What is the formula for outsized returns in investing and entrepreneurship?
It can be explained by a grid.
Lets first define the axis:
- Wrong / Right: Ie you picked the right stock to buy (investing) or the insight / idea your company is executing against is right (entrepreneurship)
- Consensus / Non-Consensus: Ie if you ask ten people on the street “is this a good idea?” nine people will say “what are you thinking?” (Consensus). One person might say “hmm you know what I agree” (Non-Consensus)
Now let’s look at the quadrants:
Wrong and Consensus
Quadrant II (top left: Wrong and Consensus) and Quadrant III (bottom left: Wrong and Non-Consensus) won’t lead to an outsized return. Why? This one’s simple: you were unfortunately wrong.
Wrong and Non-Consensus
Again you were unfortunately wrong.
So if you’re right then you get the outsized return… right?
Right and Consensus
Nope. Quadrant I (top right: Right and Consensus) is the most interesting quadrant here.
If you are Right and Consensus it means that what you are investing in or the company you are starting is too mainstream. What this means for investing is everyone already knows it’s a “good investment” so its current stock price properly reflects its value. What this means for entrepreneurship could be the company one is starting is: not differentiated enough, people are already conditioned towards it, exact versions of it already exist today etc.
However, if you are Right and Non-Consensus that is where the outsized returns are. This is because the “unique insight” is actually unique. There is a secret. You know something that the majority of people don’t know. The way this translates to an outsized return is:
- as an investor: you have time before the rest of the market realizes = the stock price increases = you bought low and can sell high
- as an entrepreneur: you have time to build a great, differentiated product for a group of people before the inevitable cutthroat competition arrives. At this point the war isn’t won but at least now you have legs to fight on (ideally product market fit) and can now pour gasoline on the fire to really grow
So next time someone asks “is X a good idea?” only time will tell if you were Right and Non-Consensus.