In addition to his entrepreneurial and investment successes, AngelList co-Founder Naval Ravikant is known for his philosophical musings on life, wealth creation, and happiness, which he often shares through social media. His aphorisms are widely quoted by entrepreneurs and business leaders alike, as they offer insights into the nature of success and fulfillment in life—but they are often hard to decipher. Reflecting on the growing VC bubble in 2017, Ravikant tweeted his “smart money” and “dumb money” rule with a sense of impending doom. We’re here.
In this post, I go back to the origins of the “smart money” vs. “dumb money” debate, try to answer the question “Is VC Smart Money?”, and put Naval Ravikant’s quote in the context of billions of dollars of write-offs likely to hit VC portfolios in the near future.
Is Venture Capital “Smart Money”?
In the world of finance and investment, the terms “smart money” and “dumb money” are often used to describe different types of investors. The expressions were popularized by Wall Street insiders in the 1980s and have since become part of the common lexicon in the financial industry.
“Smart Money” vs. “Dumb Money”
“Smart money” refers to investors who have a proven track record of making successful investments. These investors typically possess extensive knowledge and experience in a particular industry or market segment. They are also known for their ability to identify promising opportunities before they become mainstream.
“Dumb money”, on the other hand, refers to inexperienced or amateur investors who lack knowledge and expertise. They often invest based on hype or trends rather than careful analysis. In financial markets, “dumb money” describes retail investors, while “smart money” is intended for sophisticated institutional ones such as asset managers.
Where this term gets its meaning is that because trend-followers use different methodologies, some waiting until trends are well-established, by the time most trend-followers hop on a trend, and most aggressively, is about the time the trend is becoming exhausted.
Sentimentrader (source: dumb money confidence)
Those who coined these terms later clarified that the distinction aims not to shed a negative light on mom-and-pop investors but to analyze performance gaps between those who invest ahead of the curve and those who merely follow trends.
Are Promotion- Focused VCs the “Smart Money”?
It is tempting to call Venture Capitalists “smart money” because they are often seen as early adopters who spot tech trends before anyone else. However, the reality is that Venture Capital also has its fair share of “smart” and “dumb money”, with some investors setting trends while others follow them.
I often use E. Tory Higgins’s regulatory focus theory to frame this dynamic in Venture Capital:
- Promotion-focused Investors tend to be more risk-taking and seek out innovative startups with the potential for high-growth returns. These investors are more likely to be considered “smart money” as they are willing to take calculated risks on untested ideas
- Prevention-focused Investors tend to be more risk-averse and seek out established companies with a proven track record of success. These investors are more likely to be considered “dumb money” as they may miss out on emerging trends due to their reluctance to take risks
Another factor contributing to the categorization of “smart” and “dumb money” in Venture Capital is herd mentality. Investors often follow the lead of others rather than making independent decisions based on a thorough analysis of market conditions and individual company potential. Even sophisticated VCs are prone to building mental models that prevent them from making bold investment decisions. As I’ve shown elsewhere, the herd mentality promotes a safe environment. Veering from commonly-held beliefs is more damaging to most individuals than the gains they might make from such behavior.
For example, Bill Gurley explains how he missed the opportunity to invest in Google because he identified red flags that signaled overvaluation, which most Investors shared at the time. However, VCs at two other firms ignored these concerns and closed Google’s series A round. They made tremendous gains from such a bold move.
VC Value-Add and “Smart Money”
I believe we can extend the “smart money” and “dumb money” paradigm beyond just spotting potentially juicy investment opportunities. Contrary to public market investors, VCs have a say in the strategic direction of the startups they invest in. They often take Board seats giving them veto rights on critical decisions.
Proponents of VC’s value-add argue that Investors provide strategic guidance and mentorship to Founders, helping them navigate the complex entrepreneurial journey. Additionally, VCs often have extensive networks that can help startups connect with potential partners, customers, and talent. Finally, VCs may offer operational support on various issues, from marketing and sales to legal and accounting assistance.
70-80% of Venture Capitalists Add Negative Value To Startups.
Vinod Khosla – Khosla ventures (More here)
On the other hand, critics argue that many Venture Capitalists overpromise and underdeliver when it comes to adding value. Some investors may try to micromanage startups instead of providing helpful guidance, which can stifle innovation and creativity. Others may prioritize short-term gains over long-term growth strategies, leading startups down a path of unsustainable growth. Another argument is that many VC firms invest in multiple companies simultaneously, which means they cannot devote adequate time and resources to each startup in their portfolio.
So, is VC “smart money”?
My answer: not all of it. However, data confirms that the best VC firms persistently generate top-quartile-performing funds. Is it due to craft, luck, or other factors? Why does Naval Ravikant say that only a crash will separate “smart” and “dumb money” in VC?
How Failure Turns “Dumb Money” Into “Smart Money”
As we enter a period of economic uncertainty, it can be comforting to consider that the potential crash ahead will help Investors emerge more knowledgeable on the other side. However, turning wiser through failure is not automatic. Several factors must be present. It is pressing to address this issue now, as the Venture Capital industry may go through a downward spiral in the near future.
Will The Impending VC Doom Turn Copper Into Gold?
IVP’s Tom Loverro shook VC Twitter when he recently predicted a mass extinction event for early- and mid-stage startups. He cited several factors, including “toxic” market conditions in 2021 making future (down)rounds hard to accept, limited runway for most startups, “gun-shy VCs with alligator arms” failing to commit significant amounts, and Founders’ lack of downcycle experience.
Loverro’s predictions complement another analysis I mentioned in my webinar VC Returns: True Lies?, which shows that recent fund vintages’ reported TVPI is so high compared to historical levels that they are unlikely to produce similar DPI. In short, billions of dollars of write-offs are bound to occur across the VC industry. (If you’re unfamiliar with these terms, I encourage you to sign up for the webinar). How will GPs react?
We have an entire generation of financial innumerate GPs at VC firms.
Chamath palihapitiya – social capital (Source: All-In Podcast)
According to Chamath Palihapitiya and others who are less outspoken, the problem is that most active VCs are not up to the task due to insufficient experience with economic downturns. Investors who entered the industry after the 2008 crisis lived through one cycle only, and it went up. They lack the tools and knowledge to advise Founders of their portfolio companies with layoffs, cost-cutting, and strategic pivots.
The Covid-19 pandemic showed how ill-prepared many GPs were with downside scenarios. While some learned valuable lessons, will it be enough in the face of a more severe downturn?
Listening to a series of episodes Harry Stebbings ran for his 20VC podcast confirms this sentiment. Other VC Hall of Famers such as Bill Gurley, Doug Leone, and Keith Rabois, as well as Accel Founders Arthur Patterson and Jim Swartz, shared lessons learned from the bear markets of earlier decades. The wealth of experience they gathered battling the odds is impressive. There is no doubt these Investors bring “smart money” to the table.
However, I can’t help wondering: is the dumb-crash-smart money evolution automatic? What are the conditions necessary to learn from failure? Besides, don’t we learn more from success?
We Learn From Success, But There Are Pitfalls
Despite famous adages such as “Fail fast, fail often” and “Fall seven times, stand up eight” promoting the idea that failure should be viewed as a valuable learning experience rather than something to be feared or avoided, it is far from intuitive that we learn more through busts than booms.
Academia has long demonstrated that success is a positive outcome that reinforces our behavior.
Evolutionary biology suggests our desire for success is rooted in survival instincts. Throughout human history, those who were successful in hunting, gathering, and reproducing were more likely to survive and pass on their genes to future generations. As a result, the drive for success has become ingrained in our DNA.
Neuropsychology provides further insight into why success reinforces our behavior. When we experience success, our brains release dopamine, a neurotransmitter associated with pleasure and reward. This creates a positive feedback loop that encourages us to continue pursuing success.
Success is the enemy of learning. It can deprive you of the time and the incentive to start over. Beginner’s mind also needs beginner’s time.
Naval ravikant (Source: Also Twitter)
While success can be a powerful driver of knowledge, it can also lead to pitfalls. One such danger is complacency. Successful individuals become too comfortable and stop striving for further improvement. It can limit their learning opportunities and hinder their ability to adapt to new challenges.
Another potential pitfall is overconfidence, which may prevent them from learning valuable lessons by creating a false sense of security that inhibits self-reflection and critical thinking. When people believe that they already know everything there is to know about a particular subject or skill, they are less likely to seek out feedback or advice from others. It limits their opportunities for growth and development.
Not many successful Venture Capitalists are ready to recognize the role of luck in their performance. It’s hard to do in an industry where agents (GPs) bill principals (LPs) hefty management fees and carried interest to remunerate their purported superior flair and value-add capabilities.
A great deal of the reason why I’m here has to do with luck. I firmly believe that.
Doug Leone – SEquoia (Source: Stanford GSB)
Doug Leone, the former head of the elite VC firm Sequoia, is an exception. He readily recognizes the role luck played in his career, although he acknowledges that hustling abilities and having “big Dumbo ears” are also needed. In a recent podcast, Leone related his dazzling debut at Sequoia in the 1990s, which led him to drink the Kool-Aid of his financial savviness. As he later realized, his success had a lot to do with “riding the wave”, being at the right time at the right moment.
We learn from success, provided a set of conditions are present. Before we get to this point, we need to get to the bottom of Ravikant’s quote and analyze how failure may help turn “dumb money” into “smart money”.
How We Learn From (Bad) Experiences
Failure is often seen as a negative outcome that we want to avoid. However, research shows that failure can be an essential source of learning.
Again, this is not a given or an automatic process. There are ample reasons for individuals not to learn from their mistakes:
- Defensiveness: When individuals feel attacked or criticized for their mistakes, they may become defensive and deny responsibility or blame others instead of reflecting on what went wrong
- Fear of failure: People afraid of failing may avoid taking risks altogether or may be too hard on themselves when things don’t go as planned, preventing them from learning from their mistakes. I believe the fear of failure explains many entrepreneurial mistakes lethal to startups. I’ll get back to this notion later
- Lack of self-awareness: Some people may not realize their role in a mistake and, therefore, cannot learn from it
- Confirmation bias: People tend to seek out information that confirms their existing beliefs and opinions, which can prevent them from seeing the lessons that can be learned from a mistake. I’ve repeatedly demonstrated why confirmation bias is “VC’s poison pill“
- Overconfidence (again): Individuals who are overconfident in their abilities may believe that they are immune to making mistakes and therefore do not take the time to reflect on what went wrong
- Inertia: Sometimes people get stuck in patterns of behavior or ways of thinking that make it difficult for them to change course, even when they know they have made a mistake
Contrary to many, I don’t celebrate failure for the sake of it. Some mistakes are costly and are best avoided. As the legendary comic Norm MacDonald once said: “That which does not kill you makes you weaker, and will probably kill you the next time it shows up”. However, I recognize that failure is part of both creating companies and investing in them. The uncertainty inherent to these activities makes failure part and parcel of the journey.
What matters is to take a hard look at why mistakes happened and test another course of action the next time, in the hope of a different outcome.
If you keep making the same mistakes again and again, you aren’t learning anything. If you keep making new and different mistakes, that means you are doing new things and learning new things.
David Kelley – Stanford (Source: Harvard Business Review)
Softbank’s Masayoshi Son, who’s had some of the biggest successes and failures in the history of Venture Capital, has a healthy way of looking at it. In an interview about the WeWork debacle, he talked about recognizing one’s mistakes as a first step before moving on. They should not let Investors miss the next big thing.
We may learn from successes and failures, but what conditions are necessary for such learning? What happens in a crash, besides the technical experience gained, which may turn an average Investor into a great one?
What You Need To Do To Make “Dumb Money” Become “Smart Money”
Let’s take a detour through Israël to start answering the question. In a series of experiments with the Israëli army, researchers analyzed how soldiers performing navigation exercises over a few days were debriefed. At the after-action review, as it is called, officers focused feedback either on mistakes made only (control group) or on the causes for both successes and failures (intervention group). Two months later, the army subjected the same soldiers to the same navigation exercises. The findings are fascinating.
Robert Sutton, a renowned organizational psychologist at Stanford, concludes from these studies that after-event reviews are necessary to consolidate learnings from failure, but also success. “Don’t just gloat and congratulate yourself about what you did right; focus on what could go even better next time.” He cites Cisco as one firm systematically engaging in after-event reviews of its acquisitions. Treating their merger process “as an unfinished prototype” may explain why the company had such a streak of successful acquisitions and integrations.
These findings confirm research by two Harvard professors, Francesca Gino and Gary Pisano, who also insist that leaders must learn from success as much as from failure. Gino and Pisano list three impediments to learning, which are akin to those we discussed before: fundamental attribution errors, borne of the illusion of control I mentioned earlier; overconfidence bias, which leads us to believe we don’t need to change anything; and the failure-to-ask-why syndrome, described as “the tendency not to investigate the causes of good performance systematically”
You should use success to breed more success by understanding it.
Francesca Gino & Gary pisano – Harvard business school (source: HBR)
Drawing on numerous case studies including Ducati, Apple, and the 2008 Great Financial Crisis, Gino and Pisano come up with a five-step method to learn both from successes and failures. I believe Venture Capitalists can apply the methodology to their processes.
1. Celebrate Success But Examine It
Success should be celebrated, but not without examination. Delve into the reasons behind a win with the same rigor as you would analyze failure. This may lead to uncomfortable truths, such as success being achieved purely by chance. Learn from these insights and identify areas for improvement to replicate success in the future.
This recommendation must be the most difficult for VCs, who are often prone to laud their ability to recognize future tech leaders early or influence them to make the right decisions—failing to recognize that most similar actions with their portfolio companies did not materialize.
2. Institute Systematic Project Reviews
Companies should conduct rigorous postmortem reviews of successes and failures alike in order to identify areas of improvement. This is a challenge, as it is easy to skip the review process when things are going well. Pixar has found success with this by varying their reviews, collecting data on each production, and periodically getting an outsider’s perspective. By doing so, they can better understand their successes and weaknesses to further improve their process.
Elite Venture Capital firms conduct thorough reviews of their Investment Committee process each time they were offered to invest in, but turned down, a company that later became highly successful.
3. Use The Right Time Horizons
Industries such as pharmaceuticals and aerospace involve long feedback cycles. Without the right time frame for evaluating results, it is difficult to discern which factors lead to success or failure. To avoid being “fooled by randomness” (Nassim Nicholas Taleb), one should be aware of the time lag between action and consequence when making decisions. This will help prevent inaccurate assumptions and ensure that performance is accurately assessed.
Venture Capital also has long feedback cycles. It may be helpful to institute post-mortems at regular intervals (yearly, or every two Board meetings) to formally analyze the reasons for success or failure over the period.
4. Recognize That Replication Is Not Learning
It is important to capture and replicate good practices from successful actions. However, simply copying what worked in the past will not guarantee future success. We should apply the same root cause analysis used for problems to successes to understand which factors are within our control and which are affected by external sources.
VC Partners typically sit on a dozen Boards, which allows them to cross-pollinate ideas and best practices across their portfolio. However, they must also understand how company cultures and situations differ, so they don’t provide the wrong kind of advice.
5. If It Ain’t Broke, Experiment
Experimentation is essential for high performance and should not be abandoned after success. This process of continual refinement can be likened to engineering designs that are tested until they break. Instead of reflecting on the successes they have achieved, leaders in learning organizations should ask themselves: “What experiments are we running?”
Testing new solutions is quintessential to venture growth, the first step of which is reaching product-market fit. VCs should continuously encourage the Founders they work with to keep the testing mentality even after success is met.
Conclusion: tl;dr
This “navalism” hints at the idea that smart money is not necessarily born that way—it’s simply dumb money that has gone through a crash and come out wiser for it. The implication is that those who have experienced failure are better equipped to succeed in future investments. They better understand when to pull back and when to act on their instincts, how to weather the storm, and add value by correctly advising the Founders they invested in.
Anyone can invest during bubbles and make good returns. It’s just “dumb money”, for Ravikant. However, VCs who lose money but reflect on the reasons for failure and adapt their investment strategy in the next cycle are the “smart money”. They will be well-positioned to help entrepreneurs survive a future economic downturn. Twitted in June 2017, when every new deal seemed to blow the bubble a bit larger, Naval’s remark served as a warning for newcomers to the asset class.
Ravikant encourages Investors to learn from their mistakes to avoid making them again. His aphorism echoes findings from academic research on the necessity for after-event reviews to dissect the reasons for errors but also for what went right—thus building mental models to course-correct the next time.
