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August 4, 2005
Shotguns & Rifles in Venture Investing
I’ve been spending time lately mulling over models of shotgun versus rifle strategies in venture investing. Put differently, I’m looking at the differential performance from investing by taking a category-covering strategy (shotgun), versus being highly selective and trying to put a large amount of money in a small amount of winners (rifle).
Various funds take different approaches here, with rifle strategies having historically been more popular. Analytically, however, a shotgun strategy dominates (in a game theoretic sense) a rifle strategy in developed and reasonably-sized venture markets. The essence: When your downside is limited and your upside is wide open, putting small amounts of money into a large number of investments, and then winnowing mercilessly so that you don’t keep putting money into failing projects, is really just a credible penny option strategy.
Advocates of rifle strategies won’t buy this, of course. They say that by investing much more selectively and in larger amounts that they have more influence on their investments, that they are forced to make better choices, and they are less distracted.
Fair enough, but it is worth asking yourself how much better you have to be at investment selection to make a rifle strategy work. While your mileage may vary, my mini-Monte Carlo analysis here suggests that rife advocates need to be nearly 50% better at investment selection for that strategy to be at performance par with a broader shotgun strategy.
That should strike most reasonable people as unlikely. After all, the first two performance quartiles venture investing business are full of smart people, with deal flow to established marquee firms accounting for most of the performance difference — not better investing acumen. If you think your rifle-loving firm is 50% better at investing than your shotgun peer down the street you may be right, but more likely is that you’re just having some sort of gun fantasy.
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Although intuitively the shotgun strategy appears to be more likely to generate excess returns, it relies upon ruthlessly killing losers; something investors tend to do poorly. So...
How bad at the merciless winnowing do you have to be for the advantage to disappear?