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The Most Important Test Your New Business Idea Needs to Pass

The Most Important Test Your New Business Idea Needs to Pass

One of my big failures taught me that your gut reaction can give you a better answer than pages of analysis.

In 2007, I decided I wanted to open a hedge fund. It took me eight months of research without a nibble of client interest before I realized that I had to give up the venture. I realized afterward that I had been walking down a path my gut initially told me would not be a profitable one.

I thought there were plenty of good reasons to open a hedge fund. For one, there may be no higher paying activity on the planet. After all, hedge funds earn their owners annual fees of 2 percent of the assets under management and at least 20 percent of the profits. Top hedge fund managers regularly pull in over $1 billion in annual compensation.

I thought I could manage money well. I had enjoyed high returns investing in private companies during the 1990s. And in 2002, I started an investment newsletter that recommended three publicly-traded stocks each month that generated market-beating returns.

I was concerned about whether there were regulations that would prevent me from starting a hedge fund. So I met with a friend of a friend who had started one who had a law degree and he said that I did not need a specific license, but that I might need one if I attracted enough investors.

So I drafted a prospectus for my proposed hedge fund and started to consider how I would approach potential investors. This was the point where my gut started telling me I would have a really hard time. After all, I had no experience managing other peoples' money.

Having followed the stock market closely since I began appearing on CNBC in 1998, I was convinced of one part of financial theory: You can't beat the market. All the supposedly reliable techniques for picking stocks would not help me pick stocks any better than all the other well-trained analysts who were using the same approach.

I noticed another investment rule that worked almost perfectly. If a public company beat Wall Street earnings expectations and raised its forecast each quarter, its stock would go up. And if it failed in either, its shares would plunge. But this was a useless rule because the only way to know for sure how these statistics will turn out each quarter is to have insider information, which I did not have.

In short, any market-beating investment profits I had earned, I attributed to luck. And when faced with the prospect that I could be lucky in the future by betting all of my net worth and other peoples' money, in my gut, I wasn't sure I could not succeed. Still I pressed on, hopeful that my hard work would pay off.

A few months later, at a wedding, I was sitting at a table with a former business school classmate who worked in a fund-of-funds in Manhattan. He was in charge of allocating money among different hedge funds.

When I told him about my idea to start a hedge fund, he scoffed. He said that if I had any hope of starting such a fund, I should invest all of my own money using the proposed hedge funds' investment strategy. If I could show that my audited returns beat the market on a risk-adjusted basis, there was a chance I could raise money from other investors.

That's when I realized there was no way I would be willing to bet my entire net worth on my ability to make investment decisions. Why then, should I be willing to risk other people's money?

My failure to start a hedge fund highlighted an important lesson: Often your gut reaction is right. My gut was telling me this hedge fund idea would not work. But I kept pursuing it.

What I learned was that a true test of deciding if a business will work is asking yourself whether you're willing to bet everything you have on it. If that sounds like a crazy idea, maybe your gut is onto something. I know mine was.
 

The author is an Entrepreneur contributor. The opinions expressed are those of the writer.

Peter Cohan is president of Peter S. Cohan & Associates a management consulting and venture capital firm. He is the author of Hungry Start-up Strategy: Creating New Ventures with Limited Resources and Unlimited Vision (Berrett-Koehler, 2012).

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