The problem with investing based on pattern recognition

2012-03-06

A famous story in artificial intelligence is how the US military developed algorithms to determine whether an image had a tank in it. They used a standard machine learning method: feed the computer a “training set” of photos, some of which had tanks in them and some of which didn’t, and let algorithms identify which features in the photos correlated to tanks being shown.

This method worked for a while but then mysteriously stopped working. Since the features the computer identified were embedded in complicated mathematical equations, no one could figure out what it was really doing and therefore why it stopped working. Eventually someone realized that in the training set, all of the images with tanks were taken on a cloudy day, and all the images without tanks were taken on a sunny day. The algorithms had fixated on the most obvious pattern – the color of the sky. When the algorithm was tested on new photos where the weather varied, it was completely flummoxed.

It is commonly said that good startup investors develop “pattern recognition” that allows them to identify great entrepreneurs and companies. If you look at the hugely successful startups of the last decade, the founders have many similarities that are easy to observe. When they started, many were male, young, unmarried, computer programmers, dropouts of elite universities, etc. As a result, a lot of investors look for founders with these characteristics. But without an understanding of the deeper reasons these founders succeeded, these observable characteristics could just as well be the color of the sky and not the tanks.

At the level of individual investors, pattern recognition can lead to bad investments and missed opportunities. In the context of markets, it can cause companies and sectors with the “right patterns” to be overvalued, and ones with the “wrong patterns” to be undervalued. In the broader cultural context, it can cause large groups of talented entrepreneurs to be denied access to capital.

The classic scientific method provides a better model for investing. Scientists observe data, notice patterns, develop hypotheses, and then test those hypotheses. Pattern recognition is only a step along the way to developing hypotheses about the underlying cause.

Perhaps dropping out of college shows a strong level of commitment. Knowing computer science was probably a necessary condition for starting a tech company in the past, but no longer is. Being young could mean you are inexperienced enough to pursue bold ideas that more experienced people would consider crazy. I am just speculating – I don’t know why these characteristics are common among past successful founders. But the mere repetition of patterns shouldn’t be satisfactory to anyone who wants to understand and predict the success of startups.

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