This article is collated from the Myfortytwo offline event of “Signal-to-Noise Ratio in Decision Making”.
The market is desolate from 2019 to 2020. People chose to leave, be dormant, or to change. It is no easy for Jinjian Zhang to shift from Trustbridge in Signal and Noise in Investment to Vitalbridge in this article. He shares his methodology of the core decisions in the venture capital market.
Noise makes financial markets possible, but also makes them imperfect. By Econometrist Fischer Black.
The market is filled with signals and noise.
Each of us knows that we should find signals and discard noise. However, without noise, we do not have transactions. Imagine that if everyone had the same signal, you would have no one sell what you want to buy, and the transaction would not be closed.
Therefore, noise in fact drives the ecology of our entire venture capital industry. However, last year noise and noise traders slumped, thus weakening the market liquidity. In such a case, everyone was overwhelmed with anxiety and confusion.
When the overall market liquidity is reduced, “do something” always brings us a sense of security. As an inevitable result, noise traders will emerge because people struggle to find exclusive information and start transactions.
In fact, we must return to the essence and identify the signal when noise decreases.
Therefore, the best reaction at present is to stay peaceful. In a peaceful status, you may improve the signal-to-noise ratio in your decisions.
What is signal-to-noise ratio? Let’s see the picture above.
The picture on the left is the information we hope to receive, and the one on the right is what we actually receive. The gray area A on the left is the ideal power consumption and the right is the actual consumption. We can see that “excessive” information not only affects quality, but consumes energy.
Unfortunately, people’s way of thinking is closer to the analog circuit on the right rather than the digital circuit, thus inclining the expressions towards “redundant” instead of “simplified”.
What’s more, since it is an analog circuit, limitations lie in different circuit designs and component options. For us, the limitations are from our upbringings, experiences and personality traits, which will increase the system noise in our communication.
Like the college roommate I mentioned in the previous article Signal and Noise in Investment, he summoned great courage to write a love letter to the girl he loved secretly (and the girl had the same feeling as well). In the six-page letter, he shared his life experiences and irresistible aspiration to serve the country. The last sentence he added was “You are equally important”. After sending it out, the roommate was excited all night, but the girl mistook the letter as a euphemistic rejection and cried overnight.
For another example, when we discuss about a project, if you ask him invest or not, you need the answer of either 0 or 1. However, mostly, the person will respond “I can see enormous opportunities here, which are 1, 2, 3, but risks as well, which are 1, 2, 3, 4, 5.”
You ask again “invest or not?” In the end, his response can be “shall we bargain over the price?”
In this example, a lot of information is in fact noise, while the signal is uncovered. Therefore, the final conclusion is ambiguous.
Hence the signal-to-noise ratio is the ratio of signal to noise in information. Mathematically, it is the signal power divided by the noise power. The larger the number, the higher the signal proportion, and the better the information quality.
However, all the components cannot avoid generating noise as long as a signal is sent out. In investment, we make a lot of decisions every day. How can we effectively screen out signals and improve the signal-to-noise ratio?
In fact, our brains encounter similar problems every day. Limited by the processing capacity of the human brain, we cannot process all information collected by the retina. Humans solve this problem with two methods: (1) ignoring the information at the edge of the retina (2) “focusing” on processing the information in a specific area.
Therefore, even if we can see an entire book, we can only “read” a line of text. The latter is the “attention” mechanism evolved in humans. The mechanism has greatly improved the “signal-to-noise ratio” in visual information processing.
For example, in the picture above, the driver will immediately “focus” on the red signal of “STOP” and ignore other information. In contrast, computers, with unlimited computing power, will perform all-inclusive analysis instead of instant focus.
To be brief, the attention mechanism is a “top-down”-driving-“bottom-up” strategy.
In investment, “top-down” is induction: finding the internal connection and shared characteristics between matters, and generalizing the common features. For example, what are the shared features of excellent entrepreneurs? Or, what business models do high-quality projects commonly comply with?
“Bottom-up” is deduction: finding the external variations and different characteristics between matters, and demonstrating individual peculiarities. For example, what resources will the entrepreneur search for in this environment? What transformation will be made?
The former requires the capability of abstracting and generalizing large samples; the latter requires the capability of penetrating and imagining in specific events. Both have pros and cons. Let’s discuss.
When we deal with small samples in life, “bottom-up” is more flexible, so deduction is the main strategy in our daily life:
For example, in ordinary life, you now need to choose one out of the three furnishing suppliers. What is the best strategy? Meet all the three suppliers and you will draw the conclusion. The core of the strategy is comparison, that is to identify the “optimal” solution by comparing all options.
Surely some businesses take advantage of this. For example, The Economist offers three classic subscription options:
1. Digital, US$59 per year
2. Print, US$125 per year
3. Digital + Print, US$125 per year
Which one will you choose? If without Option 2, which one will you choose? The existence of Option 2 makes Option 3 the optimal choice.
However, everyone must know that in fact the comparison itself is exactly the source of most noise in life and decisions, because in the process, we believe our choice to be the best one by constantly comparing. With the increasing options under comparison and the aggravating complexity of the system, we drive ourselves into an overloaded system.
Similarly, people have the issue in everyday relationship. We compare scores at school. However, after graduation, you find that scores can no longer establish a comparison. It shifts to salary, social status, reputation, your wife, son… The comparison extends from one aspect to a hundred, which becomes the source of increasing peer pressure.
Therefore, the bottom-up comparison method fails when people face an environment of large samples.
For example, today I tell you that you only have one single opportunity to choose from top one hundred doctors in China. The choice may determine your life span. How will you choose? Will you spend two years meeting all of the one hundred doctors? Even you will, you could hardly make a decision afterwards.
The venture capital market in 2012 was exactly an environment of small samples. To be brief, it was like the picture above: China’s entire market in 2012 was composed of the five companies. The vertical bar represents the valuable company and the horizontal bars represent the worthless ones.
The ecology at that time was not mature as well. For example, China had only a few Finance Advisor institutions. As long as you knew one, you knew all the changes in the market. At the end of each year, all investors gathered to share the financing and development of specific projects. Everyone had viewed every project.
At that time, the “bottom-up” comparison strategy worked best. The volume of the entire market was small. You could view all the projects in a short time. As long as you viewed all five projects, you would be capable of identifying the best one. You could make decisions by comparing. Therefore, “sourcing” was the core of the stage.
However, today the market has changed. Today’s market is like the picture above, which is an environment of large samples.
Some investors happen to meet a column of companies, which are all bad targets, and say negatively that the market no longer has innovation because no company is worth investment. On the contrary, if some investors coincidentally viewed three good target companies, they will say that the market is as blooming as spring.
If we still want to find the two most valuable companies in the market, what can we do with our past bottom-up comparison strategy?
The strategy of comparison does not allow anything to be “missed”. Further, investment institutions began to expand around “sourcing”. Some organizations horizontally divide the entire market into tracks and others vertically divide it into industries. By dividing and grouping, institutions try to divide the graphics into one, two, …, seven, eight groups. Each group will have a leader, and the leaders discuss with each other to draw a conclusion of what to invest this year.
But what’s wrong at the moment?
First, no one can see the entire picture of information. That is to say, no one can make a comparison based on complete information. If what you compare is different from mine, how do we conduct cross-validation?
Secondly, a single comparison fails when the information dimension multiples. We must continue to add “comparison points”. With more “comparison points”, noise increases and the market begins to diverge.
There are another two points. First is about the structural difference of the unit components mentioned earlier. When one is not able to cover the entire market, only by hiring more people can he accomplish the research. Therefore, you will find the domestic VC industry has increasing levels of hierarchy. Unlike Benchmark in the United States, the company only has partners and analysts. Many people forget a critical point that any component makes noise when it sends out a signal.
Second, excessive comparison objects will overload the entire system. Just like last year, one day you unexpectedly encountered the desolateness of the market and found people around exhausted and lost. It was because the market system, under the stimulation of high liquidity, failed to support the huge collection of information.
We have mentioned earlier that noises show differences but signals demonstrate similarities. When the sample becomes larger and comparison cannot help us choose, we need to identify the similarities to find the signal.
The “top-down” induction method is exactly exploring the similarities, instead of differences, among a large sample of matters. We call the similarities peculiarities. We often refer to reviewing, which is exactly a process of understanding the essence by summarizing the peculiarities of success and failure through induction.
For individuals, the thinking upon the life plan and the defining of certain peculiarities will pilot the decision making in return. For the investment in organizations, it means the type of entrepreneurs and companies we look for, fast-growing or high-quality? The essential peculiarities finally become the consistent code of conduct for individuals and organizations, which is what we often describe as “vision, mission, value”.
When we understand and reinforce the essence, we will make decision based on the essence. When you decide to invest in a high-quality company while your opponent chooses to invest in a high-growth company, the organization will know that his financing news is full of noise. When you choose a simple and joyful life while the era chooses the hustling and highlighting, you will understand that his anxiety has nothing to do with you.
Therefore, after such a winter and long holiday, what really deserves attention of an individual or organization is what our core of standing is, what our peculiarities are, and what our essence is. The method can filter out a lot of noise, but the disadvantage is that the generalization lacks the application in specific events and becomes hollow and impracticable.
The attention mechanism is the combination of the two strategies – optimizing the comparing process of specific cases by inducting the characteristics of things in advance. Induction drives deduction; essence drives comparison. Finally, the signal-to-noise ratio in the information will be improved.
Take the example of driving at the beginning. The learning at driving schools allows us to understand some features of danger warning signs. In real world scenes, when the features appear, our brains will prioritize this part of information and ignore others. We often talk about “remaining true to our original aspiration”, and the original aspiration is one’s consistent features in life, which pilot the specific decisions in life and reduce the noise caused by comparison.
The market now is desolate and people mostly have a pessimistic attitude towards opportunities. It is the conclusion out of “comparison”. However, if we return to the “essence”, in the technology-driven Chinese consumer market, are we really short of opportunities? If we return to the two characteristics – technology and demography, did they disappear?
First, let’s take a look at technology. This chart shows the penetration rate of major technology products in American households in the past 100 years. It took about 40 years to complete the popularization of “electric power” and about 20 years for “smartphones”. “Tablets” have not finished the popularization yet, but the time is supposed to be shorter. In this chart, we can see that the penetration of technology is getting denser and steeper.
Our exploration and innovation in science and technology will be nothing but more frequent and faster. It will be faster and unexpected to grow from 0 to 90%. Especially in the next decade, with the outbreak of 5G, AI, and blockchain, we may usher a brand-new era. Therefore, regarding the field of technology, the opportunities are not diminishing.
Second, let’s talk about demography. The number of Chinese people born during the 15 years from 1980 to 1995 is basically equal to the entire population of the United States. This unique generation under the only-child policy have evolved unique consumption needs because of the special upbringing background and social experience.
On the other hand, China’s population in industrial structure is also migrating. For example, the following picture shows that the United States, as a major agricultural country, had about 3.2% of its population in the primary industry. After 1970, most population in the tertiary industry were from the secondary industry and most of them were transformed from the factories in the past. Therefore, the US service industry today is dominated by high-end service industries.
However, China’s tertiary industry population currently are mainly from the primary industry and most of them are in the low-end service industry. How many people are there in agriculture, forestry and animal husbandry in China? It’s 33.7%. The percentage is 3.2% in the United States and 3.7% in Japan. The structural difference of nearly 10 times here will cause migration in China in the next 20 year, which will evolve into a drastic transformation.
In this drastic transformation, where do the people go? How do they adapt to new industries? How can we help them? What kind of technology companies will benefit? Many issues deserve our thinking. Therefore, in the characteristics of both technology and demography, noise is increasing while signal has not decreased yet. I hope that the attention mechanism can help everyone continuously improve the signal-to-noise ratio in investment and decision-making.
How can we continuously improve the usage of attention mechanism in daily life and investment? Based on the content above, I would like to conclude with two points. First, know yourself. Know your upbringings, life experience, family relationship, and restore your original parameters and personality traits. The traits determine what we care about and what we are prone compare. It is your own assignment, as well as the organization leaders’ assignment for team and organization development. Only in this way can we make better use of our own peculiarities to improve the quality of decisions.
Second, return to the essence. Lao Tzu said “devotion to learning increases one’s knowledge; devotion to Tao diminishes one’s doings”. That diminishing noise and returning to the basic characteristics of matters is the essence, the Tao. Tao exists in businesses and entrepreneurs, witnessing the process of constantly simplifying matters and building faith.
For example, we emphasize the “power of life” inside entrepreneurs. Experiences can be accumulated and skills can be purchased. Only the power of life is inherent, distinguishing the living from the nonliving. However, the power is not preserved by many people but consumed by the noise gradually.
The English word – vitality – exactly describes the power of life. In Webster’s Dictionary, the word means the power of enduring and the capacity to live and develop. The definition is marvelous. It is what we think of as the most essential ability of entrepreneurs. How far an entrepreneur can go must not depend on his background, experience and resources, but depend on whether he has constant self-awareness, perseverance and self-evolvement. We hope to find these vital entrepreneurs to build a bridge of vitality. This is the origin of our fund name – Vitalbridge.
May every life be better saving the vitality than saving anything else. I am very happy to share with you my reflections on the past year. I hope that in this age of noise and disturbance, we can get to know ourselves, return to the essence, and improve the signal-to-noise ratio in decision-making. Just like what Myfortytwo asserts, “go back to the simple life and think about the essence of matters”. Thank you.