Deluded Investors (cont’d) These biases combine to create a two-sided irrational phenomenon that catches many people. On the one hand, if we are winning (or even if we are technically losing, but not as badly as we expected to lose) we tend to become overly conservative and reluctant to take sensible or attractive gambles. We try to lock in our wins, thinking that a bird in the hand is worth two in the bush. On the other hand, if we are losing (or even if we are technically winning, but not as grandly as we told everyone we would) we tend to become reckless risk-takers who throw “Hail Mary” passes in the slim hope that we can catch up to where we ought to be. This drives an escalating commitment, throwing of good money after bad in the hopes that the original losses can still be salvaged somehow. It is based on the stubborn human refusal to recognize that sunk costs are always irrelevant when making a decision in the present moment. For example, an investor who has watched share price fall in a clearly doomed startup company will still be strongly biased to participate in any subsequent round of funding in a futile attempt to keep the company alive for a bit longer, and thus avoid having to accept that the first round money is irretrievably lost. Prospect theory warns investors that they must not trust their gut instincts when assessing probabilities of success, and that their perceptions will be strongly skewed by recent history. It says that they must ignore the emotional perception that losses sting more than wins please, and that they must be particularly careful when publicly announcing targets (or even just privately setting their hearts and expectations on them) lest they become anchor points that will force them into irrational, escalating commitments that drive bad decisions and destroy value. TIP: To avoid escalating commitment biases arising from prospect theory, use objective calculations to determine the expected value of uncertain choices, and be very careful about the public commitments you make. Look around and you’ll see these killer biases happening everywhere, including in yourself. And, although you are now among the few people aware of them, remember that they will still affect you unless you take concrete and deliberate steps to avoid them. — Dr. Dave Valliere , Director, Entrepreneurship Research Institute, Ted Rogers School of Management
64 A Practical Guide to Angel Investing
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