“You have to figure out where you have an edge.” – Charlie Munger
In investing, an “edge” is something that gives you an advantage over other investors. Your edge is what allows you achieve above-average returns and beat the average investor.
Investors can have numerous different edges, such as more accurate information, better insights, proprietary trading algorithms, or larger networks that enables them to access more deals. Often, the best investors have multiple edges that they use to outperform others.
The question I was curious about was whether all great investors shared a common edge. Was there a common denominator?
Sequoia Capital is one of the world’s preeminent venture capital investors. Since 1972, they have invested in over 1,000 companies, hitting numerous homeruns including: Google, Apple, Instagram, and YouTube. The current combined market value of Sequoia’s backed ventures is over $3 trillion.
What makes Sequoia such a great investor? How is it able to achieve exceptional results consistently? What is it’s edge?
Undoubtedly, the investors at Sequoia have numerous edges: their reputation gives them access to deals first; their signalling status causes other investors to bid up the next rounds to join them; their partners have deep domain expertise resulting in unique insights; and their lucrative past performance has resulted in patience and trust from their LPs.
But I would argue that it is the courage of the folks at Sequoia that makes them some of the world’s best investors. In fact, I would argue that courage is the common denominator among all great investors.
Willingness To Be Wrong
At its core, the purpose of investing is to allocate capital to achieve a profit in the future. Investors are measured by one criterion—the larger the profits you produce and the more consistently you produce them, the better you are.
In investing, the biggest rewards happen when you are right and everyone else is wrong. This is the hallmark of a great investor.
When the crowd holds the same beliefs about the future returns of an asset as you do, this upside is captured in the current price. In other words, the current price of the asset will be equivalent to the expected future return. This strategy results in average returns, which is the antithesis of a great investor.
To produce exceptional returns, you need to have a contrarian viewpoint. But being a contrarian is difficult for two reasons:
(1) the crowd is more right than wrong, so you can’t consistently be contrarian and expect to win; and
(2) your errors are magnified when everyone else is right and you are wrong, and we care more about avoiding being wrong (loss avoidance) than about being right.
The decision matrix looks something like this:
So, most people choose to bet with the crowd. But betting with the crowd produces average results. To be a great investor, you need to be willing to bet against the crowd. And that takes courage.
A Carton Full Of Broken Eggs
Before Instacart, there was Webvan.
Webvan was the first company that promised to revolutionize the business of grocery shopping by leveraging the Internet. The company was founded in 1996 during the heyday of the dot-com bubble.
In 1997, Michael Moritz of Sequoia Capital led Webvan’s Series A financing. Sequoia was convinced that this was a revolutionary idea and that Webvan would run away with the market. In total, Sequoia committed north of $50m of capital to Webvan.
By 2001, Webvan had failed and filed for bankruptcy. Sequoia, along with numerous other VCs, were wrong and lost millions.
Twelve years later, in 2013, a similar looking business emerged trying to raise money—Instacart. Having learned their lesson, most VCs were skeptical and passed. The consensus view among investors was that the grocery delivery business was too capex heavy and operationally difficult to execute.
But not Moritz and the Sequoia team. They reviewed Instacart and felt that their thesis from 2001 still held true. Sequoia emerged as the lead investor in Instacart’s Series A financing, committing $8.5 million.
In a colorful quote, Moritz explained his rationale for investing in Instacart:
“Having been involved in Webvan, Sequoia is painfully familiar with what it takes to be successful in the grocery delivery business. Until we encountered Instacart, we had still been receiving outpatient therapy for our Webvan fiasco but the doctors say – and we agree – that because of advances in technology and a most imaginative approach, there is little danger of a relapse.”
What is most remarkable about this story, and why the folks at Sequoia are great investors, is the courage they showed. Having been publicly wrong once, Sequoia still had the courage to invest in the grocery delivery space again.
They were willing to bet against the crowd of other VCs who passed on the opportunity. And they were rewarded for it—Instacart is now valued north of $18 billion with plans for an IPO.
Courage As An Edge
Great investors have a plethora of edges that they use to outperform, and these edges differ from one great investor to another. This is why numerous styles of investing produce stellar results. But the common denominator found amongst all great investors is courage.
Because lacking courage negates all of your other edges.
Recall that great investing requires being right when everyone else is wrong, and having an edge helps you identify such situations. But if you lack the courage to act, it doesn’t matter how many edges you have. Your domain expertise, long-term capital, unique insights, and access to deal flow won’t matter if you don’t have the courage to bet against the crowd when you need to. If you operate based purely on the wisdom of the crowd, you will have no edge.
Foundations Of Courage
“When views are truly contrarian, they are inevitably uncomfortable. Courage and the ability to withstand pain are required.”- Michael Steinhardt
Sequoia’s story highlights the importance of courage, but it doesn’t tell us what the source of courage is.
I have no objective answer to this; I can only draw on my own experience.
The few times that I was courageous enough to bet against the crowd, my courage was rooted in A) the decision-making process I used to arrive at my conclusion and B) ensuring I survived in the likely event that I was wrong.
Confidence In Being Correct
Courage requires you to have confidence in the decision-making process used to arrive at your conclusion. This requires you to be an independent thinker, do your own due diligence, develop a unique view of how the world works, and stress-test your thinking. The better you are at doing these things, the more confident you will be in your conclusion.
“I learned a great fear of being wrong that shifted my mind-set from thinking I’m right to asking, How do I know I am right? And I saw clearly that the best way to answer this question is by finding other independent thinkers who are on the same mission as me and who see things different from me. By engaging them in thoughtful disagreement, I’d be able to understand their reasoning and have them stress-test mine. That way we can all raise our probability of being right.” – Ray Dalio
Avoidance Of Ruin
To foster the courage to bet against the crowd, you must be confident that you will survive when you are wrong.
The odds are that when you bet against the crowd, you will be wrong. If the consequences of being wrong are unbearable, the risk is not worth taking. So, you need to ensure that the bets you place are measured and that in the likely event that you are wrong, you will live to see another day.
A simple way of thinking about this from an investing perspective is to only bet what you can afford to lose. This way your downside is capped, but your upside is unlimited.
With full transparency, I have bet against the crowd only a handful of times with one positive outcome to date. The remaining bets are still too early to call, but I’ll consider any losses that I face as the Webvan to my future Instacart.
Notes, Inspirations & Additional Readings:
- Thanks to Charlotte, Kerri and Jesse for their review and feedback.