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Discipline or luck, that is the question.

Various analyses suggest that there is no magic formula for achieving profitability.

There are only two ways to invest successfully. The first is to be a fortune-teller and the second is to be disciplined. This is the conclusion that emerges from a cold analysis of historical data, and it is borne out by the daily observations of those of us who are dedicated to achieving superior returns.

What is the main problem? The problem is that most investors confuse being a soothsayer with having `ideas´. If you pretend to have ideas about the future, you are playing fortune teller, and since that is impossible, you are ultimately investing in the same way as gambling in a casino, but under the guise of having a “strategy”. This is the main source of loss of return in any asset class, especially those with higher risk/reward and therefore higher dispersion of returns, such as venture capital or private equity in general.

One of the world’s most respected venture capital managers – I won’t mention his name because it’s not public – recently produced a very interesting analysis. I’ll try to explain it briefly: this manager invests in early-stage technology start-ups, to which he devotes about fifty per cent of his investment capacity. Then he focuses the other fifty per cent on the best ones. The latter is what we call follow-on investment. The companies that receive follow-on investments typically account for twenty per cent of the total number of companies that were initially invested in. Well, they took all the historical investments they had made, more than a hundred, and did the following simulation: what would have happened if, instead of making follow-on investments only in the best twenty per cent of their investees, they had spread it equally across all of them? In other words, they would not have stopped to think about which were the winners in their portfolio but would have made follow-on investments in all of them equally without worrying about it. The result was surprising: the total return of their portfolio did not change significantly. But the conclusion is valuable. Not even a manager with the most experience and the best reputation in the market can distinguish between winners and losers in a portfolio that he himself oversees because he sits on the board. Truly surprising, but above all, humbling.

Although it has nothing to do with the previous example, this one is even more surprising because it is also very much in vogue: market timing. In other words, the manager’s ability to choose the best times to enter (or exit) positions in certain types of assets. In this case, the analysis is more thorough. This is a study carried out by the University of Oxford and Chicago Booth University, led by Professor Jenkinson in 2019. In this study, they analysed the real cash flows of the private equity and venture capital portfolios of more than three thousand American and European investors in the period between 1998 and 2018. The study sought to understand whether and by how much the returns on these portfolios would have differed under different market timing strategies.

They simulated seven scenarios: investing uniformly over several years, investing with perfect timing (guessing the future), investing with the worst timing (being an ashen man), and various “ideas” based on concentrating investments according to market timing (e.g. when the stock market is rising or falling, or when fundraising is rising or falling). Again, the result was surprising. Leaving aside the guessing scenario, the best scenario turned out to be investing in a consistent and disciplined way in all periods, although similar to investing when the cycle is down (again, guessing because it is impossible to know for sure). Another humbling experience.

The investor should therefore listen more to the data and less to the market noise, have a disciplined and coherent strategy and not deviate too much from it. Any other way of investing will negative result unless you are very lucky.

Author: Francisco Velázquez, Chairman and Managing Partner