Indexing and the Venture Capitalists

March 09, 2018

Twenty years ago, my first meeting with a venture capitalist did not go well. This wouldn't have been a problem, except my second, third, and fourth didn't go well either. When I got to my 10th strike, I realized I did not understand their thinking. At that point I did not understand that a venture capitalist might be a different genus than homo sapiens, but that's a different story.

When you are 22 years old with a resume shorter than the Lord's Prayer and are asking someone to write you a $10 million check, I learned that when they ask you a question about your business you should never answer with "it's unclear." So I hired an experienced CEO to help me, let's call him Apollo for this newsletter.

Venture capitalists would ask us questions that no human could correctly answer, and Apollo would 1. talk very loudly as if decibels predicted results and 2. answer "yes" or "oh sure" to everything they asked. It was all achievable and would be done, and soon. We would leave the meetings and I would point out to Apollo that we had zero chance of delivering any of the products he just committed to. He said it would all work out.

It didn't. After a party high above Boston celebrating the deal closing, the venture capitalists walked away without closing the deal, timing, at least of the party, that I thought odd. Apollo was soon ushered out the door and I was left to pick up the pieces.

A venture capitalist does not care about an opportunity to make 100% on their money. He or she has to pick a huge winner to offset the mediocrity in the other investments. Mediocrity is a bit kind - many of the companies they invest in are going down the flusher one way or the other, and to get good returns, the venture capitalist needs to find something like the next Google to average into the results.

One reason an index fund works is because it shares some of the characteristics of a venture capitalist, in a less extreme manner. While some of the companies in the index are not doing well, they are generally surviving. And while the winners are doing well, it's a more moderated version of success.

But you have to own the winners. And it is almost impossible, at least to those of us not named Apollo, to know this in advance. In the first 6 months of 2017, just 5 stocks out of 500 provided 28.4% of the entire gain of the S&P 500, and they were all in the tech industry (Amazon, Apple, Facebook, Netflix, and Google). Miss just one of those and your returns collapsed (In 2017, 119 members of the S&P 500 had negative returns. Someone has to make up for those slackers.) In many indexes the big returns do not come from companies with household names.

This wide diversification is fundamental to how the One Day In July model, and indexing, work. By casting a wide net, you ensure you catch the winners. Because of the dominant percentage effect of the winners relative to the others, historically an investor has ended up in a happy place in the long term.

Aah, you say. The net is wide, but how much of each fish do we collect in the catch? Do they get equal proportions, are they measured by their market size, or do their dividends determine their destiny. It's a hot area of debate, and I'll visit it in the future.

Dan Cunningham

p.s. Don't think the venture capitalists have any golden touch. Harvard Business School and the Kauffman Foundation report that the majority of venture capital funds underperform the small-cap index too.¹ In fairness, the parties are more fun.

1. https://hbr.org/2013/05/six-myths-about-venture-capitalists