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09 April 2006

The Grand National and Investment strategy

It was the Grand National today (today for me runs from 2am one day to 2am the next incase you were checking the timestamp). The Grand National is the horse race that gets more people to place bets than just about any other event. The equine fence hurdling got me thinking about equity finance hurdles (yes, quite) and the odds of predicting a winner in each.

We all want to win of course but the only winners in the long term are those who can beat the odds. As in the casino, even a small edge when it comes to predicting the next winner in a race or the next card to be drawn will statistically mount up and the probability is that you will end up a winner in the long term.

Thus if the actual probability of a number on a roulette wheel (European odds) is 35 to 1, you'll get back £36 for a £1 bet. However, there are 37 numbers and thus the house has a 2.7% advantage and over time the odds indicate you will lose. However the world of horse racing and equity investment is not as clear cut as an unbiased roulette wheel and the odds vary over time. Thus if you place a bet at 11-1 on a horse that over time has a 1 in 10 chance of winning, the odds are stacked in your favour and ultimately indicate that you will end up in profit. The same is true for investing in businesses, however the potential winnings are much greater.

Take Google as the example. The $100,000 investment which Andy Bechtolsheim made in Google as their initial investment ended up being worth more than half a billion dollars. 100,000 to 500,000,000 is a 5000 fold return on investment. Back to the casino - if someone offered you odds of better than 5000 to 1 that Google would return a 5000 fold ROI then these are odds worth accepting. In reality if you were to look at the Google business plan back in those days even the casual investor would put the odds at probably 10 to 1 or less. Even a mere $200 at the right time with Google would have made you a millionaire. The trick is not the odds, it's having the opportunity to invest. If Google had advertised for investors back then and only asked for $200, I expect they would have got more than $100,000 and there would be at least 500 happy millionaires out there as a result.

So why is it that with reasonably good odds of a business surviving and turning a profit and with very good returns on investment if it does, we do not see the startup business community as one of those places where we can beat the odds in the casino and with long term probability turn in a profit? Indeed, why is it that businesses even in the age of Web 2.0 have to go through so many hurdles to get investment and it is still so hard to find with so much associated red tape? It's easier to put $200 on a horse than it is to have a bet on a business that if it comes home will not only benefit you but the economy as well.

Anyone who finds this an interesting analogy, please get in touch with the amount you are willing to invest and the odds you are prepared to accept and we will see where this ends up.
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