Forbes: How investors use ‘gut feel’ to manage risk
Originally found at Forbes, by Michael Blanding
The odds investors face when deciding which startup to back are long enough to make any self-respecting poker player toss in their cards. “Most investors know that when they write a $50,000 check they have a 98 percent chance of never seeing that money again,” says Laura Huang, associate professor of business administration in the Organizational Behavior Unit at Harvard Business School.
And yet, investors take chances over and over often with great success when they hit it big with a game-changing entrepreneurial venture. What makes them do it? Huang finds that investors often point to a surprising explanation: their gut
“If they relied solely on pro-con lists, or what the hard numbers look like for the company at their current state, probably none of these investments would be made,” Huang says. “Gut feel is the factor that allows them to invest despite what might seem overly risky.”
Unlike most situations where making an important decision based on gut feel is seen as a negative, venture capitalists and angel investors often brag about the wisdom of their midsections. “They have a lot of pride in how they make their decisions,” Huang says. When she asked one investor how he chose investments, he rubbed his belly over and over, saying “I do that.”
A blend of both
Gut feel in investing may not be as random or capricious as it sounds, as Huang describes in the new research paper "The Role of Investor Gut Feel in Managing Complexity and Extreme Risk", recently published in the Academy of Management Journal.
Behavioral psychologists typically divide decision-making processes into two types. Type 1 is characterized by impulsive, instinctual, emotional reactions, often made quickly and without much thoughtful analysis. Type 2, by contrast, is more analytical and deliberate, using higher cognitive processing.
Continue reading original article at Forbes.
Read the original research in Academy of Management Journal
Learn more about the AOM Scholars and explore their work:
- Laura Huang, Harvard Business School