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Why Early-stage Investors Tend to Trust Their Gut

“Gut feel” plays a surprisingly important role in decision making by early-stage angel investors, according to new research by Laura Huang, a Wharton management professor, and her co-author, Jone L. Pearce, a management professor at the University of California, Irvine. Huang discusses the findings of their research paper “Managing the Unknowable: The Effectiveness of Early-stage Investor Gut Feel in Entrepreneurial Investment Decisions” in this interview with Knowledge@Wharton.

An edited version the conversation appears below.

Knowledge@Wharton: Laura Huang [is here] to tell us about her new research, which has to do with investors using their “gut feel” to make important investment decisions. It’s a little bit counter intuitive — not quite what you might think investors are relying on. So we’re anxious to hear about that.

Laura Huang: The origin of this paper is that we were really interested in how investors make decisions. And this one thing kept coming up. They would talk about the size of the market; they would talk about the product. But investors kept coming back to: “Well, then I rely on my gut feel, or then I invest based on my gut feel.” I’ve even heard stories of investors just saying, “You know, I invest because I rub my tummy, and that’s how I make my investment.”

Knowledge@Wharton: Not what we would have expected.

Huang: Right. I thought that was really interesting. And I thought it was kind of critical to understand what is this gut feel that they’re referring to? And so, the paper really sought that out. First, what we wanted to do was investigate what do investors actually mean when they say that they invest based on their gut feel? And what we found was really fascinating: Not only do they use their gut feel to make their investments, but there’s actually a practical reason for why they use their gut feel. And it makes sense in terms of looking at their outcomes and how effective they are.

“I’ve heard stories of investors saying, ‘You know, I invest because I rub my tummy, and that’s how I make my investment.’”

One of the big findings of this paper, in particular, and we’re continuing some follow-on work from here, is that decisions are not all the same. We tend to think of decisions as being right or wrong. But in the entrepreneurial context, investors are very willing to be wrong. In fact, they know that they will be wrong on a lot of their investments. And so, in terms of their gut feel, it doesn’t actually make a difference in terms of being right or wrong on any one given investment decision that they’re making. But it allows them to identify the home runs.

When they rely on their gut feel, they might be wrong on a lot of different investments, but they’re actually going to more likely be able to pinpoint that home run. So if we think about it in terms of baseball averages — if your goal is to have a very high batting average, your gut feel might not be as effective. But if you’re willing to have a really low batting average, but hit more home runs, then perhaps you want to rely on your gut feel.

Knowledge@Wharton: So this is partly a strategy that works because of the level of investment — meaning it’s very early stage, when a lot of things aren’t proven and you can’t marshal all the evidence you would because this is just a new thing.

Huang: Yes, exactly.

Knowledge@Wharton: It might be the “big new thing” but it probably isn’t — but you are going to take a risk on it.

Huang: Right. We were looking at the very earliest stages of ventures — at angel investors who typically are the first external form of financing for these entrepreneurs. And you’re at this stage where, perhaps, you may have a prototype or maybe you just have a glimmer of an idea. You’re not exactly sure what the market is going to look like. There may not even be a market out there.

And so, there’s lots of hard data. There are numbers, and facts and figures that you are able to put down. But a lot of those numbers are based on estimates and hopes, and dreams and guesses. And so, that hard data is actually not as reliable to these investors as their own experience — the things that they are getting from their own mental schemes, and prototypes and mental models, that they have really developed though lots of investments. And that’s where their gut feel is coming from. And that becomes a more reliable factor to them in gauging where this is going to be in three years, five years, 10 years down the line.

Knowledge@Wharton: So, they are not just throwing darts at the dartboard — they are basing their decisions on a lot of experience. It’s more of an educated guess.

Huang: Right. We hear the term “intuition” and “gut feel,” and a lot of times we think, “Oh, this is something that is going to be very biased, or it’s going to be something that is just based on some arbitrary kind of thing.” But their gut feel is actually based on years of experience, investments that they have made that have gone well, or that have gone poorly. It’s really something that is a criterion that they rely upon and that, in fact, has a basis for this reliance.

Knowledge@Wharton: They’re pretty good at this or they wouldn’t get to keep doing it?

Huang: You know, it’s funny. Some of the investors that we looked at in one of our samples had all approximately the same amount of experience. But we’ve also done studies where we’ve looked at different levels of experience. Some that have maybe only been investors for five years, some that have been doing it for 35 years.

You do get lots of variants. For example, we had one investor who bought the house that he lives in now in Malibu off of one investments that he made, and he said: “You know, sometimes I can tell within five to 10 seconds of meeting somebody whether or not I’m going to invest in them.” And there’s others who do lots of due diligence — probably for three months, six months, however long they do and then they say: “Well, you know, throughout the course of that, it was this judgment that I had at the very end of it — that I used my gut feeling to make this investment.” So there’s all sorts of ranges of this.

Knowledge@Wharton: What are the key takeaways from your research?

Huang: I think one of the key takeaways is that this is a highly uncertain environment. There is extreme uncertainty in this environment. And so, the ways in which we think about decisions are not going to be the same based on the different contexts, right? In the entrepreneurial investment context, we are looking at this portfolio strategy where we’re not [asking whether] the decision [to invest was] a good one or not a good one. We’re really looking at it in terms of: “I’m willing to have nine really bad investments that I make and forsake those for one huge investment that turns into an extremely profitable investment for myself.” So there is this portfolio strategy. And so, decision making is going to be different based on that.

The other thing that I think was really an important takeaway from this is that there are different types of data out there. And the investors’ gut feel is actually trumping the data behind business viability — the hard data. So [information about] financials or market size, or product — their gut feel was a more important consideration to them than some of these other things…. It’s not to say that those things don’t matter, but it’s that there’s lots of different considerations, and we tend to have this very economic-driven model of how investors should make decisions, when in fact, we should consider these behavioral and micro-level influences.

Knowledge@Wharton: When you talk about the idea that these investors are maybe doing 10 investments and maybe one pays off, in general they are doing small stakes, right? They are not betting the farm on each one of these, is that correct?

“One investor said, ‘Sometimes I can tell within five to 10 seconds of meeting somebody whether or not I’m going to invest in them.’”

Huang: Right. Relative to their net worth or to their wealth, these are small stakes. So, it could be $20,000, $50,000 that they are investing, but we also are continuing to look at this in terms of follow-on investments. Do they continue to invest going forward? If you look at some of the venture capitalists — the Sequoias of the world — they are going to have a very different sort of criteria and different way of investing.

Knowledge@Wharton: So if you hit on one Instagram, even if it was only a $20,000 investment, you are not doing too badly?

Huang: Yes, these extraordinarily profitable investments are overturning things in spades.

Knowledge@Wharton: Were there conclusions from the study that surprised you?

Huang: We were a little bit surprised that gut feel had this kind of bifurcated result, where it doesn’t actually necessarily help you identify what’s going to bring you a return or not a return, but that it does have this effect in terms of identifying those extraordinarily profitable investments. That was kind of surprising because … we hear lots [about] type one, type two [kinds] of decision making, right? Do you rely on your intuition or do you rely on data? And it seems to suggest that there’s room for both.

And that it’s not quite that clear cut, where intuition is necessarily this bad thing. It does also depend on your experience. It does depend on lots of other things.

Knowledge@Wharton: So what are some practical implications? If you’re an investor, go with your gut or don’t ignore your gut entirely?

Huang: I heard this quote at one point: “Some people go with their brain and some people decide to go with their heart, and before you decide whether to go with your brain or your heart, you should decide whether you have a better heart or you have a better brain.” And so, it’s a little bit of that, right? You want to think about the criteria that you are using. You want to think about how you are making decisions.

But if you are, perhaps, a very, very early investor in terms of this is your first investment, you want to perhaps think about this and triangulate, and look at all of the different pieces of data.

Knowledge@Wharton: You don’t know how good your gut is yet.

Huang: Right, exactly. So I think that goes into it.

Knowledge@Wharton: What misperceptions would the public have about how this all works? Are they out there thinking that investing is entirely a rational process where we are just looking at the numbers and weighing things and then making the decision?

“In the entrepreneurial context, investors are very willing to be wrong. In fact, they know that they will be wrong on a lot of their investments.”

Huang: One of the things that you already touched upon is that sometimes people will see this and say, “Okay, the conclusion here is to go with your gut, right?”

And that’s not necessarily the main sort of takeaway that we would like. Gut feeling and the investor gut feel is this very complicated, sort of emotional, cognitive thing that’s happening. And so, that’s one thing to kind of consider. The other thing is that it tends to suggest that entrepreneurs can somehow game the system, that if you are able to present yourself in a certain way or cater in a certain way, that perhaps, investors will then be somehow tricked into investing in you. That’s where I am doing a lot of follow-on research with some co-authors — the influence, the impact of authenticity versus catering to what you think the investors want.

And there are lots of implications — could this introduce bias? If investors are investing based on what their gut feel is, could this maybe be a shroud for them — that investing based on their own biases or their own reasons is a cover for how they are actually investing? These are all things that I would like to continue looking at, because I think they are important to uncover.

Knowledge@Wharton: How does your research differ from other research in this area?

Huang: A lot of the research that has looked at entrepreneurial finance and the way that investors make decisions has been very macro, has been much more economically driven, looking at these hard factors. And so, this is really looking at these subtle signals and cues that are actually driving decision making. A lot of times we look at [investment] criteria and we’re actually able to map them out and very quantifiably look at them. What we’re really trying to do is take gut feel … and look at how subtle factors [like that] are actually driving a very distinct process.

Knowledge@Wharton: And you’ve alluded to a couple of areas that you are going to look at next.

Huang: I am really interested in all of these factors that are not necessarily [ones] that we typically think about — these subtle signals and cues and biases that might be driving important decisions and how that impacts both the decision making as well as the ultimate outcomes.

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