Swing Big Swing Hard: The Babe Ruth Effect in Venture Capital

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"I swing as hard as I can, and I try to swing right through the ball...The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I've got. I hit big or I miss big."

- Babe Ruth

We recently came across an interesting blog post by Chris Dixon, general partner at VC firm a16z, on The Babe Ruth Effect in venture capital, and subsequently, a paper on the same subject by Michael J. Mauboussin and Kristen Mauboussin from Credit Suisse First Boston. Both helped shape this week's episode.

Baseball fan or not, everyone has heard of legendary batter, Babe Ruth. He became one of the greatest hitters of all time by swinging big and swinging hard. And like Ruth, venture capital’s top investors aren’t concerned about hitting every time, they’re focused on scoring those massive home runs. This is known as the Babe Ruth Effect: It isn’t about winning frequently; it’s about winning big when you do. And in the world of venture capital, it’s all about magnitude versus frequency.

Venture capital is an asset class built on the idea that only a few investments in a fund will generate the outsized returns needed to offset losses. Some investments will fail, some might break even or generate small returns, and a handful will drive exceptional profits, making up for any losses and generating impressive returns overall. Think about a fund with 20 startups. If just one of these hits a home run while the rest either break even or fail, that single investment can still drive strong returns for the fund. In venture capital, success isn’t measured by the number of wins but by the scale of those wins. While traditional investing often aims for consistent, frequent wins, venture capital flips this idea around, stressing the need to take calculated risks for outsized returns.

Mauboussin and Mauboussin’s paper tells an interesting story to illustrate this. A successful portfolio manager, one of 20 at his firm, was called in by the company treasurer to explain his stock picking strategy. The treasurer was disappointed by the performance of his managers and assumed even a random decision-making process would result in a portfolio where roughly half the stocks would outperform the S&P 500, with the other half underperforming. So, he evaluated each portfolio based on the percentage of stocks that beat the market. The portfolio manager’s overall performance ranked among the best, but his “batting average” was among the lowest. After letting go of some of the underperformers, the treasurer sat down with this particular manager to figure out why his portfolio excelled despite his so-called low average.

The manager responded that “The frequency of correctness does not matter; it is the magnitude of correctness that matters.” He explained that if he held four stocks, and three went down slightly while one soared, the portfolio’s performance would remain strong despite the majority of stocks declining. So, you don’t have to hit every time; you just have to hit big when you do.

The problem with this strategy is that most people hate losing, even if the overall outcome is positive.  Prospect Theory, a concept in behavioural economics, helps explain why it’s hard to accept the Babe Ruth Effect. The theory suggests that people have a strong aversion to losses, even when the stakes are low. Essentially, the negative impact of losing a sum of money is greater than the positive impact of winning the same amount of money. We’re naturally wired to hate losing, which is why the Babe Ruth Effect can be difficult to stomach. But building a successful VC portfolio means accepting that some losses are par for the course. Babe Ruth struck out often, but he’s still remembered as one of baseball’s greatest hitters.

However, it’s worth noting that while venture capital firms and individual angel investors may be playing the same game, they’re often playing with differing sets of rules. Venture capital is all about magnitude, not frequency, but few angel investors have the experience or capacity to make large, concentrated bets, hoping for a home run. So… how can angel investors protect themselves against losses? More importantly, how can they build a robust portfolio that can withstand those losses while keeping them in the game, swinging for those big wins?

For angel investors, diversifying across a larger number of investments provides a buffer against potential losses, creating more chances for success without relying too heavily on any single outcome. By widening the pool of investments, you increase your odds of picking a winner. This is known as an indexed approach, and while the quality of the investment remains just as important as ever, increasing the frequency of investment or ‘shots on goal’, will help investors stay in the game. Something we went deeper on in last week's episode.

Investing in startups requires a shift in thinking and a different mentality compared to short-term stock picking, so not only should you expect your money to be locked in for a long time, you also have to get comfortable with some investments in your portfolio failing - it’s just the nature of the game!

So like with any investing strategy, diversification is critical and only invest what you can afford to lose! 

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The Unsophisticated Investor is brought to you by Scott & Rob, the founders of Shuttle. We’re both sick of private markets being a playground exclusive to the ultra-wealthy so we started a company to challenge the status-quo. Shuttle’s singular focus is to unlock private markets for Millennial and Gen Z retail investors and help them build wealth through the highest performing private market opportunities.

Scott & Rob
Shuttle Co-Founders