A question I often have about the index-fund approach: if we were in a past historical moment, wouldn’t VC-style investment on moonshots perform better than index investing?
e.g. if we were in 1910, wouldn’t it be better to invest in a portfolio of moonshots that included Ford and Edison, rather than in a broad market index? (Most of the moonshots would fail but Ford and/or Edison would bring in massively outsized returns)
The answer sort of depends on what you mean by moonshot, but under one reasonable definition, it’s actually the opposite: investing in potential moonshots would have resulted in worse performance than an index fund. Or to put it another way, boring companies tend to outperform exciting companies.
You can divide stocks into two types: growth stocks and value stocks. Value stocks are cheaply priced relative to their fundamentals (e.g., they have a low price to earnings or price to sales ratio) because the market expects these companies to be “boring” and not show good earnings growth. Growth stocks are priced expensively because the market expects them to grow. This sounds basically like what you’re talking about with “moonshot” companies. If you wanted to systematically invest in moonshots, you could maybe buy the 10% most expensive stocks, because these are the ones the market believes have the most upside potential. But if you did that historically, you would’ve underperformed the market by a lot—something on the order of 5 percentage points per year. The seminal paper on this is Fama & French (1992), The Cross-Section of Expected Stock Returns.
In theory, savvy investors could identify the most promising publicly-traded growth companies and outperform the market by buying them. But studies on fund managers have found that pretty much nobody can do this.
I’m curious to hear Michael’s response, but also interested to hear more about why you think this. I have the opposite intuition- presumably 1910 had its fair share of moonshots which seemed crazy at the time and which turned out, in fact, to be basically crazy, which is why we haven’t heard about them.
A portfolio which included Ford and Edison would have performed extremely well, but I don’t know how many possible 1910 moonshot portfolios would have included them or would have weighted them significantly enough to outperform the many failed other moonshots.
Right, so if you had good judgment and a reasonable network, I think you could find a lot of the promising opportunities.
Someone would be like “I have a device that produces bright light at a low cost, and I need funding to manufacture it on a massive scale.”
So you’d be like “Really? Let me see this device.”
You’d inspect the device, see that it does in fact do the thing the inventor says it does, and then after further diligence on the business plan & team you’d invest.
I think this is roughly how to go about separating the real opportunities from the snake oil.
Worth remembering that, especially today, there are hundreds of thousands to millions of other highly intelligent and resourceful people trying to do the exact same thing. So you need to have a reason to believe you can do a better job than they can.
Philippe LeBon was a French civil engineer working in the public engineering corps who became interested while at university in distillation as an industrial process for the manufacturing of materials such as tar and oil. He graduated from the engineering school in 1789, and was assigned to Angoulême. There, he investigated distillation, and became aware that the gas produced in the distillation of wood and coal could be useful for lighting, heating, and as an energy source in engines. He took out a patent for distillation processes in 1794, and continued his research, eventually designing a distillation oven known as the thermolamp. He applied for and received a patent for this invention in 1799, with an addition in 1801. He launched a marketing campaign in Paris in 1801 by printing a pamphlet and renting a house where he put on public demonstrations with his apparatus. His goal was to raise sufficient funds from investors to launch a company, but he failed to attract this sort of interest, either from the French state or from private sources. He was forced to abandon the project and return to the civil engineering corps. Although he was given a forest concession by the French government to experiment with the manufacture of tar from wood for naval use, he never succeed with the thermolamp, and died in uncertain circumstances in 1805.
Thanks for this! Super interesting.
A question I often have about the index-fund approach: if we were in a past historical moment, wouldn’t VC-style investment on moonshots perform better than index investing?
e.g. if we were in 1910, wouldn’t it be better to invest in a portfolio of moonshots that included Ford and Edison, rather than in a broad market index? (Most of the moonshots would fail but Ford and/or Edison would bring in massively outsized returns)
The answer sort of depends on what you mean by moonshot, but under one reasonable definition, it’s actually the opposite: investing in potential moonshots would have resulted in worse performance than an index fund. Or to put it another way, boring companies tend to outperform exciting companies.
You can divide stocks into two types: growth stocks and value stocks. Value stocks are cheaply priced relative to their fundamentals (e.g., they have a low price to earnings or price to sales ratio) because the market expects these companies to be “boring” and not show good earnings growth. Growth stocks are priced expensively because the market expects them to grow. This sounds basically like what you’re talking about with “moonshot” companies. If you wanted to systematically invest in moonshots, you could maybe buy the 10% most expensive stocks, because these are the ones the market believes have the most upside potential. But if you did that historically, you would’ve underperformed the market by a lot—something on the order of 5 percentage points per year. The seminal paper on this is Fama & French (1992), The Cross-Section of Expected Stock Returns.
In theory, savvy investors could identify the most promising publicly-traded growth companies and outperform the market by buying them. But studies on fund managers have found that pretty much nobody can do this.
I’m curious to hear Michael’s response, but also interested to hear more about why you think this. I have the opposite intuition- presumably 1910 had its fair share of moonshots which seemed crazy at the time and which turned out, in fact, to be basically crazy, which is why we haven’t heard about them.
A portfolio which included Ford and Edison would have performed extremely well, but I don’t know how many possible 1910 moonshot portfolios would have included them or would have weighted them significantly enough to outperform the many failed other moonshots.
Right, so if you had good judgment and a reasonable network, I think you could find a lot of the promising opportunities.
Someone would be like “I have a device that produces bright light at a low cost, and I need funding to manufacture it on a massive scale.”
So you’d be like “Really? Let me see this device.”
You’d inspect the device, see that it does in fact do the thing the inventor says it does, and then after further diligence on the business plan & team you’d invest.
I think this is roughly how to go about separating the real opportunities from the snake oil.
Worth remembering that, especially today, there are hundreds of thousands to millions of other highly intelligent and resourceful people trying to do the exact same thing. So you need to have a reason to believe you can do a better job than they can.
Yes, I think the crux here is how good you think your judgment/taste is relative to that of all the others who are trying.
Historical anecdote: