I read Going Infinite last week, Michael Lewis’s recent book about Sam Bankman-Fried (SBF), and the ~$10 billion fraud/downfall of Bankman-Fried’s cryptocurrency exchange, FTX. I found the book totally worthwhile and hard to put down.
This week, I’ve been catching up on SBF’s trial via the Judging Sam podcast, below.
There are many crazy parts of this story and many lessons to be learned. One lesson deals with a hypothetical coin flip. Economist Tyler Cowen once asked Sam:
Let’s say there’s a game: 51%, you double the Earth; 49%, it all disappears. Would you play that game? And would you keep on playing that, double or nothing?
To add context, the 51% chance is that you’d make things twice as good on Earth. 49% chance you kill everything on Earth. Do you take that bet? And do you keep on playing?
“I’d play every time.”
Why would anyone take this bet? Let alone taking it every time, playing over and over.
To explain SBF’s “logic,” you’ll need to humor me for a minute. Let’s replace “the Earth” with $100. And let’s imagine, like any trading firm on Wall Street, you’re making thousands of bets every day.
There’s a 51% chance you double your $100. There’s a 49% chance it goes to zero. Do you take that bet thousands of times per day?
The expected value (EV) of a single bet = (51% * $200) + (49% * +$0) = $102, or a $2 gain per every $100 wagered. If you repeat that bet over and over and over, you’ll print billions of dollars, two at a time. This idea – trillions of bets worth pennies each – ties back to high-frequency trading, Robin Hood, Citadel, and the GameStop short squeeze in 2021.
That’s the world SBF thought himself in: in the artifice of Wall Street, or the game Magic: The Gathering (which, according to Going Infinite, SBF was obsessed with).
Consequences are minimal in those worlds. Lose a small trade? Try again tomorrow. Lose a game? Shuffle up and play again.
When the Consequences Matter More…
Gambling on the fate of humanity is far different. Or, most realistically, gambling on a multi-billion dollar business with hundreds of employees, thousands of clients, and billions of clients’ “safe” deposits. Any gambling of this nature requires a different understanding of risk. SBF either didn’t have this understanding, or he didn’t care. I’m not sure which is worse.
Let’s return to SBF’s original wager: 51% to make the world twice as good, 49% to destroy it. Do you play, and do you keep on playing?
SBF says yes. Let’s entertain ourselves. What if we play the game 10 times in a row?
If all ten flips land on heads, SBF just doubled the world’s goodness ten times in a row. That’s a 1024x improvement and 0.119% probability of it occurring, or an expected value (EV) of a 22% improvement. In SBF’s world, you always make a positive EV bet. That’s why SBF would do this “every time.”
But what if one flips lands tails? In those outcomes, the world is destroyed. And that’s the other 99.881% of our 10-flip outcomes.
An overall positive EV doesn’t matter when there’s a near guarantee you’d destroy the world. This is the essence of a topic we’ve discussed previously on The Best Interest: ergodicity. I won’t re-explain it here. You can read the article above if you’d like. But know this:
Ergodicity rears its head in two circumstances. First, ergodicity matters when we do things over and over and over. And second, ergodicity matters when certain outcomes are meaningful while other outcomes are insignificant.
SBF either didn’t know about ergodicity or, much worse, didn’t have empathy for the prospect of destroying the world. Based on the anecdotes in Going Infinite, I bet it’s the latter.
SBF’s former colleague and ex-girlfriend Caroline Ellison said, “He has absolutely zero empathy. That’s what I learned that I didn’t know. He can’t feel anything.”
And SBF wrote to Ellison, “In a lot of ways I don’t really have a soul. There’s a pretty decent argument that my empathy is fake, my feelings are fake, my facial reactions are fake. I don’t feel happiness.”
SBF can coin-flip the world out of existence because, to him, it’s just math. No feelings. He can ignore the desires of 7 billion autonomous individuals because the math tells him so. Black-and-white utilitarianism.
Utilitarianism – doing the most good for the most people, or justifying “bad” actions when they lead to “good/better” outcomes.
Similarly, SBF took actions within FTX that put the whole company at risk. Why? Because if the coin flip fell the right way, it’d be a massive win for FTX. And he thought the odds were in his favor.
He failed to properly account for a failed coin flip. You don’t get to try again tomorrow. It’s game over.
Our lesson is to remember that risk always matters, and some risks are too significant to ignore. We should be wary of bets that are “double or nothing,” especially when the “nothing” is extremely consequential. Russian Roulette is the best illustrative example. Play once, you’re 83% to survive. Play in ten times, you’re 84% to die.
There are some everyday personal finance and investing examples that we can learn from.
Retirement Planning and Diversification
Imagine these two scenarios:
- Scenario A: there’s a 100% chance you have a comfortable retirement and leave $200,000 to your heirs when you die.
- Scenario B: there’s an 80% chance you have a comfortable retirement and leave $1,000,000 to your heirs. And there’s a 20% chance you die broke, suffering, full of regret.
While Scenario B might have a higher EV (80% of $1M is more than 100% of $200K), the pain of “dying broke, suffering, full of regret” is worth avoiding at all costs. For most retirees, the main focus of retirement planning is avoiding terrible outcomes.
While a 100% stock portfolio has historically outperformed a 60% stock, 40% bond portfolio, the 100% stock portfolio also has a much higher probability of terrible failure. Better upside, but worse downside. Most retirement portfolios account for that downside through diversification.
This leads me to one of my favorite Buffett quotes: “It’s insane to risk what you have and need for what you don’t have and don’t need.”
Risking what you have and need (retirement security) for what you don’t have and don’t need (to die atop a bigger pile of money) is insane.
Let’s look at a hypothetical 30-year-old couple who just had their first of 3 children. They’ll be 55 when their final kid graduates college and enters the real world.
So the couple asks themselves: what are the odds we die before age 55…and what should we do about that risk?!
The Social Security Actuarial tables are clear. An American 30-year-old man has a 10% of dying before age 55, and a 30-year-old woman has a 5.5% chance of dying before 55. The odds, thankfully, are in this couple’s favor.
But the consequences of dying are so severe! The financial implications can be dire. If we gather 100 such couples in a room, we can all but guarantee that a few will face this terrible outcome.
This is where risk sharing comes in. Or, as it’s better known, insurance.
Insurance is nothing more than sharing risk with others. Most of us will never use our insurance to its total value; it’s a waste of money. But the unlucky few will use the insurance, and thus will avoid financial disaster. In a perfect world, the insurance company middleman takes a minimal cut, reducing the frictional pain of insurance ownership. However, that world is not the one we live in.
Insurance covers risk you otherwise couldn’t bear.
Risk is out there. Ignore it at your own peril.
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