Tuesday, May 16, 2017

"Enrico Fermi and the future of venture capital" (bet sizing, Kelly criterion, mastery, complexity etc)

From TechCrunch:

Enrico Fermi tore a large sheet of paper into small pieces and dropped them. A few seconds later, the pieces were blown a short distance in midair and landed some eight feet away.

Fermi paced the distance, then consulted a chart he prepared earlier. Based on the corresponding data, he told the people around him that the shockwave that hit the air to blast the papers out was from a force of roughly about 10 kilotons of TNT exploding.

On that cool morning in July 1945, Fermi and his colleagues tested the very first atomic bomb. The blast magnitude was later calculated to be 20 kilotons. That won Fermi the betting pool started by senior physicists in the project.

Once again, Fermi was correct in his guess using such a mundane test for such a complex problem. “The Pope of Physics”, his colleagues called him, for they said he was infallible, like the Pope.
No matter what the problem, not only he solved it, but he made it look effortless. But Fermi possessed no superhuman powers. He studied the fundamentals of physics and mathematics from a very young age and mastered them. Only after that, he could solve these problems with such ease.
Over the next several decades, the study of complexity progressed and extended into numerous problem domains and industries. Nobel prizes were awarded to the frontier academic leaders studying the space, starting with Herbert Simon in his groundbreaking work called “bounded rationality”.

Simon simply stated that humans are “bounded” by either the limited information they receive or the limited capacity to process vast information, therefore end up “satisficing” their decisions, choosing the best alternative on what they later identify as “gut feeling.”

Gut-feeling was all Arthur Rock and Tom Perkins had in the early days of venture investing when capital was scarce, deal flow was small, and historical data was non-existent. This scarcity led to meticulous efforts in as they discovered and funded the leading companies of the future. As venture firms building on the examples of these legends, they’ve maintained the heuristic driven strategy.
Over the next 50 years, the number of deals to choose from kept increasing exponentially and the decision process became highly prone to biases. Decision biases eventually chipped away from superior fund-level returns once delivered by the Rock’s and the Perkins’s.

Perhaps the venture capital industry became too complacent in its decades old strategies as top firms faced no shortage of capital flowing into their consecutive funds. Still, heuristics stayed as the de-facto strategy mostly because venture capital is inherently complex.

Samuel Abresman describes complexity thoroughly in his book Overcomplicated.
In a complex system, he explains:
The parts themselves need to be connected and interacting together in a tumultuous dance. When this happens, you see certain characteristic behaviors, hallmarks of a complex system: small changes cascade through this network, feedback occurs in the complex system, and there is even a sensitive dependence on the initial state of this system. These properties, among others, take a system from complication to complexity.
Peter Tetlock and Dan Gardner explain methods of attacking such complex problems in their remarkable book called Superforecasting: The Art and Science of Prediction. Not surprisingly, we find Enrico Fermi at the core of this book....

As noted in last year's "Global Macro: There Are Many Ways To Approach It, Here's A Good One":
...The key is to have enough exposure to your subject that your understanding is innate, that you don't have to consciously think "Now when interest rates go down, bonds go up". When you've achieved this level of mastery you immediately sense when the presented facts aren't conforming to the mental model and may be worth further scrutiny....