Excerpted from the Spearhead podcast: http://spearhead.co

Part 1 is here: https://youtu.be/YLFHVye3Q7w

As you might know, Naval and I have another podcast called Spearhead where we discuss angel investing.

A few months ago, I collected all the short little Spearhead episodes and published them here in 1 big episode.

That was part 1 of the theory of angel investing.

If you want to subscribe to Spearhead, you can go to spearhead.co.

We've spent the last few episodes talking about why you should be angel investing.

We talked about how to get your own proprietary deal flow and the short answer on that was build a brand.

Now we're going to talk about judgment, how important is it, how to develop it?

Long-term judgment is absolutely critical because without judgment, you'll end up with a bad portfolio.

You won't have other investors backing you.

You'll lose your money and your brand will suffer.

Good entrepreneurs won't want to be associated with bad judgment.

At the end of the day, judgment is actually the single most important thing.

It's more important than access to deals.

It's more important than access to capital.

The problem with judgment is everybody thinks they already have it.

So, your own judgment is subject to your own judgment.

If you have poor judgment, then you won't know you have poor judgment.

This is called the Dunning-Kruger effect.

People who are not that intelligent usually don't know they're not that intelligent.

Some of it being an ego defense mechanism, some of it just being intrinsic to the nature of judgment and intelligence.

So you don't know if you have good judgment or not.

Furthermore, you may have good judgment in certain areas, certain verticals, or you might have good people judgment, but you may not have good market judgment.

The only way to tell if you have good judgment is to look over a very long period of time.

And unfortunately, in early stage investing, it takes 5 to 15 years to figure out if you have good judgment.

The first thing to do is to be very honest about where your judgment is and calibrating it.

And then there's a longer term plan we can work on to improve our judgment.

At the seed stage, it does matter, but it's much more about people judgment and product and market potential than being able to size up a cash flow stream, cost of customer acquisition, or virality metrics because you don't have that much data.

As your judgment is lower, not because of some failing on your part, just because you don't have enough data, then you need a more diversified portfolio.

In some sense, diversification is a hedge against a lack of knowledge.

The less knowledge you have, the more you're going to diversify.

At Warren Buffett's level, where you can examine an existing company that's been around for 20 years in great detail, you don't need to have a lot of judgment, you need to have a lot of diligence.

Yes, judgment still applies, but you can pick 1 deal after having done lots of diligence on a whole bunch.

At a seed stage startup, you have very little data.

You may just be looking at other people's judgment around you.

And this is why social proof plays such a big role.

But at the end of the day, you're going to have to build a portfolio in early stage investing because nobody has enough data to have very high conviction or foolproof judgment early on.

Parker Thompson, who had the startup L Jackson handle on Twitter, had a funny quote, and I think he was quoting somebody else on Twitter, where he said, everyone who invests after me is a spreadsheet jockey and everyone who invests before me is a dart throwing monkey.

It is the tendency to look at people who come before you as making wild guesses.

That's what seed investors look like to later stage investors and later stage investors look like spreadsheet jockeys to early stage investors but they're just applying different levels of judgment, different kinds of judgment because they have different data available to them and they're going to then have different size portfolios and conviction because of the judgment they can and cannot apply.

How important is judgment given the amount of luck involved at the seed stage?

Investing at the seed stage is like playing the lottery except that you can use your access and judgment to get 1 or 2 of the winning numbers in advance, which increases the odds but you still need a portfolio effect.

The better your judgment, the more numbers you know in advance.

So it's absolutely still worth cultivating and honing judgment.

This is a long-term game that will be played out over dozens and eventually hundreds of investments.

How much time do I really have to apply my judgment given how quickly deals move?

Aren't I gonna miss out on a deal if I take time to really think things through?

Judgment isn't necessarily diligence or even thinking.

So when the deal arrives, your subconscious can process it very quickly.

I don't think the best judgment for early stage investing is done through extensive due diligence.

Yes, it's smart to check references, talk to other people in the space and think it through, but we're talking about something that takes days, not weeks.

Over time you will build up your gut instinct enough that you'll need less and less data to make an assessment.

You'll know if a founder is speaking such a way that they're credible.

You know if the network that they come through means that you don't have to reference check as much.

You will already have established how customers in the space think and behave, so you'll have your own gut feel for what's really possible to sell them.

A lot of startups are now trained, especially by accelerators, to run a very tight, fast fundraising process.

They can pressure you hard to make a decision.

The better investors are absolutely immune to that FOMO effect.

If you push them hard, even on a really hot deal and say, you have to decide within 48 hours.

They'll always say, well, I don't decide within 48 hours, so it's not a fit for me.

FOMO works on many investors up to a point, but it will not work beyond a certain point on the absolute best investors.

I have had to institute a 24-hour cooling off period rule for myself, which is even after I decide to invest, I force myself to wait 24 hours.

Don't a lot of companies do soft and hard pivots?

Arif Fakhryi Even when there's a pivot, the judgment about the people matters.

A pivot is really defined as keeping 1 leg in place and moving the other 1 around.

It's not a jump, it's not a leap into a completely different industry.

Oftentimes when there are pivots, they're into adjacent spaces, but you're still operating within the broader market.

You will then overweight your team and execution evaluation and overweight that the market that they're operating in has enough room to pivot around and maybe underweight the exact product approach, the valuation has to reflect that the company might go through some pivots.

And the company's cash burn and cash planning has to reflect that it might go through some pivots.

How is the investor supposed to know which companies to invest in given how much they can do a soft pivot or what I'm calling a hard pivot, which is same team, but completely different market.

Uber started off with just black cars, Lyft was Zenride.

I would argue that Uber's movement from black rides into shared rides wasn't really even a pivot, it was just an extension.

Zimride's movement from long range shared rides to short range shared rides, was also an extension and a very brilliant innovation on their part, so it wasn't much of a pivot.

ODO to Twitter was a pivot, but it was a pivot from podcasting to microblogging from a person who had popularized blogging as we know it, F.

So it was really a bet on a great individual staying very much within their space.

I'm not even sure I'd call it that, more of a step.

If you look at Genie to Yammer, that was a jump, but that was David Sachs, who was 1 of the greatest product designers we've ever seen in the technology space.

He was the founder of PayPal, he pivoted Genie into Yammer, he ran Zenefits, and he's been an incredible investor early on in some of the greatest hits that are out there.

That was a David bet, like an Elon Musk bet, and the people who bet on David would bet on him again all day long.

Another big jump was Glitch, which was a game company to Slack.

Even Flickr, his previous hit, had also been a jump of sorts.

That's a case that I think was very unpredictable.

People who invested in his gaming company, invested in Stuart, and just hoped for the best, and Stuart delivered.

But for every 1 of those, there's 10 failures.

When you want to develop your judgment, the first step is to calibrate it.

Obviously, it would be great if you could just look at the data and say, was I correct?

But you won't know that for 10 years, 15 years.

And by that time, the industry will have changed.

You may have been correct for the way the industry was 10 years ago, but this is an industry that evolves and adapts very quickly.

Another way to do it is you can look at intermediate markups where Sequoia or Andreessen or Benchmark or whoever are marking up your rounds and they're coming in after you and paying higher prices.

That's an interesting metric, although there it's really your taste in what other taste makers like.

It's a Keynesian beauty contest where each judge is being rewarded based on what the judge in the next round thinks.

You're becoming a good arbiter of future taste.

This does have some value because if you're good at predicting what the VCs are going to fund, then your companies will get funded.

And through the funding, they're likely to have some competitive advantage and to win.

But this won't help you when Bitcoin is first starting up and it's incredibly strange and nobody understands it and there's no subsequent round of VC funding to bet on.

You just have to make the decision yourself.

That kind of judgment is a people proxy mechanism.

It's not really a way to build and calibrate your own judgment.

When you invest, you can also look at what other investors are coming into the same round, but right behind you.

If they're coming in front of you, then it's not a good proxy for your judgment because you're probably keying off of them.

But If you invest in a round and then good investors who have proven good judgment pile into the round after you, then that is a reasonable indication of your judgment.

Don't ask them if you have good judgment or not because they'll always tell you that you have good judgment if they're polite.

Of course, only ask this of people who themselves have good judgment.

I find that people who have good judgment have good judgment in all aspects of life.

Judgment is an ability to be humble, think critically, be well-read, have a broad range of ideas, hold conflicting ideas and opinions in your head, to have a relatively low ego so you don't get too attached to your earlier decisions, and be constantly questioning yourself, preferably have scientific training or a technical background, have worked in an industry where you have to deal with the real world consequential feedback and not just what other people think of you, and the willingness to be unpopular.

Clear thinkers think from the ground up and they use first principles in a lot of their reasoning so they end up relying on their own authority.

Things that will lead to poor judgment over time are groupthink, over socialization of judgment, picking things that you know are going to be politically or socially popular.

Lots of people lose money in this business chasing things that they wish were true as opposed to what actually turns out to be true.

The PayPal mafia is famous for being very insular.

Many of them are extremely unpopular and they're not afraid to hold unpopular viewpoints, but they really respect and value each other's insights and judgment.

Whatever people say about Peter Thiel, no 1 wants to go head to head in a debate with him because he's brilliant and he's contrarian and he's a first principles thinker from the ground up.

If you surround yourself with people who are brilliant, controlling, first principles thinkers over your career, you will develop extremely good judgment.

You may not end up being very popular, however.

Do great deals even look that normal when they're first getting started?

the nature of the industry that you want to be non-consensus right.

In other words, you want to be right when everybody else is wrong.

If you're right when everybody else is right, you won't make enough of a return.

And of course, if you're wrong, then you're not going to make any return.

So the best deals are either weird, or socially unacceptable, or not normally considered part of venture, or look far too niche to be interesting, or are brought in by a founder that doesn't fit the normal founder mold, or in a geographic location that doesn't fit the normal geographic mold, or have some cap table problem, but the best deals always have something broken, strange or different about them.

That doesn't mean you're going to make the best investments if you only invest in weird deals.

This is a little bit like that old saying that there's a very fine line between a genius and a madman.

Both seem like crazy people from the outside until after they're validated.

And 1 out of a hundred turns out to be a genius and 99 out of a hundred turn out to be crazy.

You have to be iconoclastic enough yourself to recognize the genius founders without being so low in judgment or being so strange that you're letting in all the crazy ones too.

1 could argue that the way portfolios are constructed, you're better off investing in a lot of crazy deals than you are in a lot of decent looking deals.

To give a recent example, there's a fund started by Patry Friedman called Promonos Venture Capital.

Patry is going out there and investing in experiments in governance, new city states or even new towns or localities, how people are taking local government into their own hands or doing experiments in governance.

The history with seasteading in Honduras doesn't look that great.

But all you have to do is stumble into the next Singapore or Hong Kong, whether it's virtual or physical, and you have something that can create trillions of dollars in wealth plus completely change the way that people live their lives.

That's an example of a fund that is doing very difficult and strange investments.

1 is they're going to have a unique brand.

There's nobody else doing that so everybody knows to go to them.

And second, they're going to bet on the kinds of things where the vast majority of their investment are going to be looked upon as mad investments, but the few genius outliers should return huge returns because they're non-consensus investments.

Similarly, Founders Fund and Steve Jervitson build their brands on being willing to fund weird things long before anybody else.

With every deal, you can give it 1 fatal flaw, 1 thing that some established traditional venture capitalists will look at and use that as an excuse to not fund the deal.

But if there's more than 1, then you have to worry.

Startups are rewarded for innovating on something new.

If they're trying to innovate on things that already exist and work, such as team structure or founder mentality or those kinds of things, they're just taking on additional risk.

You have to use your judgment to figure out where they can break the rules and where they have to follow the rules.

A startup that follows all the rules is unlikely to be interesting.

A startup who breaks all the rules is not going to get anywhere because they have to spend time reinventing everything from scratch.

Uber, when it first came along, was strange because at the time VCs did not invest in offline industries.

Yes, there's an app stitching it all together, but looks like the app is 5% of it, 95% of it is people in cars driving around.

And they were correct, but the question is how much that leverage can accrue to the person who owns the app and how much they can expand the market because of the app by creating new products and bringing on new users and creating convenience.

Google was strange because everyone thought the search wars had already been won by the time Google showed up.

It really helps to understand technology to understand which rules to break.

The best position to be in as an investor is when somebody shows up and the technology is too difficult for other people to calibrate or understand.

So therefore they pass on it because they don't think the technology is feasible, but you have enough technical insight that you know that it is feasible.

Then you just have to make sure that you can get it funded to the point where it's obvious to everybody.

The value there comes in breaking a rule that you know is not really a rule to be broken but everybody else thinks it is.

It's very easy to overestimate your own judgment.

It's perfectly okay to say, I don't know.

Most of the times your answer should be, I don't know.

There's only a few times where you should say, I have conviction.

And even there, you want to be very careful about how much conviction you have.

At the seed stage, if you are putting a lot of money into 1 company and very little into another company, that begs the question, do you really have conviction in the 1?

Or do you just have a lot of access in 1 deal and therefore you're putting in more capital there?

Generally, The better the deal, the less access you're going to have.

If you end up putting a lot of money into a few deals and then very little money into many other deals, you'll find that your winners tend to come disproportionately out of the deals where you have very little money, which hurts your portfolio return.

Once you have conviction, always try to get your standard bite size into that deal.

If a deal has too much space for you, then that either means you should be investing more in the other deals, or you should be investing less in this 1, or you should be getting rewarded through a lower valuation because you're creating the signal, then the company is actually going to use to raise the bulk of the money.

Anyone in this business who's chasing hot markets gets killed.

There was a time when consumer social was the hot market.

If you started investing in seed stage when that market was hot, by the time your companies matured, that market was done.

Same way, once it became obvious what Uber was and was winning, if you started investing in the masses of food delivery companies that showed up, numbers 5 through 50, and there were a lot of them, you lost your money.

Today, SaaS is the proven moneymaker and very hot.

Probably 5, 10 years from now, when your current seed stage SaaS investments hit the market, you'll find the returns are a lot lower.

It's good to be at the beginning of a market, not the tail end of a market.

By the time there are conferences about it and TechCrunch is writing about it, it's probably a little late.

If you got in in 2017, you were actually the tail end of the market.

The early side of the market was in 2009 to

1 common trap, especially for former entrepreneurs, is you'll look at a company, you won't really listen to the founder pitching it.

Rather, you'll be fantasizing about all the things that you could do with this company.

And you'll be taught the painful lesson that no, it's actually not you who's running the company, it's the entrepreneur running the company.

It's important to listen very carefully and take the founder at their word as to what they're saying and what they want to do and not get caught up in this idea that somebody else is going to run the company.

This is the exact opposite of value investing.

Buffett says, invest in a company that even a fool can run because eventually a fool will run the company.

Almost all the value creation happens while the founder is intimately involved in most of these companies.

If you bet on a founder that you're not that excited about with a market or product that you are excited about, the founder will often fumble the company.

Or Often you will have just invested in this company and then a competitor will come along with a much better founder and now you're blocked out or conflicted out from investing in the new company or the new founder doesn't want to talk to you because they know you invested in the competitor.

There are multiple ways to build judgment.

The timeless kind of judgment, good decision-making and sizing people up, a lot of that comes through experience or reading great works and books that intersect science, business, philosophy and cover how very smart people think, building up so-called mental models, understanding microeconomics, game theory, etc.

Within a field, you can build specific knowledge that's timely.

The way to do that is to dive into that field and learn everything as quickly as possible.

You're not going to become a great tech investor by reading TechCrunch or Bloomberg News, you're going to have to go to the source and the source is often research papers.

You have to genuinely enjoy the act of learning science and technology.

Technology is applied science, so you shouldn't hesitate to read scientific papers, brush up on your mathematics, and make sure you understand what's going on in the scientific journals.

Similarly, you can start out by investing in the smartest scientists in the space, knowing that even if they don't necessarily make you money, these are the people that will perform due diligence for you and perhaps you'll make them advisors to your fund or give them a small piece or let them co-invest if they have the means, they'll actually validate and calibrate things for you and they will also send the best scientists your way.

For example, early on When I was investing into cryptocurrency companies, I became friends with Zuko Wilcox-Hearn, who started Zcash, and Juan Binet, who started Filecoin, and Ryan Shea and Muneeb Ali, who started Blockstack, and also Eli Ben-Sassoun and Andrew Miller, Bram Cohen, Creator of BitTorrent.

These became my go-to people for vetting and validating deals.

They would tell me which technologies were real and which ones weren't, which scientists were credible and which ones weren't.

Being surrounded by good technologists and scientists is a secret weapon because you'll get referred in through their networks and these people tend to be no bullshit.

They'll tell you exactly what they think of a new technology.

You do have to use your own judgment to calibrate when they are being unnecessarily negative or when they're being jealous because it's just human nature.

But usually very technical people tend to be extremely objective because they're used to corresponding with the real world and scientific results and not necessarily with other people who are more influenced by subjectivity.

If you can find a group of painfully honest and distinguished scientists and technologists to connect with, that will be a secret weapon throughout your investing career.

Why don't we break down judgment and talk about how it applies to investing in teams, evaluating the product and the market, looking at their traction, and also evaluating any social proof around the deal.

So we're going to break up judgment into team, product and market, traction, and social proof.

This is a technology business, and you want to be investing in technology teams.

That means every great team is highly likely to have a great technologist as part of the core founding team.

See all Naval transcripts on Youtube

How to Angel Invest, Part 2