There’s much that’s being written about Sam Bankman-Fried (SBF) and the choices he made. We think there’s one particular aspect of his thinking and actions that has received less attention than it deserves, and perhaps explains better than anything else the arc of his narrative.
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In a range of interviews and Twitter threads (see links and excerpts below), SBF explained that he approached financial decisions with little or no aversion to risk. That’s a valid personal choice, but it’s highly unusual. In our own experience, we’ve never met anyone who made important financial decisions consistent with being anywhere in the ballpark of zero risk aversion.
To see why, it’s helpful to take a look at where risk-aversion comes from. It arises from the fact that most people derive less and less incremental satisfaction from progressive increases in wealth – or, as economists like to say: most people exhibit diminishing marginal utility of wealth. This naturally leads to risk aversion because a loss hurts more than the equivalent gain feels good. The classic Theory of Choice Under Uncertainty recommends making decisions that maximize Expected Utility, which is the probability-weighted average of all possible utility outcomes.
SBF explained on multiple occasions that his level of risk-aversion was so low that he didn’t need to think about maximizing Expected Utility, but could instead just make his decisions based on maximizing the Expected Value of his wealth directly. So what does this mean in practice? Let’s say you find an investment which has a 1% chance of a 10,000x payoff, but a 99% chance of winding up worth zero. It has a very high expected return, but it’s also very risky.3 How much of your total wealth would you want to invest in it?
There’s no right or wrong answer; it’s down to your own personal preferences. However, we think most affluent people would invest somewhere between 0.1% and 1% of their wealth in this investment, based on observing other risky choices such people make and surveys we’ve conducted (e.g. here). We suspect that range sounds reasonable to you.
SBF on the other hand, making his decision strictly according to his stated preferences, would choose to invest 100% of his wealth in this investment, because it maximizes the Expected Value of his wealth. In one of his interviews, he did suggest that perhaps he wouldn’t go all the way to 100%, but that he’d still invest way, way more than the typical choice of 0.1% to 1%. However, in other interviews, he didn’t back off of the implications of maximizing Expected Value – as in, for example, his conversation with the economist Tyler Cowen (March 9, 2022).
Read the full article here by Victor Haghani and James White, Advisor Perspectives.
