When Davenport contrasted the algorithm’s predictions with the investors’ decisions, he finds that the venture capitalists spent millions of dollars to back startups they should’ve known would inevitably fail. For his data set covering $9 billion of investments, the lost returns came to $900 million, he calculates, reaching that conclusion after modeling alternate portfolios that dropped low-performing startups and replaced them with bonds or stocks.
There was a strong link between decisions to invest and startup founders’ backgrounds—details such as where the founders went to school or how many board seats they occupied, the study indicates. This was especially the case when investors were considering low-quality startups. A founder’s background and experience do matter, but “the algorithm tells us venture capitalists rely on these things too much,” Davenport says.
The good news is that they could easily improve their decisions by incorporating more machine-learning techniques, which would benefit not only themselves but their limited partners (including their clients, university endowments, and retirement pensions), who rely on them to make savvy financial moves.
At least for now, however, most venture capitalists are reluctant to use artificial-intelligence tools. For one thing, they worry about the reliability of algorithms, which use past patterns to make projections. Data on startups are also notoriously difficult to obtain. But perhaps the biggest reason is pride.
“They’ll say, ‘Look, you have to be in the room and see the passion in the eyes of the founder—no algorithm could ever detect that,’” Davenport says. “That highlights the overconfidence a lot of investors have, particularly because they already have good returns. But they underperform what they could be getting. It creates this situation where, if you win the game, it’s hard to understand how many more points you could’ve scored.”