Why (Private) Investors are Herd Animals

It’s a common complaint – venture investors are driven by what other investors think, and therefore lack imagination and spine.

There’s some truth to it – it is human nature, after all, to look for social proof and authority when making decisions. However, that’s not the whole story.

In public markets, Investors make their decisions to invest in parallel, and in theory, most of the relevant information about a company is publicly disclosed, by law. Businesses are also much more mature, and therefore easier to value. Finally, the market is very liquid and very deep, so there isn’t much uncertainty about the supply of money available and availability of money in the future.

In a public market, it’s unlikely that I have access to private data about a company’s prospects, and if I do, I buy or sell the stock and move the price. Your ability to act on my knowledge is zero – by the time you learn about it, it will already be built into the price.

By contrast, in private markets, there is a lot more non-public information scattered across many individuals, and they have the luxury of deciding in series. Businesses are brand new and immature, and very difficult to value. The market is shallow and illiquid, and a “Keynesian Beauty Contest” means that you want to finance a company now just because it is likely to be financed in the future.

Therefore, when you see other investors piling into a company, you can infer: – They probably know something about the company or the market that you don’t, given that a lot of the information (quality of founders, state of competition, true size of market, etc.) is private and scattered across many minds
– This company is more likely to get financed in the future, since it seems able to attract many, high quality investors (the aforementioned Keynesian Beauty Contest)
– And you *still have time to act at the same price* on this new information

That last fact more than any other causes Investors to move in herds.

It is rational for private investors to move in herds. They have the strong incentive – limited and diffuse knowledge. More importantly, they have the means – financings in which the price doesn’t change as the investors decide in series.

6 thoughts on “Why (Private) Investors are Herd Animals

  1. Sounds like this could have the unintended effects of:

    1) gaming of the system by a few influential investors to ensure that their investments are always “hot”.

    2) mini “bubbles” like the one in social networking a couple of years ago that we’re seeing popping right about now.

  2. As a result then, is it also possible that the herd is heading in the wrong direction.
    I would like to point “FourSquare” as an example. It happens to be the hottest startup around these days and there doesnt yet seem to be a compelling reason for what it offers from a business standpoint.

    Digression: Follower of Venture Hacks. Love what your doing. Hope to put it all together myself someday :)

  3. I can uartdsennd where you're coming from, but if you're unhappy here, what's the worse that will happen? You're unhappy at your next job? Don't be afraid of success! Be optimistic!

  4. I assume private investors ar eboth Angel and VC ?
    I know VC’s have a heard menthality. I suspect Angel Groups the same.
    How about individual Angels? Do they use theier network to see who else is investing too? Do “Lead Angels” take their decision individually? Some seem to do that..

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