If too much people pay attention to adverse selection, I’d argue that there’s an opposite effect: advantageous selection.
Imagine a world where every venture capitalist only invests in ‘hot’ rounds. Like this post advocates, they become wary when they’re easily able to trade their cash for a company’s equity. In this world, the market is inefficient. Supposing you have the cash to keep your portfolio companies alive (e.g., you’re SoftBank), you’d be much better off only investing in the companies that other investors don’t want to touch. This is because even though the hot startups are on average better startups (because of adverse selection), the low prices you pay for the not-hot startups should more than make up for it. Warren Buffet famously recommends “to be fearful when others are greedy and to be greedy only when others are fearful.” And it’s a rule of markets that in order to make outsized returns, you need to be both right and contrarian.
The rule I apply is considering the quality of the average market participant’s information. Back to your Alice’s Restaurant vs. Bob’s Burgers example, it’d matter a lot whether the typical eater is a local or a tourist. If it looks like most eaters are locals, they likely have very good information on both places: almost all of them have likely tried both multiple times. But if they’re all tourists, people may have just gone to the restaurant because they saw others there. In effect, there’s a speculative bubble in Alice’s food. So you’re probably better going off the beaten path: although Bob’s burgers is ceteris paribus of lower quality, the extra benefits (e.g., better service, chef can pay attention to crafting you an excellent burger) will ceteris paribus make up for it!
If too much people pay attention to adverse selection, I’d argue that there’s an opposite effect: advantageous selection.
Imagine a world where every venture capitalist only invests in ‘hot’ rounds. Like this post advocates, they become wary when they’re easily able to trade their cash for a company’s equity. In this world, the market is inefficient. Supposing you have the cash to keep your portfolio companies alive (e.g., you’re SoftBank), you’d be much better off only investing in the companies that other investors don’t want to touch. This is because even though the hot startups are on average better startups (because of adverse selection), the low prices you pay for the not-hot startups should more than make up for it. Warren Buffet famously recommends “to be fearful when others are greedy and to be greedy only when others are fearful.” And it’s a rule of markets that in order to make outsized returns, you need to be both right and contrarian.
The rule I apply is considering the quality of the average market participant’s information. Back to your Alice’s Restaurant vs. Bob’s Burgers example, it’d matter a lot whether the typical eater is a local or a tourist. If it looks like most eaters are locals, they likely have very good information on both places: almost all of them have likely tried both multiple times. But if they’re all tourists, people may have just gone to the restaurant because they saw others there. In effect, there’s a speculative bubble in Alice’s food. So you’re probably better going off the beaten path: although Bob’s burgers is ceteris paribus of lower quality, the extra benefits (e.g., better service, chef can pay attention to crafting you an excellent burger) will ceteris paribus make up for it!