From Jan Andriessen – henQ (@janandrssn)

Most people in finance know that capital markets are cyclical and that investors deviate from rational investment decision making principles from time to time. As pointed out over and over again by value investors such as Warren Buffett and Charlie Munger, as well as seasoned venture capitalists, the majority of investors fall victim to the market’s mania during both times of inflated expectations and fear of the future. The reasons for the market’s cyclicality in more traditional environments have been well-documented, but why it is particularly strong in case of venture capital not so much.

We expect most from the technologies we understand the least
A number of academics from the United States have come up with a finding that might be one of the factors contributing to the extreme cyclicality in venture capital. They call it the Technology Effect and it might help us better understand the venture capital cycle.

The Technology Effect basically means that people tend to associate new technology with success. They are prone to assume that a new technology will solve a myriad of different problems, without knowing exactly how it works or how it specifically pertains to the problems it is supposed to solve.

As the authors of the article that pitches the Technology Effect put it: “you’re more likely to have faith that something you don’t really understand will work.” This is driven by the selection bias that people suffer from when it comes to new technologies.

Most people only become fully aware of the potential of a new type of technology after they notice the success of the already emerged dominant company in a space (e.g. Uber, Airbnb, Facebook). They consequently mainly base their view of the potential of such a space on just a single or a few successful companies, as they have only been exposed to these superficially. As a result, they forget to include in their mental dataset all the failures that were also necessary for these few successes to emerge, and have an overly optimistic view of the technology.

The Dotcom Bubble and other examples of the Technology Effect
An obvious example of the Technology Effect would be the majorly inflated expectations surrounding any internet startup prior to the burst of the dotcom bubble. Another example would be formed by all the family funds, corporate VC’s and other investors that in the past few years made their debut investing in apps and other software startups. The reason for many of these first time tech investors to enter the industry seems to have been the amazing success of the likes of Uber, Airbnb and Facebook; the successful examples of technologies for which there also were many less visible failures.

The strange ideas the Technology Effect might bring to our minds
Another, more timeless example of the Technology Effect that I find particularly beautiful dates back to the 19th century. It demonstrates well how optimistic the Technology Effect can make some people. Back then, the telegraph had just been invented and successfully commercialized. For a while, based on the recent success of the technology, people expected that telegraphy would swiftly advance to the extent that entire human beings could be sent via this telegraphy. In hindsight, given what we know now about telegraphy, this definitely seems like the Technology Effect at work. You can only assume that you can send people via telegraph if you do not understand the inner workings of that technology.

Expectations which might currently be influenced by the Technology Effect
It is difficult to assess with certainty which of our investment expectations are currently inflated by the Technology Effect, without the benefit of hindsight. However, I think it might apply to any technology for which the prospects do not seem to be founded on technological fundamentals but rather on hopes, dreams and intangible visions.

For example, if someone would currently say that computers will be smarter than people thirty years from now, this would be taken seriously by most of us. In light of the Technology Effect however, before accepting this statement, a key question about it should be: artificial intelligence (e.g. machine learning conversion algorithms, visual recognition software, etc.) is highly useful, but do I actually understand how it will evolve to human equivalent levels so swiftly? What proofs of nearby progress exist?

Personally, I have not yet been fortunate enough to find an article that could actually explain how this human intelligence surpassing technology will work. Nor have I met such a person. Singularity is a deeply intriguing and reasonable idea given sufficient time, but could I envision crystal clearly how a particular, existing technology is fit to achieve this? It is insane that IBM’s Watson has beaten humans in playing Jeopardy, but is there proof that it is capable of more intelligence than the equivalent of dissecting phrases and consequently running very effective searches in a huge database? Do we even know enough about the human brain’s workings to be able to judge what human-equivalent artificial intelligence would entail?

I do not know the answers to these and other questions. Does this mean certain people’s high expectations for artificial intelligence are driven by the Technology Effect? No, it does not. It might be that I just have not come across the right people and information yet, where others have. Or maybe it’s just not my vertical.

What it does mean, according to the Technology Effect, is that I should not hold high expectations for artificial intelligence as long as I cannot answer questions such as the above. I should (and will) refrain from judgment until I understand how artificial intelligence will lead to Singularity.

The Technology Effect drives venture capitalists to go outside of their Circle of Competence
More generally – whether it is artificial intelligence, cybersecurity, augmented reality or some other vertical – only those who fully understand a technology, and hence tangibly see where its potential begins and ends, do not have to be wary of overoptimism and could justify high investment amounts at seemingly high valuations.

As such, the Technology Effect seems very much aligned with what Warren Buffett and his business partner Charlie Munger call the circle of competence. A person’s circle of competence is the domain in which that person has an ‘unfair advantage’ over others in terms of knowledge. It is advantageous for an investor to stay inside of his (her) circle of competence, because this is where (s)he will know the difference between value vs. price and be able to capitalize on this insight. The farther (s)he goes out of his (her) circle of competence, the more valuation will become a gamble and the more erroneous investment results will turn out to be.

When it comes to technology, as we have learned by now, people have a natural inclination to be most attracted to those technologies that are farthest out of their circle of competence. This poses a challenge to venture capitalists, as their work and investments are the most technology driven of all investors among different asset classes. Therefore, it will be more tempting for them to step out of their circle of competence than for any other type of investor. It also means the risk of erroneous investing driven by this bias is considerably higher for venture capitalists than for anyone else.

In short: the Technology Effect might be one of the reasons venture capital is one of the most cyclical asset classes as it contributes to investors leaving their circle of competence.

Conclusion: beware of the Technology Effect and stay inside your Circle of Competence
As a venture capitalist you are exposed to a wide range of interesting investment opportunities in an array of different technology sectors. Moreover, as a prospective startup investor the technology space might seem super interesting based on what you see and read from the outside about the most striking tech successes. However, I recommend you not be tempted to invest in any technology until you have a decent understanding of how it fundamentally works and hence what it’s worth.

Remember that there is positive correlation between your degree of unfamiliarity with a technology and the height of your expectations for that same technology. This might cause you to expect the most from the technology you understand the least. Within your circle of competence you might see all the problems and nuances that you do not see looming over the technologies outside of it. The Technology Effect teaches us that this is a good thing. Seeing clear limitations tells you that you have an edge over others and that you can distinguish value from price. Good things will come to you!