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ISSUE 13, JULY 2017 - GUT INSTINCT WITH SCIENCE

Apply scientific thinking to the art of entrepreneurial investments

by Dr. Jack Hong, Research Room Pte. Ltd.  |  www.researchroom.sg

 

Entrepreneurship and gut instincts

Entrepreneurs are a breed of people who excel at economic value creation, and observers typically characterize them by mastery of some skills, such as identifying opportunities, internalizing risks, organizing resources, and executing plans swiftly and decisively. Personally, I like how John Maynard Keynes uses the term “Animal Spirits” to describe the gut instincts that compel people to make decisions under uncertainty. Entrepreneurs have more affinity to this phenomenon than others, and this manifests as two dominant traits of entrepreneurship: 1. not averse to risk-taking, and 2. the urgency to get things done.

Having “animal spirits” is necessary, but insufficient, for entrepreneurs to make good investment decisions. By good investments, we mean allocating capital into business opportunities that provide acceptable levels of returns. The good news is that there is a benchmark for us to refer. The not so good news is that everybody’s acceptable level is different. In this article, I will introduce the scientific thinking for making investment decisions, to help entrepreneurs make objective investment decisions.

Financial economics, the science of making investment decisions

The science of making investment decisions is called Financial Economics, a branch of economics that studies decisions relating to money. Many of you are acquainted with economics principles relating to allocation, or choice combinations, of goods and services in a single period. For example, most people examine demand and supply of a certain commodity within a snapshot in time. In comparison, financial economics examine the value of this commodity over time, into the future.

In business, we say that time = money. Economists agree that time cannot be free, and they call the cost of time the interest rate. Imagine you have S$100. You can choose to spend it now on something you like, or you can keep it and spend it one year later. Given what we know about human behavior, delayed gratification is painful. Thus, keeping the money incurs the cost of delayed gratification, and we will be less happy than if we were to spend the money now. However, if there is a reward for saving that exceeds the cost of delayed gratification, then people will choose to save. Recall that I mention that everybody’s level of required return is different? In this example, because everybody’s level of pain from delayed gratification is different, therefore the more painful it is, the higher the required level of rewards.

The universal benchmark for investment decisions

Despite the fact that everyone’s required level of investment returns is different, there is a common agreement as to what the lowest level should be. Economists call it the risk-free rate. It is a level of monetary returns (almost) guaranteed to anybody who parks their money in such investments. Examples are savings/fixed deposits, and highly rated government bonds.

Since investors can store their money in such investments, do nothing about it, and is (almost) guaranteed a promised level of returns, there is no reason to participate in any endeavors that promise you lesser. The risk-free rate is the universal benchmark for the lowest expected investment returns.

But the investment returns from risk-free instruments are unattractive

Investment returns over and above the risk-free rate are known as risky returns, simply because the originators of such investment opportunities cannot guarantee this level of returns. Take a good company, like Apple, for example. Investing in Apple’s stocks avails us to two types of returns: capital appreciation from stock price movements; and dividends from Apple’s annual profits. The actual returns that investors receive are highly dependent on macroeconomic, industry, and company-specific conditions. The joint uncertainty of such conditions implies that the actual returns on our Apple investments can vary. The magnitude of such possible deviations is what economists call volatility. Volatility increases with uncertainty, and since uncertainty is undesirable, volatility is a risk.

Recall our delayed gratification example from before: people will demand higher returns to higher levels of pain. In the same spirit, investments with higher volatility (risks) have to promote higher levels of returns before people are willing to risk their money on it. Since such returns are uncertain, economists aggregate the various probabilities of realizations into a number called the expected return. If an investment has a 50% probability of returning S$1 and a 50% probability of returning nothing, then the expected return is S$0.50. This economics concept is the intuition behind the phrase “Higher risks = higher expected returns.”

Relating back to entrepreneurial activities

There are two scientific principles that entrepreneurs have to keep in mind:

There is a cost to time.

Higher uncertainty must commensurate with higher expected returns.

We have worked with many entrepreneurs over the years, and we deeply admire them for the passion in their visions, missions, and actions. However, we also notice that their passions can sometimes turn into over-confidence, which cloud their judgment when it comes to evaluating the alternative uses of capital.

The first mistake is to think that capital is free. Although the company does not have to pay interests on capital as loans do, using the capital to undertake in-house projects incurs opportunity costs. We could measure the opportunity costs by examining the highest expected returns if we were to invest the capital in something else. We should deploy capital to other similar investment opportunities in the market (either private or public) that provide higher returns, rather than undertaking in-house projects.

The second mistake is to underestimate the risks of projects under the entrepreneur’s control. It is related to behavioral biases such as the illusion of control and optimism bias. The former bias describes the tendency for people to overestimate their ability to control random outcomes, and the latter describes a person’s belief that they are less likely to experience a negative event compared to others.

Both mistakes combine and result in capital investments into projects that have higher risks, lower returns, and insufficient compensation for the cost of opportunity.

An objective method to estimate the required returns for a risky project is to examine the returns of publicly listed companies that undertake similar tasks. This method is objective because the company is under the continuous scrutiny of many stakeholders in the stock market, which includes informed participants such as financial institutions, professionals, and regulatory agencies. Other than publicly listed companies, the entrepreneur can further inform themselves by looking at similar deals in the private equity and venture capital markets.

Unless the entrepreneur has core competencies and unique selling points that exceed current endeavors in the market,  they would be better off investing their capital into these endeavors instead.

 

About the writer:

Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organizations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).

Last updated on 19 Jul 2017 .

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