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What Most Angel Investors Can't Predict

When you invest in private companies, Scott Shane says you shouldn't rely on what the majority thinks

Editor's note: This column is part of a series that challenges misconceptions about entrepreneurship. Myth: Most angel investors can predict what's going to happen with angel investing. Reality: Every year, the Angel Capital Assn., the industry trade group, conducts a survey of the leaders of its nearly 200 member groups. Part of this survey asks about the current year's investments, and part of it asks for predictions about the next year. Because one can compare the predictions made for 2008 (as shown in the 2008 report with the actual outcomes for 2008 (as shown in the 2009 report, I was able to examine how accurate the angel group leaders are in predicting what will happen in the market for angel capital. On average, angel group leaders aren't very good at predicting. When forecasting what would happen to angel investing in 2008, 54.8% of the group leaders said the number of investments and total dollars would go up, 31.5% said the two numbers would stay constant, while only 2.7% said both the number of investments and the dollar value of the investments would decrease. (Eleven percent offered some other prediction.) The reality was a decline in both investment dollars and number of investments. The 2009 survey reports that investment dollars went down 9% and the number of investments declined 14% during 2008. Admittedly 2008 was a tough year to predict, and more than 2.7% of angel group leaders probably forecast accurately whether the angel capital market will go up or down in most years. But the poor predictions for 2008 show that most angel group leaders don't have special skills that help them figure out what is happening in the angel capital market. Betting With the Majority?

The predictive skill of most of the angel group leaders raises some important questions. First, if most angel group leaders are lousy at predicting overall trends in the market for angel capital, are they any better at predicting what will happen to their investment portfolios or which individual companies are most likely to be successful? Second, in investing, should you follow the views of the majority or try to figure out what the truly prescient think? If you went with what most angel group leaders predicted about the angel capital market in 2008, you'd have been wrong. And unless angel group leaders' ability to forecast what will happen to specific companies is very different from their ability to forecast what will happen to the overall angel capital market, then going with what the majority thinks isn't going to provide the right answer. Unfortunately, that's how most (angel) groups make decisions about which companies to invest in and how much to invest. My third question: What's different about the group leaders who predicted the downturn in the angel capital market? Were they just lucky, or do they truly have a better ability to predict? If there are characteristics that help to identify the angel group leaders who have better foresight, it would be good to know what those are. I, for one, would prefer to do what the truly knowledgeable angel group leaders predict rather than what the majority believes if it would allow me to make a higher return on angel investments. Unfortunately, unless these people identify themselves, we'll never know who the "experts" are. Inaccurate predictions of the majority isn't just a problem with angel group leaders' forecasts of what will happen to the overall angel market. It also appears to be a shortcoming of angels' individual investment decisions. According to the Kauffman Foundation's Angel Investor Performance Project, the top 10% of angel investors made 50% of the returns, suggesting that a few angels are better at picking winners than the rest (or are luckier). The gap between reality and the predictions made by angel group leaders points to a general problem when groups make investment decisions. Usually, a small number of people have more knowledge than the others, making the majority a less accurate set of decision makers than the minority.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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