Wharton’s Laura Huang discusses her research on “gut feel” and early-stage investing.
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“Gut feel” plays a surprisingly important role in decision making by early-stage angel investors, according to new research by Laura Huang, a Wharton management professor, and her co-author, Jone L. Pearce, a management professor at the University of California, Irvine. Huang discusses the findings of their research paper “Managing the Unknowable: The Effectiveness of Early-stage Investor Gut Feel in Entrepreneurial Investment Decisions” in this interview with [email protected]
An edited version the conversation appears below.
[email protected]: Laura Huang [is here] to tell us about her new research, which has to do with investors using their “gut feel” to make important investment decisions. It’s a little bit counter intuitive — not quite what you might think investors are relying on. So we’re anxious to hear about that.
Laura Huang: The origin of this paper is that we were really interested in how investors make decisions. And this one thing kept coming up. They would talk about the size of the market; they would talk about the product. But investors kept coming back to: “Well, then I rely on my gut feel, or then I invest based on my gut feel.” I’ve even heard stories of investors just saying, “You know, I invest because I rub my tummy, and that’s how I make my investment.”
[email protected]: Not what we would have expected.
Huang: Right. I thought that was really interesting. And I thought it was kind of critical to understand what is this gut feel that they’re referring to? And so, the paper really sought that out. First, what we wanted to do was investigate what do investors actually mean when they say that they invest based on their gut feel? And what we found was really fascinating: Not only do they use their gut feel to make their investments, but there’s actually a practical reason for why they use their gut feel. And it makes sense in terms of looking at their outcomes and how effective they are.
“I’ve heard stories of investors saying, ‘You know, I invest because I rub my tummy, and that’s how I make my investment.’”
One of the big findings of this paper, in particular, and we’re continuing some follow-on work from here, is that decisions are not all the same. We tend to think of decisions as being right or wrong. But in the entrepreneurial context, investors are very willing to be wrong. In fact, they know that they will be wrong on a lot of their investments. And so, in terms of their gut feel, it doesn’t actually make a difference in terms of being right or wrong on any one given investment decision that they’re making. But it allows them to identify the home runs.
When they rely on their gut feel, they might be wrong on a lot of different investments, but they’re actually going to more likely be able to pinpoint that home run. So if we think about it in terms of baseball averages — if your goal is to have a very high batting average, your gut feel might not be as effective. But if you’re willing to have a really low batting average, but hit more home runs, then perhaps you want to rely on your gut feel.
[email protected]: So this is partly a strategy that works because of the level of investment — meaning it’s very early stage, when a lot of things aren’t proven and you can’t marshal all the evidence you would because this is just a new thing.
Huang: Yes, exactly.
[email protected]: It might be the “big new thing” but it probably isn’t — but you are going to take a risk on it.
Huang: Right. We were looking at the very earliest stages of ventures — at angel investors who typically are the first external form of financing for these entrepreneurs. And you’re at this stage where, perhaps, you may have a prototype or maybe you just have a glimmer of an idea. You’re not exactly sure what the market is going to look like. There may not even be a market out there.
And so, there’s lots of hard data. There are numbers, and facts and figures that you are able to put down. But a lot of those numbers are based on estimates and hopes, and dreams and guesses. And so, that hard data is actually not as reliable to these investors as their own experience — the things that they are getting from their own mental schemes, and prototypes and mental models, that they have really developed though lots of investments. And that’s where their gut feel is coming from. And that becomes a more reliable factor to them in gauging where this is going to be in three years, five years, 10 years down the line.
[email protected]: So, they are not just throwing darts at the dartboard — they are basing their decisions on a lot of experience. It’s more of an educated guess.
Huang: Right. We hear the term “intuition” and “gut feel,” and a lot of times we think, “Oh, this is something that is going to be very biased, or it’s going to be something that is just based on some arbitrary kind of thing.” But their gut feel is actually based on years of experience, investments that they have made that have gone well, or that have gone poorly. It’s really something that is a criterion that they rely upon and that, in fact, has a basis for this reliance.
[email protected]: They’re pretty good at this or they wouldn’t get to keep doing it?
Huang: You know, it’s funny. Some of the investors that we looked at in one of our samples had all approximately the same amount of experience. But we’ve also done studies where we’ve looked at different levels of experience. Some that have maybe only been investors for five years, some that have been doing it for 35 years.
You do get lots of variants. For example, we had one investor who bought the house that he lives in now in Malibu off of one investments that he made, and he said: “You know, sometimes I can tell within five to 10 seconds of meeting somebody whether or not I’m going to invest in them.” And there’s others who do lots of due diligence — probably for three months, six months, however long they do and then they say: “Well, you know, throughout the course of that, it was this judgment that I had at the very end of it — that I used my gut feeling to make this investment.” So there’s all sorts of ranges of this.
[email protected]: What are the key takeaways from your research?
Huang: I think one of the key takeaways is that this is a highly uncertain environment. There is extreme uncertainty in this environment. And so, the ways in which we think about decisions are not going to be the same based on the different contexts, right? In the entrepreneurial investment context, we are looking at this portfolio strategy where