Standards

Incentives

The defensive ways people play Valuation Games often set up conditions for cheating, fraud and other forms of rule bending. It's a paradoxical situation: players create danger for themselves when they try too hard to avoid it. This can happen even when players have good intentions and a sincere desire to play the game within a specific set of boundaries.

This tends to kick off when Commanders set unreasonable standards that others have to find a way to satisfy. In finance, for example, there are investors who refuse to put money into any hedge fund that doesn't present strategies with backtests that demonstrate Sharpe ratios of 3 or higher. This level of performance is rare, but it's easy to tamper with backtests.

All a fund manager who wants that investor's money has to do is fake their data in order to make their backtests fit that profile. They may have strategies that perform quite well, but that extreme standard means the manager needs to adopt extreme strategies to win. Given the stakes involved, it should be no surprise that plenty of people will resort to fraud to get what they need.

Standards like this can have cascading effects. If one well-respected investor makes that unreasonable standard public, other investors will copy them and suddenly crazy benchmarks become mandatory. They've created a Valuation Game where they think they're protecting themselves from poor performance, but in reality they've only created a new vulnerability to fraud.

Overfitting

A general way to view how this works is with the use of the concept of overfitting. Overfitting is a modeling error that occurs when a function is too closely aligned to a limited set of data points, a concept born out of machine learning. It's an optimization problem: the machine sees a pattern that works in a small sample of data, then optimizes all its behavior towards that specific pattern. But once the machine finds itself out of sample, performance dies.

For a more human example, picture a coach who devises a game plan based on the last ten games of their next opponent. The plan is so specific that it only works if the opponent repeats their exact moves. Any deviations from those patterns will catch the coach off-guard and the team will underperform. It's like learning to dodge bullets from a gun that only fires in a set pattern. Once the pattern changes, you're getting hit.

This is a common problem with Commanders as well. They tend to have overly rigid ideas in their heads about how to manage risk, including how to assess the value of people and assets.

The issue here is that, while those patterns are often built on experience and wise judgement, they can be used against them. Someone who knows how to play Valuation Games well can simply determine what patterns matter to a given set of Commanders, then maximize for those patterns in order to get what they want out of them.

Star Syndrome

Skilled players of Valuation Games, particularly adept Contenders, can recognize and manipulate these overfitting tendencies. By presenting themselves or their assets in a way that aligns with the Commanders' established patterns, they can gain favor or investment. This involves a deep understanding of what Commanders value and a strategic presentation that ticks all the right boxes.

For example, a highly capable person with a proven track record may get passed over by a Commander because they didn't go to a prestigious enough university. Meanwhile, a far less capable person with a degree from Harvard, Stanford or Oxford may easily pass the Commander's smell test.

More than anything else, what most overfit investors seek is the elusive star player. This is the person who outperforms everyone else across every significant metric. They're good-looking, educated, charming, have all the right credentials and play the game better than anyone else.

Unfortunately, the brightest stars tend to be frauds. They're the kinds of people who understand how to "(over)fit the profile" by checking every imaginable box in the minds of their victims, which is impossible to do honestly in most cases. We all like to say "nobody's perfect," but our assessments of stars seems to betray our real beliefs about what's possible.

When someone is clearly overfitting for stars, they're suffering from what I call star syndrome. The irony of star syndrome is that it's built on a sincere desire to associate with the best of the best. It's a risk-minimization strategy. This is a natural, understandable tendency. But when you start to believe in magic and suspend disbelief as soon as someone tickles your fancy, you create a whole new world of risks for yourself.

Sam Bankman-Fried sold himself as a youthful genius so well that nobody seemed interested in looking behind the curtain until he'd already stolen a fortune. Elizabeth Holmes portrayed herself as the next Steve Jobs, to the point of wearing black turtlenecks every day, which only endeared her more to investors. The list of frauds who knew how to overfit is long, as are the numbers of people who suffered as a result of their desperate desire to play it safe.

Adam Neumann is perhaps the most successful perpetrator of this type of Valuation Game. It's a common belief in the world of venture capital that eccentric, outrageous behavior is the mark of a charismatic genius. Neumann took that to an extreme, smoking weed in the office while walking around barefoot demanding employees take tequila shots. He sold his property management company as a form of accelerated human evolution—a movement, not a company.

Investors ate this act up. He was encouraged by Masayoshi Son, his biggest investor, who reportedly told him (while driving around in Son's limo) to act even crazier. This allowed him to not only inflate the value of the company, but behave in ways that would in other circumstances would be considered fraudulent.

Many of his supporters knew what was going on and hoped to just exit for a big multiple once WeWork IPO'd (which he almost got away with). But others simply bought his story without any critical assessment and let overfitting drive their decisions. He walked away with a multi-billion dollar fortune, but the company eventually went bankrupt and most investors lost their shirts.

This is the price you pay when you over-optimize for sure things and disconnect your critical thinking in the name of standards.