Many small bets with outlier potential
Most of my writing is about the balance between risk and reward. I can’t stop thinking about it. My whole life revolves around identifying opportunities, estimating the risk involved in capturing value, and then deciding on what to do. All under significant uncertainty. I constantly work on improving my thinking around risk and reward.
What levels of risk am I comfortable with? When placed in an organization or situation that requires or assumes a higher or lower risk baseline than your preference, you will struggle. You will feel others are either reckless or cowards.
My approach to evolving my reasoning about risk is to read as much as I can, talk to as many people as possible, and then write. By writing in public I force myself to think carefully. My most recent read was The Power Law by Sebastian Mallaby. It has quickly become one of the canonical texts on venture capital. A sentence appears early in the book, without specific attribution, but in a section about Vinod Khosla. I think it captures the Silicon Valley mindset in a single sentence:
“There is no glory in projects that will probably succeed, for these by definition won’t transform the human predicament.”
Risk can only be understood in the context of what you might lose. All financially successful entrepreneurs and venture capitalists have taken risks. Usually an extraordinary amount of it. “No risk, no reward”, after all. But what might seem like a big risk to one person, may be a rounding error to someone else. Many famous people who celebrate taking risks are financially independent. Just like people who tell you to “follow your heart and have fun” often toiled through extreme pains to get rich. Advice can only be understood in context. What does a person have to lose by saying “You should take risks”? What do they gain? I think about that when I read the sentence above. And I think about that when I read writings by Sam Altman, Marc Andreessen, Peter Thiel, Elon Musk, Roelof Botha, and other promoters of risk. A common denominator between these people is that they all had major success early in life. They have been financially independent for most of their adult life. Another important factor is that they were not born rich. Even if they did bet big, they would always have a few tens of millions of dollars stoved away for a rainy day. For someone not born with money, that’s essentially an endless amount. If you are born into wealth, having less will feel like a failure, so then you might experience risk differently. Risk becomes a matter of social status and comparative achievement. Generational wealth seems to mess with people’s perspectives.
Some might say “But what about Elon Musk, he has bet everything a few times”. Well, I don’t think that’s true actually. I’m sure he always kept a few million dollars off the table. Either way, for every Elon Musk, there are at least ten Henrik Fisker who go bust. Survival bias is real. I strongly recommend reading "Speed & Scale" by investor John Doerr where he describes betting on Fisker instead of Tesla. Random events had a major impact on the outcome.
A wise man I know always says “Luck, Timing, Talent. In that order.” I think about that a lot. There is a deep, and humbling, truth to it - especially in the context of outlier outcomes. Up to a certain point, I maintain that you can influence rewards through hard work and talent. But eventually, effort and rewards are decoupled. At least in a financial sense. Founders who build billion-dollar companies do not work a billion times harder than other talented founders.
People with high intrinsic motivation, who see themselves as the agents of their success, will claim they “manufacture luck”. They feel that while they may not work a billion times harder, they are responsible for creating the leverage that produced their outlier outcome. The media isn’t interested in actual causality, instead, they will immediately print articles about “the genius X who foresaw Y”. The best people I know acknowledge the significant amount of luck involved.
All that said, there is no doubt prolific and hard-working people are positioned to have more luck. A legendary Swedish skier once said:
“I don’t know much about luck, but I do know I have more of it the more I practice.”
If you work hard and seek high-risk, high-reward situations, you are likely to get lucky more than others. The better you are at skewing the odds through strategic positioning, the further you can increase your odds of being lucky. Reversely, those who consistently avoid risk also reduce their chances of being lucky.
Venture capitalists make a living by exposing themselves to many small-ish bets, each with the potential to create outlier outcomes. I think the same strategy can be applied in almost any context: business leadership, personal life, etc. Position yourself so that you can make small, highly leveraged bets with fast feedback, i.e. bets with a small downside and a large upside within about a year. If you can create a flow of such opportunities, and work hard to maximize the odds of each bet, then you are in a good position to get a few great outcomes.
An interesting consequence of this strategy is that investors and founders are not aligned. Most founders only have one company. Most likely, the vast majority of their net worth is concentrated in that one entity. They probably have little or no optionality. If their company fails, they get nothing. And they may struggle to ever get close to what they had again. Most investors can afford to write off a few of their investments. Venture capitalists expect to write off most of them. This becomes particularly clear right now when raising money is hard. Founders have been encouraged to take risks and burn money in their pursuit of growth. Venture capital investors hunt outlier outcomes. But if commercial progress is not consistent with the outlier model, and there is a contraction in the funding ecosystem, then investors might suddenly consider your company “sunken cost”. I guess each generation needs to relearn this by going through a boom-bust cycle.
So, what’s my conclusion from all this? My goal is to make it easy to make many small bets, in proportion to available capital, each with potentially extraordinary rewards.
This can be done in all situations in life. Everything from hiring someone, trying a new product idea, or starting a conversation with a stranger. Each action can be a small bet with potentially extraordinary returns. You might find an excellent performing team member or make a valuable connection. If we apply this idea specifically to investing and personal wealth, I’ve arrived at the following algorithm:
1. Secure a financial foundation and set boundaries. To invest and take risks, I want to have 10x more cash-equivalent assets than I’m betting. The reason is that I want to make decisions unburdened by fear of losing my money. To invest $100k, I want to have $1M of liquid assets. For similar reasons, I’ve set an assets floor I won’t go under. If I have less than $X, I won’t place any bets, no matter how small. I’ve set my assets floor to ensure we can keep our house for a few years even if I lose everything (i.e. enough time to regroup without harming my family). Those funds are off-limits, and I’ve firewalled investing from my household finances. To bootstrap my foundation, I did two things: I joined a startup with a high probability of an excellent outcome (Recorded Future) and then I started my own company (Kognic). I think a major reason some people achieve extraordinary wealth late in life is they start early and then compound. I was lucky to become founder and CEO the year I turned 30, and experienced my first exit when I was 32.
2. Have the discipline to partially exit successful bets. If you have a successful outcome in one of your bets, you eventually want to exit part of your position to diversify. Rather than have your entire net worth locked into one asset, you want to get cash out and redeploy it. Remember, we want to place many small bets, not just keep one big one going. So, depending on the trajectory, you want to make a partial exit at some point. The option is to start diversifying what your company does, but that’s not always possible.
3. Develop access to a flow of bets with great odds of outlier outcomes. Get to know great, insanely driven people, and then help them with whatever they need. Provide tangible assistance without any strings attached. If you can figure out how to help great founders and investors you respect, then good investment opportunities will come your way. This is true for other things as well, not just investing. Being a prolific helper is a great way to build relationships and trust. Plus, it feels good and makes life meaningful. Being active and curious is the best way to find interesting problems, interesting people, and thereby interesting opportunities.
4. Decouple sizing your bets from your emotions. I’m inherently too optimistic to size bets appropriately. As a passionate person who easily gets excited, I tend to think “Wow, this is a great opportunity, let’s go all in”. Resist that temptation. Instead, apply a rigid and systematic approach when placing bets. When I seed invest, for example, I nowadays always invest the same amount. I’ve decided I only place a bet if there is a chance of an extraordinary outcome, so all opportunities should be approximately equally promising. If an opportunity feels less promising, I pass instead. I’ve started to think about business decisions this way too. Evaluate the upside, if it’s huge, place a default-sized bet (ticket size, number of FTEs, number of sprints, amount of money, hours, or whatever unit is applicable). Then just trust the process.
5. Remember that the strongest force in the universe is compound interest. My goal is to achieve a 20% annual increase in assets by placing many small bets. Based on top-performing venture funds, that should be possible. Over 5 years, that’s a ~2.5x increase. Over 10 years, ~6.2x, and over 20 years it’s a whopping 38x. I don’t need blowout years, I aim for consistently high returns.
Interestingly, the strategy of making many small bets is very similar to agile product development. Rather than make complex, long-term plans, you form a hypothesis, build a minimum viable solution, and test it on users. By placing a small bet, and evaluating the outcome, you learn quickly and can double down on bets that show promise. If early feedback isn’t great, you haven’t wasted too much time considering all the consequences.
Executing this strategy over the next twenty years will likely increase my odds of being lucky. It will require insanely hard work, and it’s far from certain I will reach my goal. But it sure feels like a fun challenge! 🤩