I am a big fan of mental models.
Charlie Munger, Warren Buffett’s older, smarter but poorer investment partner, has long focused on the importance of mental models.
Munger says he’s rich because he identified a set of human psychological biases and applied them to investing. You can listen to the speech “The Psychology of Human Misjudgement” by Munger at Harvard University in which he describes his favorite mental models.
By definition, these mental models are what I have called the “Critically Counterintuitive.” Thanks to the newfound popularity of behavioral finance, many of these models are much better known than when Munger made his speech in 1995.
These mental models include the “Pareto principle” or the 80/20 Rule; Robert Cialdini’s “levers of influence” discussed in his classic work Influence; as well as the Nobel Prize-winning work of Princeton’s Daniel Kahneman, as discussed in his 2011 best seller Thinking, Fast and Slow.
A Mental Model for Angel Investing
Today, I rarely come across new mental models.
I did find a compelling one in Jason Calacanis’ new book: Angel: How to Invest in Technology Startups — Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000.
Jason Calacanis is one of Silicon Valley’s leading angel investors. Since starting about six years ago, Calacanis has invested in more “Unicorns” — start-ups that have achieved a valuation of $1 billion dollars — than anyone else in Silicon Valley.
There is a standard textbook definition of the distribution of returns that angel investors and venture capitalists can expect to make.
The model is as follows:
Make 10 investments. One or two of them will tank.
Six or seven will join the ranks of the “living dead” — stumbling around until the companies fold or sell themselves.
One or two investments will cover the losses in the others.
So far, so good.
So what new thing did I learn from Calacanis?
I never realized how big the returns on those 1 out of 10 (or, more accurately, 1 out of 100) successful investments could be.
Calacanis described the disparity of investment returns with an ingenious metaphor.
Baseball fans know that there is nothing better in the game than a grand slam. A bases loaded home run is worth four runs.
Calacanis says the returns on a successful angel investment are as if the rules of baseball were changed so that a grand slam is worth 100 home runs.
Put another way, a successful angel investment is worth 25 times more than the most profitable investment made under conventional rules.
And even that metaphor may be conservative.
Calacanis says he invested $25,000 in Uber at a $5 million valuation. Uber’s latest valuation stood at $70 billion. My back of the envelope calculation shows that Calacanis’ $25,000 investment is now worth $2.8 million.
That’s an astonishing 112 times return over the course of three or four years.
As Calacanis put it: once you hit a grand slam, it’s “game over.”
Keep in mind a couple of caveats.
First, the winners always jump out at you with the benefit of 20:20 hindsight.
But you still have to hit the grand slam.
Cherry picking winners to tell an Uber-type story is tempting but inaccurate.
And you have to be both lucky and smart.
Calacanis admits that he passed on investing in Twitter at an early stage.
That decision alone cost him $50 million. That’s a much bigger “loss” than his successful investment in Uber.
Second, Calacanis is adamant that you have to be at the “right place at the right time.”
And in this decade, both the place and the time are in Silicon Valley.
So Calacanis has disturbing news for the Silicon Valley wannabes of the world.
Yes, Stockholm may produce a Spotify. London/Tallinn may generate a TransferWise.
But the next Google (GOOGL) is not coming from Brazil. Global tech brands are born and bred in Silicon Valley.
Even the internet giants of China that scale hugely — Baidu (BIDU), Alibaba (BABA) and Tencent (TCEHY) — operate only in their home markets.
So if you want to play the angel investment “unicorn” game, you need to be in Silicon Valley.
Calacanis has moved promising start-ups from Shanghai to Palo Alto so that they can reach their potential.
So what’s the takeaway?
Calacanis’ mental model of “a grand slam is worth 100 home runs” may just be an extreme version of the “Pareto principle.”
Still, it communicates the potential scale of returns on winning investments in the world of high-risk angel investing.
It’s a mental model that even crusty old Charlie Munger would appreciate.
P.S. If you want to learn about my favorite investment ideas, I encourage you to check out my Smart Money Masters investment newsletter by clicking here. Among noteworthy current recommendations, I wrote about the strong potential of an auto company last month and it already is up more than 40%. An internet-related recommendation I made in February 2017 has zoomed 53%. A restaurant chain I recommended in the same month has risen 23%, while a broadband company I also wrote that my subscribers should buy that month is up 18%. As for the overall portfolio, five of my 13 current recommendations are up by double-digit percentages and 10 of them, or 76.9%, are profitable.
In case you missed it, I encourage you to read my e-letter from last week about the potential of lithium as an investment.