Saturday


Dollars funnel.

In my post on why the future doesn’t get funded I examined the question of unimaginative funding that locks up the better part of the world’s wealth in “safe” investments. In that post I argued that the kind of person who achieves financial success is likely to do so as a result of putting on blinders and following a few simple rules, whereas more imaginative individuals who want adventure, excitement, and experimentation in their lives are not likely to be financially successful, but they are more likely to have a comprehensive vision of the future — precisely what is lacking among the more stable souls who largely control the world’s financial resources.

Of course, the actual context of investment is much more complex than this, and individuals are always more interesting and more complicated than the contrasting caricatures that I have presented. But while the context of investment is more complicated than I have presented it in my previous sketch of venture capital investment, that complexity does not exonerate the unimaginative investors who have a more complex inner life than I have implied. Part of the complexity of the situation is a complexity that stems from self-deception, and I will now try to say something about the role of self-deception on the part of venture capitalists.

One of the problem with venture capital investments, and one the reasons that I have chosen to write on this topic, is that the financial press routinely glorifies venture capitalists as financial visionaries who are midwives to the future as they finance ventures that other more traditional investors and institutional investors would not consider. While it is true that venture capitalists do finance ventures that others will not finance, as I pointed on in the above-linked article, no one takes on risk for risk’s sake, so that it is the most predictable and bankable of the ventures that haven’t been funded that get funding from the lenders of last resort.

Venture capitalists, I think, have come to rather enjoy their status in the business community as visionaries, and are often seen playing the role in their portentous pronouncements made in interviews with the Wall Street Journal and other organs of the financial community. By and large, however, venture capitalists are not visionaries. But many of them have gotten lucky, and herein lies the problem. If someone thinks that they understand the market and where it is going, and they make an investment that turns out to be successful, they will take this as proof of their understanding of the mechanisms of the market.

This is actually an old philosophical paradox that was in the twentieth century given the name of the Gettier paradox. Here’s where the idea comes from: many philosophers have defined knowledge as justified true belief (something that I previously discussed in A Note on Plantinga). I myself object to this definition, and hold, in the Scholastic tradition, that something known is not a belief, and something believed cannot be said to be known. So, as I see it, knowledge is no kind of belief at all. Nevertheless, many philosophers persist in defining knowledge as justified true belief, even though there is a problem with this definition. The problem with the definition of knowledge as justified true belief is the Gettier paradox. The Gettier paradox is the existence of counter-examples that are obviously not knowledge, but which are both true and justified.

Before this idea was called the Gettier paradox, Betrand Russell wrote about it in his book Human Knowledge. When stated in terms of “non-defeasibility conditions” and similar technical ideas, the Gettier paradox sounds rather daunting, but it is actually quite a simple idea, and one that Russell identified with simple examples:

“It is clear that knowledge is a sub-class of beliefs: every case of knowledge is a case of true belief, but not vice versa. It is very easy to give examples of true beliefs that are not knowledge. There is the man who looks at a clock which is not going, though he thinks it is, and who happens to look at it at the moment when it is right; this man acquires a true belief as to the time of day, but cannot be said to have knowledge. There is the man who believes, truly, that the last name of the Prime Minister in 1906 began with a B, but who beleives this because he thinks that Balfour was Prime Minister then, whereas in fact it was Campbell Bannerman. There is the lucky optimist who, having bought a lottery ticket, has an unshakeable conviction that he will will, and, being lucky, does win. Such instances can be multiplied indefinitely, and show that you cannot claim to have known merely because you turned out to be right.”

Bertrand Russell, Human Knowledge: Its Scope and Limits, New York: Simon and Schuster, 1964, pp. 154-155

Of Russell’s three examples, I like the first best because it so clearly delineates the idea of justified true belief that fails to qualify as knowledge. You look at a stopped clock that indicates noon, and it happens to be noon. You infer from the hands on the dial that it is noon. That inference if your justification. It is, in fact, noon, so your belief is true. But this justified true belief is based upon accident and circumstance, and we would not wish to reduce all knowledge to accident and circumstance. Russell’s last example involves an “unshakeable conviction,” that is to say, a particular state of belief (what analytical philosophers today might call a doxastic context), so it isn’t quite the pure example of justified true belief as the others.

An individual’s understanding of history is often replete with justified true beliefs that aren’t knowledge. We look at the record of the past and we think we understand, and things do seem to turn out as we expected, and yet we still do not have knowledge of the past (or of the present, much less of the future). When we read the tea leaves wrongly, we are right for the wrong reasons, and when we are right for the wrong reasons, our luck will run out, sooner rather than later.

Contemporary history — the present — is no less filled with misunderstandings when we believe that we understand what it is happening, we anticipate certain events on the basis of these beliefs, and the events that we anticipate do come to pass. This problem compounds itself, because each prediction borne out raises the confidence of the investor, who is them more likely to trust his judgments in the future. To be right for the wrong reasons is to be deceived into believing that one understands that which one does not understand, while to be wrong for the right reason is to truly understand, and to understand better than before because one’s views have been corrected and one understands both that they have been corrected and how they have been corrected. Growth of knowledge, in true Popperian fashion, comes from criticism and falsification.

This problem is particularly acute with venture capitalists. A venture capital firm early in its history makes a few good guesses and becomes magnificently wealthy. (We don’t hear about the individuals and firms that fail right off the bat, because they disappear; this is called survivorship bias.) This is the nature of venture capital; you invest in a number of enterprises expecting most to fail, but the one that succeeds succeeds so spectacularly that it more than makes up for the other failures. But the venture capital firm comes to believe that it understands the direction that the economy is headed. They no longer think of themselves as investors, but as sages. These individuals and firms come to exercise an influence over what gets funded and what does not get funded that is closely parallel to the influence that, say, Anna Wintour, has over fashion markets.

Few venture capital firms can successfully follow up on the successes that initially made them fabulously wealthy. Some begin to shift to more conservative investments, and their portfolios can look more like the sage of Omaha than a collection of risky start ups. Others continue to try to stake out risky positions, and fail almost as spectacularly as their earlier successes. The obvious example here is the firm of Kleiner Perkins.

Kleiner Perkins focused on a narrow band of technology companies at a time when tech stocks were rapidly increasing, also known as the “tech bubble.” Anyone who invested in tech stocks at this time, prior to the bubble bursting, made a lot of money. Since VC focuses on short-term start-up funding, they were especially positioned to profit from a boom that quickly spiraled upward before it crashed back down to the earth. In short — and this is something everyone should understand without difficulty — they were in the right place at the right time. After massive losses they threw a sop to their injured investors by cutting fees and tried to make it look like they were doing something constructive by restructuring their organization — also known as “rearranging the deck chairs on the Titanic.” But they still haven’t learned their lesson, because instead of taking classic VC risks with truly new ideas, they are relying on people who “proved” themselves at the tech start-ups that they glaringly failed to fund, Facebook and Twitter. This speaks more to mortification than confidence. Closing the barn door after the horse has escaped isn’t going to help matters.

Again, this is a very simplified version of events. Actual events are much more complex. Powerful and influential individuals who anticipate events can transform that anticipation into a self-fulfilling prophecy. There are economists who have speculated that it was George Soros’ shorting of the Thai Baht that triggered the Asian financial crisis of 1997. So many people thought that Soros was right that they started selling off Thai Baht, which may have triggered the crisis. Many smaller economies now take notice when powerful investors short their currency, taking preemptive action to head off speculation turning into a stampede. Similarly, if a group of powerful and influential investors together back a new business venture, the mere fact that they are backing it may turn an enterprise that might have failed into a success. This is part of what Keynes meant when he talked about the influence of “animal spirits” on the market.

What Keynes called “animal spirits” might also be thought of as cognitive bias. I don’t think that it one can put too much emphasis on the role of cognitive bias in investment decisions, and especially in the role of the substitution heuristic when it comes to pricing risk. In Global Debt Market Roundup I noted this:

It seems that China’s transition from an export-led growth model to a consumer-led growth model based on internal markets is re-configuring the global commodities markets, as producers of raw materials and feedstocks are hit by decreased demand while manufacturers of consumer goods stand to gain. I think that this influence on global markets is greatly overstated, as China’s hunger for materials for its industry will likely decrease gradually over time (a relatively predictable risk), while the kind of financial trainwreck that comes from disregarding political and economic instability can happen very suddenly, and this is a risk that is difficult to factor in because it is almost impossible to predict. So are economists assessing the risk they know, according to what Daniel Kahneman calls a “substitution heuristic” — answering a question that they know, because the question at issue is either too difficult or intractable to calculation? I believe this to be the case.

Most stock pickers simply don’t have what it takes in order to understand the political dynamics of a large (and especially an unstable) nation-state, so instead of trying to engage in the difficult task of puzzling out the actual risk, an easier question is substituted for the difficult question that cannot be answered. And thus it is that even under political conditions in which wars, revolution, and disruptive social instability could result in an historically unprecedented loss or expropriation of wealth, investors find a way to convince themselves that it is okay to return their money to region (or to an enterprise) likely to mismanage any funds that are invested. The simpler way to put this is to observe that greed gets ahead of good sense and due diligence.

Keynes thought that the animal spirits (i.e., cognitive biases) were necessary to the market functioning. Perhaps he was right. Perhaps venture capital also can’t function without investors believing themselves to be right, and believing that they understand what is going on, when in fact they are wrong and they do not understand what is going on. But unless good sense and due diligence are allowed to supplement animal spirits, a day of reckoning will come when apparent gains unravel and some unlucky investor or investors are left holding the bag.

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Tuesday


future-next-exit

Introduction

Why be concerned about the future? Will not the future take care of itself? After all, have we not gotten along just fine without being explicitly concerned with the future? The record of history is not an encouraging one, and suggests that we might do much better if only provisions were made for the future, and problems were addressed before they become unmanageable. But are provisions being made for the future? Mostly, no. And there is a surprisingly simple reason that provisions are rarely made for the future, and that is because the future does not get funded.

The present gets funded, because the present is here with us to plead its case and to tug at our heart strings directly. Unfortunately, the past is also often too much with us, and we find ourselves funding the past because it is familiar and comfortable, not realizing that this works against our interests more often than it serves our interests. But the future remains abstract and elusive, and it is all too easy to neglect what we must face tomorrow in light of present crises. But the future is coming, and it can be funded, if only we will choose to do so.

hundred banknotes

Money, money, everywhere…

The world today is awash in money. Despite the aftereffects of the subprime mortgage crisis, the Great Recession, and the near breakup of the European Union, there has never been so much capital in the world seeking advantageous investment, nor has capital ever been so concentrated as it is now. The statistics are readily available to anyone who cares to do the research: a relatively small number of individuals and institutions own and control the bulk of the world’s wealth. What are they doing with this money? Mostly, they are looking for a safe place to invest it, and it is not easy to find a place to securely stash so much money.

The global availability of money is parallel to the global availability of food: there is plenty of food in the world today, notwithstanding the population now at seven billion and rising, and the only reason that anyone goes without food is due to political (and economic) impediments to food distribution. Still, even in the twenty-first century, when there is food sufficient to feed everyone on the planet, many go hungry, and famines still occur. Similarly, despite the world being awash in capital seeking investment and returns, many worthy projects are underfunded, and many projects are never funded at all.

safe-as-houses

What gets funded?

What does get funded? Predictable, institutional projects usually get funded (investments that we formerly called, “as safe as houses”). Despite the fact of sovereign debt defaults, nation-states are still a relatively good credit risk, but above all they are large enough to be able to soak up the massive amounts of capital now looking for a place to go. Major industries are also sufficiently large and stable to attract significant investment. And a certain amount of capital finds itself invested as venture capital in smaller projects.

Venture capital is known to be the riskiest of investments, and the venture capitalist expects that most of his ventures will fail and yield no returns whatever. The reward comes from the exceptional and unusual venture that, against all odds and out of proportion to the capital invested in it, becomes an enormous success. This rare venture capital success is so profitable that it not only makes up for all the other losses, but more than makes up the losses and makes the successful venture capital firm one of the most intensively capitalized industries in the world.

risk blocks

Risk for risk’s sake?

With the risk already so high in any venture capital project, the venture capitalist does not unnecessarily court additional, unnecessary risks, so, from among the small projects that receive venture funding, it is not the riskiest ventures that get funded, but the least risky that get funded. That is to say, among the marginal investments available to capital, the investor tries to pick the ones that look as close to being a sure thing as anything can be, notwithstanding the fact that most of these ventures will fail and lose money. No one is seeking risk for risk’s sake; if risk is courted, it is only courted as a means to the end of a greater return on capital.

The venture capitalists have a formula. They invest a certain amount of money at what is seen to be a critical stage in the early development of a project, which is then set on a timetable of delivering its product to market and taking the company public at the earliest possible opportunity so that the venture capital investors can get their money out again in two to five years.

Given the already tenuous nature of the investments that attract venture capital, many ideas for investment are rejected on the most tenuous pretexts, rejected out of hand scarcely without serious consideration, because they are thought to be impractical or too idealistic or are not likely to yield a return quickly enough to justify a venture capital infusion.

temperaments

Entrepreneurs, investors, and the spectrum of temperament

Why do the funded projects get funded, while other projects do not get funded? The answer to this lies in the individual psychology of the successful investor. The few individuals who accumulate enough capital to become investors in new enterprises largely become wealthy because they had one good idea and they followed through with relentless focus. The focus is necessary to success, but it usually comes at the cost of wearing blinders.

Every human being has both impulses toward adventure and experimentation, and desires for stability and familiarity. From the impulse to adventure comes entrepreneurship, the questioning of received wisdom, a willingness to experiment and take risks (often including thrill-seeking activities), and a readiness to roll with the punches. From the desire for stability comes discipline, focus, diligence, and all of the familiar, stolid virtues of the industrious. With some individuals, the impulse to adventure predominates, while in others the desire for stability is the decisive influence on a life.

With entrepreneurs, the impulse to adventure outweighs the desire for stability, while for financiers the desire for stability outweighs the impulse to adventure. Thus entrepreneurs and the investors who fund them constitute complementary personality types. But neither exemplifies the extreme end of either spectrum. Adventurers and poets are the polar representatives of the imaginative end of the spectrum, while the hidebound traditionalist exemplifies the polar extreme of the stable end of the spectrum.

It is the rare individual who possesses both adventurous imagination and discipline in equal measures; this is genius. For most, either imagination or discipline predominates. Those with an active imagination but little discipline may entertain flights of fancy but are likely to accomplish little in the real world. Those in whom discipline predominates are likely to be unimaginative in their approach to life, but they are also likely to be steady, focused, and predictable in their behavior.

Most people who start out with a modest stake in life yearn for greater adventures than an annual return of six percent. Because of the impulse to adventure, they are likely to take risks that are not strictly financially justified. Such an individual may be rewarded with unique experiences, but would likely have been more financially successful if they could have overcome the desire in themselves for adventure and focused on a disciplined plan of investment coupled with delayed gratification. If you can overcome this desire for adventure, you can make yourself reasonably wealthy (at very least, comfortable) without too much effort. Despite the paeans we hear endlessly celebrating novelty and innovation, in fact discipline is far more important than creativity or innovation.

The bottom line is that the people who have a stranglehold on the world’s capital are not intellectually adventuresome or imaginative; on the contrary, their financial success is a selective result of their lack of imagination.

giving_money

A lesson from institutional largesse

The lesson of the MacArthur fellowships is worth citing in this connection. When the MacArthur Foundation fellowships were established, the radical premise was to give money away to individuals who could then be freed to do whatever work they desired. When the initial fellowships were awarded, some in the press and some experiencing sour grapes ridiculed the fellowships as “genius grants,” implying that the foundation was being a little too loose and free in its largesse. Apparently the criticism hit home, as in successive rounds of naming MacArthur fellows the grants become more and more conservative, and critics mostly ceased to call them “genius grants” while sniggering behind their hands.

Charitable foundations, like businesses, function in an essentially conservative, if not reactionary, social milieu, in which anything new is immediately suspect and the tried and true is favored. No one wants to court controversy; no one wants to be mentioned in the media for the wrong reason or in an unflattering context, so that anyone who can stir up a controversy, even where none exists, can hold this risk averse milieu hostage to their ridicule or even to their snide laughter.

Who serves on charitable boards? The same kind of unimaginative individuals who serve on corporate boards, and who make their fortunes through the kind of highly disciplined yet largely unimaginative and highly tedious investment strategies favored by those who tend toward the stable end of the spectrum of temperament.

Handing out “genius grants” proved to be too adventuresome and socially risky, and left those in charge of the grants open to criticism. A reaction followed, and conventionality came to dominate over imagination; institutional ossification set in. It is this pervasive institutional ossification that made the MacArthur awards so radical in the early days of the fellowships, when the MacArthur Foundation itself was young and adventuresome, but the institutional climate caught up with the institution and brought it to heel. It now comfortably reclines in respectable conventionality.

clock with dates

Preparing for the next economy

One of the consequences of a risk averse investment class (that nevertheless always talks about its “risk tolerance”) is that it tends to fund familiar technologies, and to fund businesses based on familiar technologies. Yet, in a technological economy the one certainty is that old technologies are regularly replaced by new technologies (a process that I have called technological succession). In some cases there is a straight-forward process of technological succession in which old technologies are abandoned (as when cars displaced horse-drawn carriages), but in many cases what we see instead is that new technologies build on old technologies. In this way, the building of an electricity grid was once a cutting edge technological accomplishment; now it is simply part of the infrastructure upon which the economy is dependent (technologies I recently called facilitators of change), and which serves as the basis of new technologies that go on to become the next cutting edge technologies in their turn (technologies I recently called drivers of change).

What ought to concern us, then, is not the established infrastructure of technologies, which will continue to be gradually refined and improved (a process likely to yield profits proportional to the incremental nature of the progress), but the new technologies that will be built using the infrastructure of existing technologies. Technologies, when introduced, have the capability of providing a competitive advantage when one business enterprise has mastered them while other business enterprises have not yet mastered them. Once a technology has been mastered by all elements of the economy it ceases to provide a competitive advantage to any one firm but is equally possessed and employed by all, and also ceases to be a driver a change. Thus a distinction can be made between technologies that are drivers of change and established technologies that are facilitators of change, driven by other technologies, that is to say, technologies that are tools for the technologies that are in the vanguard of economic, social, and political change.

From the point of view both of profitability and social change, the art of funding visionary business enterprises is to fund those that will focus on those technologies that will be drivers of change in the future, rather than those that have been drivers of change in the past. This can be a difficult art to master. We have heard that generals always prepare for the last war that was just fought rather than preparing for the next war. This is not always true — we can name a list of visionary military thinkers who saw the possibilities for future combat and bent every effort to prepare for it, such as Giulio Douhet, Billy Mitchell, B. H. Liddell Hart, and Heinz Guderian — but the point is well taken, and is equally true in business and industry: financiers and businessmen prepare for the economy that was rather than the economy that will be.

The prevailing investment climate now favors investment in new technology start ups, but the technology in question is almost always implicitly understood to be some kind of electronic device to add to the growing catalog of electronic devices routinely carried about today, or some kind of software application for such an electronic device.

The very fact of risk averse capital coupled with entrepreneurs shaping their projects in such a way as to appeal to investors and thereby to gain access to capital for their enterprises suggests the possibility of the path not taken, and this path would be an enterprise constituted with the particular aim of building the future by funding its sciences, technology, engineering, and even its ideas, that is to say, but funding those developments that are yet to become drivers of change in the economy, rather than those that already are drivers of change in the economy, and therefore will slip into second place as established facilitators of the economy.

open door on road

What is possible?

If there were more imagination on the part of those in control of capital, what might be funded? What are the possibilities? What might be realized by large scale investments into science, technology, and engineering, not to mention the arts and the best of human culture generally speaking? One possibility is that of explicitly funding a particular vision of the future by funding enterprises that are explicitly oriented toward the realization of aims that transcend the present.

Business enterprises explicitly oriented toward the future might be seen as the riskiest of risky investments, but there is another sense in which they are the most conservative of conservative investments: we know that the future will come, whether bidden or unbidden, although we don’t know what this inevitable future holds. Despite our ignorance as to what the future holds, we at least have the power — however limited and uncertain that power — to shape events in the future. We have no real power to shape events in the past, though many spin doctors try to conceal this impotency.

Those who think in explicit terms about the future are likely to seem like dreamers to an investor, and no one wants to labeled a “dreamer,” as this a tantamount to being ignored as a crank or a fool. Nevertheless, we need dreamers to give us a sense as to what might be possible in the future that we can shape, but of which we are as yet ignorant. The dreamer is one who has at least a partial vision of the future, and however imperfect this vision, it is at least a glimpse, and represents the first attempt to shape the future by imagining it.

Everyone who has ever dreamed big dreams knows what it is like to attempt to share these dreams and have them dismissed out of hand. Those who dismiss big dreams for the future usually are not content merely to ignore or to dismiss the dreamer, but they seem to feel compelled to go beyond dismissal and to ridicule if not attempt to shame those who dream their dreams in spite of social disapproval.

The tactics of discouragement are painfully familiar, and are as unimaginative as they are unhelpful: that the idea is unworkable, that it is a mere fantasy, or it is “science fiction.” One also hears that one is wasting one’s time, that one’s time could be better spent, and there is also the patronizing question, “Don’t you want to have a real influence?”

There is no question that the attempt to surpass the present economic paradigm involves much greater risk than seeking to find a safe place for one’s money with the stable and apparent certainty of the present economic paradigm, but greater risks promise commensurate rewards. And the potential rewards are not limited to the particular vision of a particular business enterprise, however visionary or oriented toward the future. The large scale funding of an unconventional enterprise is likely to have unconventional economic outcomes. These outcomes will be unprecedented and therefore unpredictable, but they are far more likely to be beneficial than harmful.

There is a famous passage from Keynes’ General Theory of Employment, Interest and Money that is applicable here:

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

John Maynard Keynes, General Theory of Employment, Interest and Money, Book III, Chapter 10, VI

For Keynes, doing something is better than doing nothing, although it would be better still to build houses than to dig up banknotes buried for the purpose of stimulating economic activity. But if it is better to do something than to do nothing, and if it is better to do something constructive like building houses rather than to do something pointless like digging holes in the ground, how much better must it not be to build a future for humanity?

If some of the capital now in search of an investment were to be systematically directed into projects that promised a larger, more interesting, more exciting, and more comprehensive future for all human beings, the eventual result would almost certainly not be that which was originally intended, but whatever came out of an attempt to build the future would be an unprecedented future.

The collateral effect of funding a variety of innovative technologies is likely to be that, as Keynes wrote, “…the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” Even for the risk averse investor, this ought to be too good of a prospect to pass up.

vision

Where there is no vision, the people perish

What is the alternative to funding the future? Funding the past. It sounds vacuous to say so, but there is not much of a future in funding the past. Nevertheless, it is the past that gets funded in the present socioeconomic investment climate.

Why should the future be funded? Despite our fashionable cynicism, even the cynical need a future in which they can believe. Funding a hopeful vision of the future is the best antidote to hopeless hand-wringing and despair.

Who could fund the future if they wanted to? Any of the risk averse investors who have been looking for returns on their capital and imagining that the world can continue as though nothing were going to change as the future unfolds.

What would it take to fund the future? A large scale investment in an enterprise conceived from its inception as concerned both to be a part of the future as it unfolds, and focused on a long term future in which humanity and the civilization it has created will be an ongoing part of the future.

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