Avoiding cognitive biases when investing in startups
You walk into your first pitch night. The room is alive and buzzing with people anticipating seeing solutions that will shape the future. After chatting with a few participants, you sit down with a cup of coffee to hear the first pitch. The energetic founders start engaging your interest and it’s hard to resist the sparkle in their eyes as they share their vision. Cue the magical music because their ideas have captured you and you’re swimming in their passion. It feels like it's meant to be! You want to fund their venture and join the journey.
Look around, who else is hearing the music? Tapping their feet to the beat, nodding their heads as if they’ve made a connection. You may have just applied some cognitive biases to what you’ve heard and you need to take a moment to add some objectivity to the mix.
What are cognitive biases, why should you be aware of them and what do they have to do with angel investing?
Cognitive biases involve irrational errors in decision making and can affect the way one invests and judges an opportunity. It is critical to be aware of being influenced by them in making impulsive decisions as an angel investor. We have listed a few biases that may cloud your judgement at a vibrant pitch session.
Emotions drive many of the decisions we make but when you are listening to a startup pitch, you need to exercise caution around your feelings. This bias will have you making a quick decision to commit based on the good feeling the pitch gave you. The founders have likely touched on one of your passions, deeply inspired you or wowed you with their mission and approach. Good feelings can have you underestimating the risks associated with an investment decision.
An incredible pitch was made with strong concepts. Well done to the founders, you are captivated by what’s been shared, but ignore or are not aware of the whole picture. Important that we see the wood from the trees. See the pitch in context, assessing that which was said and that which wasn’t.
A startup’s pitch may pull the strings on your pre-existing beliefs. You may fully believe in a startup’s vision and hope that this idea will work. Unfortunately, this is not the only indicator for a good investment.
Loss or Regret Aversion
In line with the popular hashtag #FOMO (fear of missing out), this bias will have you fearful of missing out on an opportunity. You're afraid that you will regret taking a pass on this pitch. What if they are an incredible success and transform their space? They could very well be but it’s best to focus on business fundamentals.
Angel investing is an extension of entrepreneurship, you have to be optimistic to play with the crazies. Optimism, however, can work against you when it comes to angel investing. You may assume your choices are more likely to work than that of others. Our take when it comes to angel investing: add a spoon of realism, objectivity and pragmatism to the optimism.
This term may fit well into the gambling arena and rightfully so. It describes the belief that a person who has experienced success in a random event is more likely to experience the same success in future events. Similar to the optimistic bias, this line of thinking has an investor believing that they are on a lucky streak. You have had great things happen for you up to this point, so how could your impulsive choice on a startup go wrong? In reality, this constitutes an uninformed choice.
This bias involves us calculating the probability that a startup will succeed based on a comparable known situation. The danger with this approach is the likelihood to make an incorrect judgement. Even though two companies can be compared for their services or marketing strategy, their probabilities to succeed cannot. You can’t drive looking in the rearview mirror.
Biases are part of the human experience; we are all guilty of exercising them when making decisions. An important lesson for an angel investor is to be aware of them. In addition, an investor needs to be honest about the impact of a bias on the decision they are leaning toward. It would be good practise for an investor to run their thoughts by an objective person to get a clearer and more rounded view. This is one of the benefits of being part of an angel network. The music is magical in the startup space, just make sure you’re not the only one hearing it.