Naval: At the seed stage, judgment is much more about people judgment, product potential and market potential than your ability to size up cashflows, customer acquisition costs or virality metrics—because you don’t have much data.
Diversification is a hedge against lack of knowledge
When you have less data, you need a more diversified portfolio. In some sense, diversification is a hedge against the lack of knowledge.
Warren Buffett can examine in detail a company that’s been around for 20 years. Judgment still applies, but he can pick one deal after doing diligence on many. With seed-stage startups, you have very little data. You might have to rely on other people’s judgment, which is why social proof plays such a big role.
Nobody has enough data to have high conviction at the seed-stage
To be successful in early-stage investing, you’re going to have to build a portfolio, because nobody has enough data to have high conviction or fool-proof judgment early on.
When he was posting as @StartupLJackson on Twitter, Parker Thompson wrote: “Everyone who invests after me is a spreadsheet jockey, and everyone who invests before me is a dart-throwing monkey.” I thought that was very appropriate.
Later-stage investors look at seed investors as making wild guesses. And seed investors look at later-stage investors as spreadsheet jockeys.
But they’re just applying different levels and types of judgment, because they have different data available to them. They’re going to have different size portfolios and conviction because of the judgment they can apply.
Judgment gives you the winning lottery numbers in advance
Nivi: Given the amount of luck involved at the seed stage, how important is judgment?
Naval: Investing at the seed stage is like playing the lottery—except that you can use your access and judgment to get some of the winning numbers in advance. The better your judgment, the more numbers you know in advance. This increases your odds, but you still need a portfolio effect to be successful.
So it’s crucial to cultivate and hone your judgment. This is a long-term game that will be played out over dozens—and eventually hundreds—of investments.