Psychology of early-stage investing (Part II)
This is part II in the series of blogs about mental models from the field of psychology which impacts an investor and how to be aware of it while making investing decisions. Click here to read Part I
In continuation of our previous blog, let me introduce you to 5 new mental models in psychology which are very important for every investor to understand.
6. Pavlovian Conditioning
We all know the story of the Russian scientist Ivan Pavlov and his experiment with dogs. He ran a bell every time just before giving food to the dog. He did this many times until the dog salivated at the sound of the bell alone without the sight or smell of food. Similarly, we are conditioned to associate “X” with “Y” despite both being independent events/actions. For eg., If we receive a deal from a successful entrepreneurs’ reference, we associate the deal to be a good quality lead. This is Pavlovian bias at play. Another example is if a startup is raising a seed round at $20 mn valuations, can we assume that is a high-quality startup? Or say if we get a Y-Combinator startup to invest in, should we assume it to be a high-quality startup? If a reputed VC is an existing investor in a startup, then should we assume it is a high-quality startup? These are the questions which early-stage investors need to answer keeping in mind the Pavlovian conditioning bias.
7. The Framing Effect
People react differently to a particular choice depending upon how it is communicated. For eg., Read the below two statements made by a startup:
> Raising $1 mn out of which $800K is closed.
> Raising $1 mn out of which $200K is the balance.
For a majority of investors, the first statement will have a more appealing and positive impact than the second one. It is similar to saying ‘99% fat-free’ rather than labeling ‘contains 1% fat’ on a product. Investors must also be careful in the way they frame their questions while evaluating a startup and apply the Framing Effect to get unbiased responses.
One way to cure the Framing Effect cognitive bias is to delegate thinking to the Reflective brain (rational, deliberate and slower mode) rather than the Reflexive brain which is more intuitive.
8. Status Quo Bias (SQB)
People have a tendency to stick with their current situation. The default setting. Humans resist change and prefer effort minimization. Thus products and processes need to be “Frictionless”. SaaS pricing models work because the default billing option is auto-renewal and we need to put in efforts to stop the renewal. In investing, SQB can result in outdated poor investments, holding on to bad investments longer than required. Investors need to back founders that challenge the status quo, simply because very few people have the guts to do so and the founder then sets a new status quo (norm), benefits of which it can reap far longer till a new entrepreneur comes to challenge the status quo again.
9. Twaddle Tendency
Charlie Munger dubs the “need to say something” when one doesn’t have anything useful to say as Twaddle Tendency. Investors come across many entrepreneurs who twaddle. Best way to cut through the twaddle is to ask “Why” a couple of times and you can see how deeply that person has thought through the problem or issue. If the entrepreneur has personally faced the problem or issue, he/she will be able to answer at multiple levels. Elon Musk uses this technique during his interview process for hiring as well.
Few other pointers to dish out twaddle are when there is an unnecessary use of jargons/keywords in the pitch deck, ideas are not presented with simplicity but have been complicated, bold unverified statements made about the market, competition or the product itself, opinions made without the support of any research work. “I don’t know” is usually the most honest and the best answer rather than Twaddle.
Investors themselves are also guilty of twaddling many times. Investors also need to understand that unsolicited bits of advice are like armpits. Everyone has one and they stink.
10. Reciprocation Tendency
Simply put, there is a strong social stigma attached to the act of not returning a favor. So if we do a ‘favor’ to someone, we expect a return in kind. This cognitive bias is used very often by salespeople where they trigger the reciprocation tendency in a customer without actually doing any favor. For eg., a salesman trying to sell you a credit card with annual charges, which you decline and so he then immediately offers you a credit card which is free of cost (after taking approval from his senior) and makes you believe that the concession is done for you only. Reciprocation tendency gets triggered and you end up keeping the credit card. This tendency can be fatal for both the investor and the entrepreneur. For eg., an investor recommends an entrepreneur to another large and reputed investor, one triggers reciprocation tendency in the entrepreneur.
There are 5 more mental models which I will cover in Part III of this series. Hope you enjoyed reading this.
To read Part I please click here.
To read Part III please click here.
I can be reached on adith@gembacapital.in. Please visit us at www.gembacapital.in
This blog series is inspired by reading the blogs at Safal Niveshak. If you wish to know more details about these mental models, then I highly recommend you to visit their blog.
Further reading on mental models can be found at Farnam Street Blog by Shane Parrish.
Few good books to read on psychology related mental models are:
> Thinking Fast and Slow By Daniel Kahneman
> Art of Thinking Clearly By Rolf Dobelli
> Predictably Irrational By Dan Ariely
> Seeking Wisdom By Peter Bevelin
> Influence: The Psychology of Persuasion By Robert Cialdini
> Antifragile By Nassim Nicolas Taleb
