In investing, you have to know what game you’re playing. Consider the following two very different approaches:

APPROACH 1: Don’t lose money

The first is from Steve Schwarzman, founder of the private equity firm The Blackstone Group. Here’s Schwarzman from his book What It Takes:

People often smile whenever they hear my number one rule for investing: Don’t. Lose. Money. I never understand the smirks, because it is just that simple. At Blackstone we have established, and over time refined, an investment process to accomplish that basic concept. We have created a framework for assessing risk that has been incredibly reliable. We train our professionals to distill every individual investment opportunity down to the two or three major variables that will define the success of our investment case and create value. At Blackstone, the decision to invest is all about disciplined, dispassionate, and robust risk assessment. It’s not only a process but a mind-set and an integral part of our culture.

APPROACH 2: Take the bet — lose 1x or make 1,000x

A different philosophy comes from Marc Andreessen, co-founder of the venture capital firm Andreessen Horowitz. Here’s Marc Andreessen from a fireside chat at Stanford Graduate School of Business (summary, video):

In venture capital, there's two kinds of mistakes you can make. There's a mistake of commission. I make a decision. I invest in a company. I lose all my money. That's the mistake everybody thinks about. And then there's the mistake of omission. Mark Zuckerberg walks in the door at venture capital firm XYZ in 2004. They think: “What is this little kid doing? This idea is crazy. Friendster proved that this could never work. This is ridiculous.” That is, by the way, what he got told by a lot of people. In the venture capital business, every highly successful VC has made mistakes of omission—really big ones—of companies that they had the chance to invest in, that they should have invested in, and that they didn't invest in. It turns out the mistakes of commission don't really matter. They don't scar you for life. They just go and fade into history. The mistakes of omission are much worse. There’s an asymmetric payoff. When these companies work, they work at 1,000x. If you lose, you lose 1x. If you win, you win 1,000x or 10,000x. … We call this mentality the “slugging percentage” mentality, which is basically: take the bet, lose 1x; don't take the bet, possibly miss on 1,000x.

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Now, clearly, given both firms are tremendously successful, both approaches can lead to successful outcomes. The mistake is in mixing the approaches and not following them to their logical conclusion.

The “don’t lose money” approach the requires extreme vigilance on the downside. You can’t afford to be wrong.

The “take the bet” approach requires a “swing for the fences” mentality with every single investment. You still understand the downside, but you spend more time on understanding whether and how each investment can pay off on the upside for a 1,000x return, if not more. Each investment has to fit this profile because you can’t place one or two of those bets; you need to place enough to have one in your portfolio that pays off, more than compensating for the numerous bets that won’t pay off.

The key is to know — with clarity and conviction — which game you’re playing. You must not mix the two approaches. I’ve seen firsthand how easy it is to get this wrong.

A private equity investor I know had a large investment go to zero because they missed the downside risk. The investment had significant financial and operating leverage, so even a relatively small miss in projections resulted in a dramatically bad financial outcome. The investment had high downside risk, but on the upside it promised “only” 3x to 8x returns. This was a private equity investment on the upside and a venture investment on the downside. That doesn’t work.

On the flip side, I’ve seen venture investors do this as well. Here, I made the mistake. I met Brian Armstrong at YC Demo Day in 2012, and he visited the offices of the venture capital firm I worked with at the time, Rho Ventures. He painted a truly breathtaking story, but one that was so hard to grasp, we ultimately didn’t pursue an investment. Brian ultimately raised from Andreessen Horowitz and Union Square Ventures. Certainly, hindsight is 20/20, but that’d be “resulting” — judging a decision by its outcome, not its process. Rather, our process was flawed. What we got wrong was that we overly focused on the downside but not on the upside. Yes, Coinbase could have gone to zero, but if it worked (and it has), it was well north of a 1,000x return (possibly magnitudes more, especially if you include the value of Bitcoin at the time compared to today). The expected value of the investment, even with high likelihood of failure was positive. We should have taken the bet. (More precisely: we should have been willing to take the bet. In all likelihood, Brian would likely have ended up partnering with A16Z and USV regardless, given their reputations, more significant knowledge and proactive stance on the sector, etc.)

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Fat Tails

Relatedly, I’ve been reading a lot lately on “fat tails”—the idea that investment returns are riskier than typical risk models would have you believe.

I started spending more time on the topic after reading The Dao of Capital by Mark Spitznagel and The (Mis)behavior of Markets by Benoit Mandelbrot.

After reading the books it occurred to me that there have been a surprisingly large number of “extreme” events:

The Black Monday crash of 1987
The Asian economic crisis of 1997
The Russian default in 1998 that led to the collapse of the hedge fund LTCM
The financial crisis of 2008 that brought the world financial market to the brink of collapse

When extreme events happen often, you have to start wondering whether they’re really extreme events or normal events. Is the world defying our models, or are our models of the world wrong?

Spitznagel and Mandelbrot along with Nassim Taleb, Vineer Bhansali of LongTail Alpha, and others believe our models are wrong.

Among the compelling arguments in Mandelbrot’s book is that economists have twisted themselves into knots for decades trying to solve the “equity premium puzzle”—the “excess” reward stocks have provided above risk-free investments, even when adjusted for risk.

As Mandelbrot points out (emphasis mine):

…these papers miss the point. They assume that the “average” stock-market profit means something to a real person; in fact, it is the extremes of profit or loss that matter most. Just one out-of-the-average year of losing more than a third of capital—as happened with many stocks in 2002—would justifiably scare even the boldest investors away for a long while. The problem also assumes wrongly that the bell curve is a realistic yardstick for measuring the risk. As I have said often, real prices gyrate much more wildly than the Gaussian standards assume. In this light, there is no puzzle to the equity premium. Real investors know better than the economists. They instinctively realize that the market is very, very risky, riskier than the standard models say. So, to compensate them for taking that risk, they naturally demand and often get a higher return.

I’m convinced, and over time, I’ve increasingly found myself forming an investment philosophy to invest accordingly, both in public and private markets. More to come, but here’s a simple visual for now of “fat tails” investing: