Clustering Illusion

Clustering illusion is a cognitive bias defined by Wikipedia as the tendency to overestimate the importance of small runs, streaks, or clusters in large samples of random data (that is, seeing phantom patterns).

Investors will see a few deals in a space exit and consider it a hot spot for success when in the big picture the sector is no better than any other.

Sectors rotate in and out of favor based on investors’ interest in funding that sector.

When a few startups in a sector raise funding, investors often consider the sector a good area to invest in.

After only a handful of deals receive investing interest other investors will flock to the sector to find more deals to invest in.

In analyzing the field of startups, it’s often the case that that sector is no better than any other sector for investment.  

They’re looking for patterns where none exist.

To overcome the clustering illusion, use data analysis to statistically analyze the data.

This will tell you if there’s a real pattern or only the appearance of one.

 

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Hall T Martin is the director of Investor Connect, which is a 501(c)(3) nonprofit dedicated to the education of investors for early-stage funding. All opinions expressed by Hall and podcast guests are solely their own opinions and do not reflect the opinion of Investor Connect. This podcast is for informational purposes only and should not be relied upon for the basis of investment decisions.