The rational way to invest in something – a startup, public company, venture capital firm, real estate project, etc. – is to base your decision on an assessment of its fundamental value. The most common way to do this is to try to predict the asset’s future profits. In reality, many of the largest pools of capital in the world – pensions, endowments, and mutual funds – think in terms of “allocations.” This means they start with a model for how to distribute their funds across a set of dimensions, including asset classes, industries, and geographies. This allocation mentality is based partly on prevalent academic theories (the “Capital Asset Pricing Model” or “CAPM”) and partly on the success of certain famous money managers (the “Yale Model“).
Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).
Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”
We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.