

Upside risk - sama
http://blog.samaltman.com/upside-risk

======
codex
If an angel loses all of their money on their prior round of investments, they
will have no more capital to invest in that "single best investment" just
around the corner in the next round. That is why they insist on onerous terms
--to keep them in the game.

And because no one can predict the future, they must give the same onerous
terms to that one "moonshot success" which will give them their 3000x return.
They simply don't know which one it is in advance.

~~~
kunle
> If an angel loses all of their money on their prior round of investments,
> they will have no more capital to invest in that "single best investment"

Agreed. That being said, putting all your liquid capital to work in one round
is pretty imprudent, no?

~~~
001sky
round/s...same diff

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danielpal
Although some founders might pursue high valuation as a way to get validation,
the majority or at least good founders pursue high valuations to avoid
dilution.

Another big reason would for recruiting. I've seen that's become increasingly
common that job offers include options as prices instead of percentages. Eg
you'll get $500,000 in stock based on the last round valuation as opposed to
saying 0.5%. This is increasingly common in later stage companies and it seems
to be very effective. Now companies in early stage with high valuations can do
the same.

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bsbechtel
I wish Sam provided a little more insight into upside risk, such as maybe how
an angel investor could best structure his investments to ensure he gets that
one 'outstanding investment'. He basically just stated what upside risk was,
which has been discussed multiple times over in this forum.

I think Sam knows the Y Combinator investment strategy is best designed to
take advantage of power law distributions and getting the very best
investments. With crowdfunding and the JOBS act, being able to spread $10k
across 50 different companies seems to open the door for everyone to
participate in this type of investment strategy. Thoughts?

~~~
sama
The way to do it is to have a good reputation among founders, and the way to
do that is to a) work hard to help the founders you invest in and b) don't
screw them. This becomes very important when the founder you really want to
invest in is choosing among lots of offers.

Of course, you also have be able to identify the good companies, which I will
write about later.

~~~
bsbechtel
Looking forward to it.

------
oskarth
Nassim Nicholas Taleb has talked at great length about this and related topics
in _The Black Swan (2007)_ and _Antifragile (2012)_ for those interested in
the topic.

~~~
msandford
Can't agree hard enough. He's synthesized who knows how many years (hundreds?
thousands?) of human thought on the topic. If you want to understand
investment in a non-gambling way it's all must-read.

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tempestn
PG investigated the same concept in more detail in this essay:
<http://www.paulgraham.com/swan.html>

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nirmel
We are indeed hardwired to focus on downside risk.

<http://en.wikipedia.org/wiki/Loss_aversion>

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ivankirigin
I wonder what this implies about YC's demo day. The hottest deals offer poor
economics but attract the best investors. Besides investing in a YC index
fund, those looking to mitigate upside risk could pursue a top-10 strategy.
But in that case the economics of the round (what percentage of the company
you own for the $) are worse.

~~~
sama
It's much better to invest in a good company at a high price than a bad
company at a low price.

~~~
loganfrederick
While this is true, I would take away from your post an almost opposing
viewpoint: That it would be better to invest in more startups, rather than
fewer, because of the difficulty in identifying which companies are "good" and
"bad" ahead of time.

How do you resolve the conflict between trying to only invest in good
companies (almost regardless of price) versus investing in as many startups as
possible (so as to increase your likelihood of investing in a good startup
since they are hard to find and identify)?

~~~
tptacek
That stops working if your "increase quantity" mechanism sets up a filter on
companies with worse terms; it's an adverse selection problem, because the
companies that are easiest to buy into are going to include a disproportionate
share of the losers.

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hcarvalhoalves
This reminds me of a TV show here in Brazil:

They stop someone at the street to ask 4 questions. If the person knows the
answer, he has to find someone else on the street who also does; if he doesn't
know, find someone who doesn't know. Everytime both he and the person he finds
either answer correctly or not, the participant gets R$ 250.

Then, after the participant wins R$ 1000, he's offered the chance to find
_one_ person on the street who can answer 2 of 4 (trivial) questions correctly
to win R$ 2000, or leave with R$ 1000.

The funny thing is that, even when the participants manage to find 4 others
who answer all the questions correctly, they refuse the chance to double their
money out of fear - even when they proved themselves that the people on the
street know the answers!

It's mind-boggling how risk-adverse we are.

~~~
derefr
That's not simple risk-aversion, that's the decreasing marginal utility of
gains _versus_ risk. If you need $1000 for something urgently, then $1000 at
100% probability is much more important than $2000 at 50%.

~~~
hcarvalhoalves
I guess you're right.

By my math, the probability of one given person knowing two answers out of
four to win another R$ 1000 is _way higher_ than the probability of four
people answering exactly like the participant required to win the first R$
1000. So it feels intuitive to take the final chance, specially given how much
data/options the participant has (knows all the questions and correct answers
already, and can choose any geek on the street).

But I'm being purely rational - R$ 1000 on the hand is certainly worth more
than a possible R$ 2000. Maybe if the final prize were R$ 10.000 or more
people would chose differently?

~~~
derefr
Also note: if the participant and their partners got all four questions wrong
(but got them wrong _together_ ), the particpant still "wins", and moves on to
the second round. But in this case, they have no evidence that the people on
the street can be trusted to answer questions. If this scenario is common, it
could be throwing off your expectations.

~~~
hcarvalhoalves
Not sure if my math is right, but cope with me...

To win the first prize, four independent events should happen: the participant
has to answer (either right or wrong), and a random person in the street has
to answer the same way.

Let an event "QnPmAo" mean "Question n, Person m, Answer o", where n=4, and o
can be 1 (right) or 0 (wrong). The probability of winning the first prize
would be:

P(Win) = (P(Q1P1A1 ∩ Q1P2A1) + P(Q1P1A0 ∩ Q1P2A0)) * (P(Q2P1A1 ∩ Q2P3A0) +
P(Q2P1A1 ∩ Q1P3A0)) * ... and so on, for all four questions.

To win the second prize, only two independent events are need: a participant
knowing any two out of four questions. The probability would be:

P(Win) = P(Q1 ∩ Q2) + P(Q2 ∩ Q3) + P(Q3 ∩ Q4) + P(Q1 ∩ Q4)

From a statistical viewpoint, the second scenario seems always more likely
than the first, assuming the knowledge of the population about trivial
questions follows a normal distribution. If during the first round all four
participants know the answers, the odds of a fifth participant knowing at
least two are high.

Still, from the episodes I watched, people seem to refuse the second challenge
regardless of the outcome of the first round - in other words, they don't seem
to make a rational decision.

Hope someone less rough than me in statistics can shed some light if there's a
mistake!

~~~
derefr
> assuming the knowledge of the population about trivial questions follows a
> normal distribution

This is the assumption I question. Knowledge tends to cluster geographically--
people in the same area get the same cable channels, on which are aired the
same re-runs of Jeopardy on the same nights.

------
6thSigma
This is also very good advice for entrepreneurs. Choose what you work on based
on the upside risk rather than the downside risk.

~~~
yakiv
Or you could consider both.

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bornonmars
I don't agree. They already focus on upside risk, the main fear being to miss
out.

There's no bias left, at least not there.

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jamiequint
Investors also have a hard time valuing optionality, they tend to only see the
thing that is currently in front of them. Sure that airbed and couch rental
startup might not be a big market but what if they moved into the market for
all spaces...

