Applying the Power Law to Investment and Life Choices

Key Insight

In venture capital, success is defined by the power law, meaning returns are not normally distributed but rather concentrated in a select few companies that radically outperform all others. Most venture-backed companies ultimately fail, causing funds to incur initial losses. The prevalent strategy of diversification, or 'spray and pray,' based on an erroneous expectation of normally distributed returns—where good investments yield modest multiples like two to four times—is ineffective. This approach leads to missing the rare, exponentially valuable companies, as evidenced by Founders Fund's experience where the best investment in their 2005 fund, Facebook, returned more than all other investments combined, a pattern consistent across all their funds.

Understanding this power law dictates two core rules for venture capitalists. First, every investment must possess the potential to return the entire fund's value, a highly restrictive criterion that disqualifies the vast majority of opportunities. For instance, Andreessen Horowitz's 250000 dollar investment in Instagram, yielding 78 million dollars (a 312 times return in under two years), was still insufficient for their 1.5 billion dollar fund, necessitating 19 such successes to break even. This highlights the imperative to make substantial commitments to truly promising ventures. Second, given the stringency of the first rule, no other investment rules should exist. Effective venture portfolios, like Founders Fund's focus on five to seven companies, prioritize immense potential over diversified hedging, which otherwise reduces investing to a mere lottery.

The power law extends beyond financial investment, critically influencing personal and career decisions, as every individual acts as an investor of their time and effort. The common advice to diversify ('Don't put all your eggs in one basket') is a misapplication of principles; neither an entrepreneur nor an individual can effectively diversify across numerous ventures or careers. Educational systems often reinforce this flawed mindset, promoting generic skills and the notion that 'it doesn't matter what you do, as long as you do it well.' Instead, individuals must relentlessly focus on their strengths, but crucially, only after a rigorous evaluation of whether that chosen path will achieve significant future value. For example, joining a rapidly ascending, top-tier company can be far more rewarding than owning 100 percent of a failing startup; 0.01 percent of Google, for instance, represents over 35 million dollars. Successful company operation under the power law demands concentrated focus on singular, most impactful elements: the dominant market, the best distribution strategy, and critical decision points, recognizing that true leverage often lies in non-obvious, even secret, areas.