The Babe Ruth Effect

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Hey friends đź‘‹ ,

Happy Monday and welcome to the second issue of Through the Noise!

What a crazy week it's been– 1,063 of you have joined the party since last Monday (🤯).

It's time to strap in and enjoy.

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The Babe Ruth Effect

In 1923, Babe Ruth broke the record for most home runs in a season. But in that same year he struck out more times than any other player in Major League Baseball. This is how swinging for the fences creates the best investors in the world.

Babe Ruth had a total of 1330 strikeouts in his career. This is a record that would remain unbroken for 30 years. His fearlessness led to him achieve 714 career home runs across 22 seasons. Ruth was the first player to hit 60 home runs in one season, a record that endured 34 years until Roger Maris broke it in 1961. Ruth's famous words:

"How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big."

Even though Ruth struck out a lot, he was one of baseball’s greatest hitters. The "Babe Ruth effect" occurs in many categories of investing, betting and gambling but is most pronounced in VC. Venture investing is no easy way to make money– it requires big wins to make the model work. These big wins can be taken as "outliers".

A Game of Outliers

When constructing a venture portfolio, you look for deals that can return the fund. To quote Fred Wilson on the dynamics of an early stage venture fund:

  • Lose money on 1/3 of its investments.

  • Breakeven (or small return) on 1/3 of its investments.

  • Make good money (5-10x) on 1/3 of its investments.

However the reality is even more stark than this. Wilson mentions that every good venture fund he has been involved in or witnessed had one or more investments that paid off so large that one deal single handedly returned the entire fund.

An outlier is a data point in a set of other data points that differs significantly. In statistics they’re viewed as experimental error. VC is a game of outliers.

Home Runs, Not Averages

There is a central understanding within venture portfolio construction that the majority of a fund's return will be generated by a very small number of portfolio companies. This leads to two implications:

  1. Every deal needs to have the potential to return the fund (home run)

  2. Forget about failed investments

In Chris Dixon’s article, “Performance Data and the Babe Ruth Effect in Venture Capital,” he mentioned how our human adversity to taking losses is an innate mechanism:

Behavioural economists have famously demonstrated that people feel a lot worse about losses of a given size than they feel good about gains of the same size. Losing money feels bad, even if it is part of an investment strategy that succeeds in aggregate.

However in VC, this way of thinking is entirely wrong. Ruth's 714 home runs to 1330 career strikeouts showed that the latter don't matter...

Forget the Strikeouts

Correlation Ventures takes a data-driven approach to investing. They released a study that showed the distribution of outcomes across 21,000+ financings from 2004-2013. In comparison to the 1/3, 1/3, 1/3 model by Fred Wilson, 65% of VC deals returned less than the capital that was invested in them. Wilson's model presents a brighter picture of VC than what reality suggests.

The best funds have more strikeouts than average funds. Further to this, the number of failed investments made by VCs does not affect the fund's overall performance.

The reason why Ruth has such a relevant link to VC lies in his batting style. Even though he was known for many years as the "King of Strikeouts", in the end this didn't matter. VC returns are driven by the few home runs that produce outsized returns, not the failed investments.

Yet a dangerous trend with new funds is attempting to emulate the investing strategy of big hitters such as a16z or Sequoia. Whilst "unicorn fever" is tapering from an all time high, funds must focus on thesis and a competitive offering to achieve high multiples upon exit when returning the fund. The great investors do this, all whilst building a portfolio with proper risk and reward to increase the likelihood of home runs throughout market cycles.

Conclusion

Strikeouts don't matter. Home runs do. To quote the great Charlie Munger:

"I didn’t get to the top where I am by going after mediocre opportunities."

But there is a clear tradeoff here. Most people want to hit home runs, the problem is they are afraid of striking out in order to get there. The risk-return tradeoff is a fundamental investment principle that creates two distinct categories of investors.

The first investor creates consistent, reliable returns that doesn't strikeout often. In turn they don't hit many home runs yet mitigate their risk profile.

The second investor swings for the fences. They take outsized bets from a sound strategy with a willingness to strikeout for a higher potential reward.

As with all things in life, there is a balance to be found.

In Fred Wilson's blog post from 2008 he mentions:

"If you try to hit every one out of the park day one, you’ll strikeout way too much and the fund won’t work out very well."

When you do strikeout, don't let it overwhelm you. The best investors have struck out many times: they learned principles from their failures, repositioned themselves and tried again.

Never let the fear of striking out keep you from playing the game.

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Through the Noise Podcast

E2: Barrett O'Neill - High Tech vs Tech-Enabled Startups

This week we recorded the second episode of the Through the Noise podcast.

Our guest was the Co-Founder of OnDemand Storage, a technology based storage company and ex-Bain Capital Barrett O'Neill.

One big takeaway: storage is sexier than I thought.

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Next Up

Back in January, I set an audacious goal to reach 25,000 Twitter followers by the end of the year. Whilst reluctant to post the Tweet, I knew a public declaration would hold me accountable on my output.

At the time of writing, I had 822 followers. Fast forward two months and we rocketed through our ANNUAL objective.

Another 19 days pass and we launch Through the Noise newsletter on 4th April.

Our community has grown by 1,063 brilliant people, up from 417 last week; that's 155% in our first week of being live!

Today, I'm setting another audacious goal:

Whilst the distribution of newsletters is incomparable to that of "viral" Tweets, I know one thing's for sure: our community's network effect.

So if you've made it this far, feel free to share this newsletter with your smartest friends on Twitter, LinkedIn, WhatsApp or your company's Slack. It would mean the world as we embark on this foray together into the world of startups, community and capital.

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That's all for today friends!

As always feel free to reach out @thealexbanks as I'd love to hear your feedback.

Thanks for reading and I'll catch you next Monday.

Alex