a great weekend touring Alcatraz and walking amongst the sequoias at Muir Wood National Monument – some of these trees predate Christianity.  Both worthy uses of time, and good places to clear one’s head.  But the 50 minutes I spent listening to Professor Sahami and dodging candy was just as special.  Thanks, Rich.