Why The Optimism Of Angel Investors Is Rational

A lot of mainstream equity investors feel that angel investors just end up burning money because angel investing is illiquid and risky. Success stories are few and far between and they feel that angels are being shortsighted in their attempt to find the proverbial point at the end of the rainbow.

When you talk to experienced angel investors, especially those who are willing, to be honest, they too will tell you that most of the startups they’ve invested in have failed. They’ve either folded or have become lifestyle companies which have failed to provide a return to the investor. Yet in spite of all these failures, why do angels continue to invest in new startups? Why do they continue to have optimism in the face of uncertainty?

These are valid questions, and I sometimes doubt my sanity when I continue investing in startups. This is why it is useful to do an objective sanity check. Am I just getting carried away by all the media hype around startups?

The reality is that my optimism is perfectly rational. A useful mathematical framework to think about this is the upper confidence bound algorithm.

It can be summed up by the principle of optimism in the face of uncertainty.

“We need to  construct an optimistic guess as to how good the expected payoff of each action is, and pick the action with the highest guess. If our guess is wrong, then our optimistic guess will quickly decrease, and we’ll be compelled to switch to a different action. But if we pick well, we’ll be able to exploit that action and incur little regret. In this way, we balance exploration and exploitation. Explore too much and you won’t make enough profit to sustain yourself. Narrow your view too much and you will miss out on opportunities whose return surpasses any of your current prospects.”

This is an example of a multi-armed bandit problem and you can read more about this here.

This explains why angels are likely to jump at the chance of investing in new startups with enthusiasm because we know any of them could be the next best thing. This is why we continue to give new entrepreneurs the benefit of the doubt, and this is why we are excited to meet new founders who want to try out new things. Even though some of our founders have given us grief, it still makes sense to assume the best about a new entrepreneur in the absence of evidence to the contrary. Since no one else can identify the winners reliably either, we have as good a chance as the VCs!

It’s not just a question of greed or the itch to gamble. Most investors are mature enough to realise that it’s hard to become rich quickly. It’s also not a question of the fear of missing out (FOMO), even though it’s true that both fear and greed are very powerful influences which often cause irrational herd behaviour. It’s simply that in the long run, optimism is the best prevention for regret.

We know that the odds are stacked against us as angels because success in the startup ecosystem follows the power law. One company’s success will pay off for the failures of hundreds, but because we cannot identify which that company will be, angels need to continue to explore the ecosystem because uncharted terrain is potentially valuable, and it’s worth mining for hidden nuggets, in the hope that we will hit pay dirt if we are patient, systematic and disciplined.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.