Are Market Black Swans Like Startup Unicorns?

The stock market has had a bit of turmoil the last couple of weeks.  It was reported that Nassim Taleb’s fund made $1B dollars in the huge drop last Monday.  That’s a pretty great headline number and if I was a fund manager seeking new clients I’d have a publicist barking up every tree.

Post 2008 crash, I read Taleb’s book on Black Swans and a lot of it made sense until it didn’t.  When Taleb starts to take issue with EMH and the rational investor, I differ.  I think he is wrong about that.  But, as a trader, I admired his strategy.

At the same time, without a huge wad of cash cushion, his strategy is not able to be executed by mortals.

Essentially, this is how it works.  You go into the index option markets and you find put options that you discern as “cheap” relative to the

of the option chain.  You go all in and buy those underpriced put options.  As a hedge, you might sell some at the money puts or calls to take in some premium.  But, mostly it’s a cash outlay.  Then you use futures to manage your deltas and wait.

If the market doesn’t have a big break, you lose some money.  Reload again for the next expiration cycle.

There are infinite ways to do this now between all the indexes.  Multiple expirations between weekly, monthly, and quarterly option cycles give lots of opportunity to get the trade on.  At the same time, the trade costs money.  The real number that you would want to know is how much did they have to invest after March 9, 2009 until today to earn the headline number of $1B.   How’d they do after management fees and carry?  It might be pretty good, and it might not be.

Seed stage startup investing isn’t a lot different.  But mortals can pursue seed stage investing and do well.

In seed stage investing, you put a little bit of cash in companies early.  Earlier the better in most cases.  That’s how you find the unicorns.  Unicorns are billion dollar companies.  a16z is considered one of the top investors in the venture capital world.  Look at when Andreessen Horowitz invests:

Then, look at their reinvestment rate after seed. This chart compares them to other funds. I don’t think that matters for the sake of this comparison.  Their reinvestment rate is about 45% after initial seed investments.

In trading terms, that’s cutting your losers and pressing your winners. In startup investing, it’s taking advantage of the optionality of investing-just like Taleb and his strategy. Invest a little and roll it to make a lot.

The thing is, most of the time startups aren’t unicorns.  Most of the time, the market doesn’t crash.

In startup investing, this means that in the first five years that you invest, you are guaranteed to lose money.  All startups fail fast.  It’s also likely your returns won’t happen for ten years.   I realize that VC funds are structured to be five year funds, but the reality is none of those funds will see any return for ten years.  They are structured that way so that the partners get their management fee.  There also has to be some sort of hard time horizon on the fund because startups are not liquid like hedge funds.  Once the money goes in, you can’t get it out.

But, in startup investing when you find the unicorn it’s usually not a small victory.  It’s usually worth more than a billion.  My friend Howard Lindzon pointed out if you invested $25,000 in the seed round of Uber, it’s worth $120,000,000 today.  In a previous blogpost, I illustrated how to get a 27% IRR investing by chasing Gazelles.

There are certainly tradeoffs between trying to hunt a Black Swan by trading options and trying to hunt a Unicorn by investing in startups.  But my guess is you will be more capital efficient, and have greater success hunting Unicorns.  It’s a lot of work, and it’s not easy.  Sometimes, you just have to be in the right place at the right time and you never know when that will happen.  The trick is to have an income stream that let’s you survive until you find and exit one.