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In praise of irrational exuberance 

It’s easy to be a naysayer. 

Christopher Columbus endured multiple rejections from both Portugal and Spain before a third appeal to Queen Isabella finally convinced her that a westward expedition to Asia was a worthwhile risk. 

At least 70 venture capital investors declined to fund Sandy Lerner’s new networking startup, Cisco, before Don Valentine bought 30% of it for just $2.5 million.

Twelve publishers turned down JK Rowling before a 13th chose to take a chance on Harry Potter.

In hindsight, all these rejections seem like failures born of undue pessimism.

But in each of these cases, there were ample reasons for caution: Columbus was completely wrong about the size of the globe; networking equipment eventually proved to be a commodity; and children don’t usually read 300-page books.

In fact, despite the outcomes, saying no was probably the right thing to do given the risks — as any poker player will tell you, you can’t judge a decision by its outcome.

I am a huge fan of Harry Potter, for example, but I also think choosing to publish it was an overly optimistic and therefore poor investment decision. 

Fortunately, the world of investing is full of such Dory-like optimism — because the non-investing world, on balance, is a better place as a result.

No risks, no rewards

US mega-cap tech stocks’ relentless march higher may be dulling our recognition that investing in risk assets is meant to be, well, risky. 

Our 401ks are booming because the S&P 500 finished the first half of the year up another 15%, but that’s entirely thanks to the outsized influence of just a few names at the top.

Under the hood, things look a little less rosy: The equal-weight S&P is up only 5% year-to-date, and small-cap US stocks are down 5%.

The latter is perhaps a needed reminder that risk assets don’t always go up.

Japanese equities made a new all-time high this year, but we should recall that the previous high was made in 1989.

Twenty-five years is a long time to wait to get back to breakeven.

US equities similarly spent 30 years in the wilderness between 1965 and 1995.

Also, things can be far worse if you’re not just passively investing in indexes: Crypto, for all of its success, has had only a handful of winners and many thousands of losers.

Such investing futility may be less of an exception and more of a rule than the recent performance of US equities would have us believe.

“Buy and hold” has become the received wisdom in investing, but without our recent experience to go on, John Maynard Keynes concluded the opposite: “Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable.”

Similarly, the great Adam Smith thought long-term investors are simply deceiving themselves: “The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued.”

The economist Reuven Brenner later agreed, finding that investors display an optimism bias that leads them to take greater risks than a rational calculation of self-interest could possibly justify.

All three of those great economists thought this tendency was generally a bad thing.

Adam Smith, in particular, blamed investors’ over-optimistic risk-taking for creating the financial manias that regularly destabilize economies.

That view feels increasingly outmoded, though, perhaps because recent financial manias have given us things like high-speed internet, solar panels and electric vehicles — all financed at the expense of early investors who have little or nothing to show for the risks they took. 

This applies even more directly to the risks that founders take.

In his upcoming book on risk-takers, Nate Silver quotes the co-founder of Y Combinator, Paul Graham, saying that optimism, strictly speaking, is “an error” — but also that “all successful founders are optimistic.”

If founders weren’t making this error of optimism, not very much would get invented.

Most significant inventions start with someone optimistically taking a risk, but we give founders a hard time for being successful — and we give investors a hard time for being either foolish or greedy (depending on how they do). 

Would we prefer them all to be pessimists?

“If we all convince ourselves not to work because things are guaranteed to suck,” Sam Altman says (again quoted by Silver), “it’s a self-fulfilling prophecy.”

Fortunately, markets are full of both founders and investors that believe things generally don’t suck — and that too seems to be a self-fulfilling prophecy.

That doesn’t mean things will work out for investors — just the opposite.

Investors are currently taking an optimistic view that the hundreds of billions of dollars that a handful of our 401k investments are optimistically pouring into AI infrastructure will turn out to be a good long-term decision. 

Keynes and Smith would surely warn us that this type of exuberant thinking will be bad news for our portfolios — and I suspect they may be right.

But I'm certain it will be good news for the world.

— Byron Gilliam

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