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By Nathan Rose, Assemble Advisory
The 21st century is only halfway into its second decade, but we have already witnessed remarkable advances in every technological field. It is a cliché to say the world is changing fast – people have been saying so for at least the last 100 years. But with drones, electric cars, 3D printing, hover-boards and the sharing economy either coming or already here, people can sense that this time, it really is different. Technology is enabling an entrepreneur-led renaissance, unleashing disruptors that will touch every aspect of our lives.
With this step-change in entrepreneurship so obviously visible, it is striking that how most of us are allocating our investment dollars has barely changed at all. We still pump billions of dollars into portfolios made up, largely, of the debt and equity of large corporations – or keep it locked away in the bank at near-zero interest rates.
Any time the wisdom of stock ownership is questioned, fund managers will invariably trot out their well-rehearsed trump card: “over the long-run, equities have performed well”, probably accompanied by a chart of the S&P500 over the last 100 years that backs up their claim. But when it comes to investing, we shouldn’t care about the past, we should care about the future – and they’re not the same thing.
Nassim Nicholas Taleb brought this into sharp focus with his seminal book, The Black Swan. The title of his book comes from the belief of pre-colonial Europeans that all swans were white – that is, until Australia was discovered and the presence of black swans instantly forced a revision despite the prior data of centuries. No matter how many white swans we see, we cannot definitively say “all swans are white”. And just because we have over 100 years of backward-looking data does not mean we can declare with confidence that stocks are a good bet for the future. Disruptors could easily change that.
In Thinking Fast and Slow, author Daniel Kahneman blames a form of mental laziness called the “affect heuristic” on our tendency to extrapolate the past into the future. “Which assets will outperform in the future” is a more-difficult question to answer than “Which assets have outperformed in the past”. Our brains, finding the first question to be far too difficult, will substitute the second answer for the first question – often without knowing it.
Why has stock ownership performed so well over the course of the 20th century, and what evidence says that this good run may be coming to an end?
Ron Davison’s book The Fourth Economy conceptualizes Western economic growth over the last 700 years. In a wide-ranging study, he argues our economic progress has been defined by three distinct stages: A land-based economy until 1700, where the powerful were the kings and lords who could raise armies and acquire territory. When the industrial revolution took hold, capital became the most important factor for growth, making the banks that controlled it extremely wealthy. Around 1900, capital became easier to access and the knowledge-based economy of the 20th century took its place, meaning a shortage of educated workers who could plug into corporations.
The 20th century was exceptionally kind to big corporations. Company laws changed in all kinds of favorable ways, they were able to benefit from things like globalization to expand their reach, and the bigger they got, the more powerful they became. We had Standard Oil, General Motors, US Steel. Economies of scale ruled the day.
Investing in the stock market generally means investing in large corporations. Fund managers simply don’t have the mandate or the wherewithal to invest in small, non-listed companies in most cases. I would make the case that owning a share of a corporation in the 20th century was like owning land during the renaissance, owning capital during the industrial revolution… or owning information, big data and web traffic today – therefore the returns we saw to corporate equity in the 20th century are unlikely to be repeated in the 21st.
Davison goes on to argue that we now sit at another transition point. With college education becoming so widespread, both in the West and in the increasingly globally-connected developing world, knowledge work is becoming commoditized. The advantages that corporations enjoyed are now being dissipated among many more entrepreneurs, targeting many more niches, with very low startup costs breaking down the barriers to entry. As Silicon Valley’s Paul Graham put it, innovation has become more important than scale.
The question therefore becomes: during this time of unprecedented disruption, would you rather invest in the disruptors or the incumbents?
Until recently, this was a hypothetical question. Early stage companies could only market themselves to sophisticated / high net-worth investors, and ordinary investors could not participate. In many Western countries, equity crowdfunding legislation has changed all that. Imagine if shares in well-known disruptors like Airbnb had been up for grabs to members of the public when the company needed its first $1 million. With equity crowdfunding, this is a real possibility.
Since the eponymous book was published, the term “Black Swan” has come to be synonymous in finance circles with high-impact, seemingly-low probability events – the collapse of communism, September 11, and the credit crunch of 2008/09 being examples. Evidence shows we systematically underestimate the probability of Black Swans. Taleb himself made a fortune as a derivatives trader by employing this strategy.
Equity crowdfunding is investing with exposure to “positive Black Swans” – capped downside, virtually unlimited upside. It’s investing in the disruptors with huge ambitions that need money to bring their plans to fruition – a domain formerly restricted to angel investors and venture capitalists. The idea: own dozens of these companies, accept a relatively high rate of failure, but trust that the wins will be large.
The problem for most of us is this philosophy goes against every ounce of our nature. Our minds are generally risk-averse, and even if we understand mathematically the way the venture capital method works, we have a hard time emotionally accepting the prospect of so many losses. We prefer portfolios made up of seemingly safe assets, determining what is safe by looking at the past – but as we’ve seen, this can be a fallacy.
Of course, the “venture capital method” only works when an investor has access to a sufficiently high-quality pool of companies. If all of them fail, or the wins are not large enough, the math will not add up. As the medium is so new, equity crowdfunding has yet to deliver enough data on success rate or exit values achieved to be meaningful. The degree of curation of opportunities available, as well as the reputation of the crowdfunding portal is critical to making equity crowdfunding work for investors.
The point is, the potential is there for equity crowdfunding to give ordinary investors access to investments in the new, entrepreneurial economy. To invest in the Black Swans. And to make healthy returns in the process. In this time of unprecedented disruption, doing what we have always done will not get investors what they have always got.
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