Early Investing

The Number One Rule of Investing

The Number One Rule of Investing
By John Fanning
Date August 19, 2020

Note: We’re pleased to welcome John Fanning to the Early Investing family. John was the founding chairman and CEO of napster. He has an impressive track record as both a founder and startup investor. And he will be sharing his thoughts — and occasional startup recommendations — on an ongoing basis with the Early Investing community. John is one of the sharpest minds in the space. We hope you enjoy his insights!

There are only two surefire ways to acquire massive wealth in America: 

  1. Inherit money, and 
  2. Obtain ownership equity in a very early stage company that becomes a phenomenal success. 

Unless you won the genetic lottery, we can rule out the first option. That leaves option 2 — angel investing. 

There is a dizzying amount of money that can be made through angel investing. In all kinds of investing the basic rule of thumb is buy low, sell high. And that’s the beauty of angel investing: You can buy very low. Equity in early stage companies comes at a dirt cheap price compared to equity in late stage companies that are publicly traded.

Back in 2004, Peter Thiel acquired a 10.2% stake in Facebook for just $500,000. That investment netted him almost 45 million shares. Today, Facebook is traded at around $220 a share. Thiel’s initial $500,000 investment would be worth well over $10 billion now. 

Anyone with an inkling of Facebook’s future worth would have jumped at the chance to buy shares in 2004 for a fraction of a dollar each. But many investors didn’t. Why? 

Because in 2004, investors — and even Mark Zuckerberg — didn’t know how successful the company would be. Although shares in the company were dirt cheap then, there was another hidden price: risk.

Investing in startups is an enormous risk. There are many things that can go wrong at the early stage — low market demand, high cash burn, inability to capture market share from competitors, poor management, lack of financing, unsustainable business model… In fact, 20% of startups fail in the first 2 years. And 50% fail after 4 years. Ultimately, 90% of all startups fail.  

Clearly, startup investing is high risk. But it’s also high reward. For most people, the high risk is enough of a deterrent to prevent them from investing altogether. But that is a massive error. The most important lesson in investing is this: To become a billionaire, you have to be willing to take risks for your high conviction ideas.

The most successful angel investors are not clairvoyant. They don’t have a crystal ball telling them which companies will be successful in the future and which will go bust in two years. Just like you, they face uncertainty. When Peter Thiel invested in Facebook, he didn’t know for sure it would be the astronomical success it is now. He took a calculated risk. He reasoned that the potential upside was much higher than the downside of losing $500,000. 

Think about it this way. Let’s say you make a bet with a friend. You flip a coin, and if it lands on tails, you have to pay the friend $50. If it lands on heads, then the friend pays you $500. Would you make the bet? You should. The upside of $500 far outweighs the downside of losing $50. And the odds are 50/50 for each to occur.  

But let’s take this further. Say it lands on tails, and you lose $50. Did you make a bad decision? This is where most people’s reasoning fails. They say, of course I made a bad decision. I lost $50. But the truth is you made a great decision. You just got a bad outcome. The same holds true for investing. 

Would you then flip the coin again? You certainly should. Say you flipped the coin 100 times. The statistical probability is you would win half the time and lose the other half. Your cumulative gain would be $25,000 and your total loss would be $2,500. That’s a net gain of $22,500.

Now let’s consider a more risky scenario, involving dice. If you roll a die and it lands on a 6, then you win $50,000. If it lands on any other number, you lose $500. Would you roll the die? The answer should still be yes. It’s true that the odds of losing are higher than the odds of winning. But the potential upside of $50,000 is still much higher than the downside of $500. You would have to lose 100 consecutive times to lose $50,000. But just one good roll can gain it. That’s called asymmetric risk. As an angel investor, asymmetric risk is the risk you want to take. 

You should always take the asymmetric risk if the probable return is higher than the probable loss. That’s what good investors realize. You rarely hear stories of average Americans striking it rich by only investing in the blue chip stocks of Facebook, Apple, Amazon, Netflix, and Google — the so-called FANG stocks. Blue chip companies are established, late stage and have minimal risk (not zero risk — even blue chip companies can fail). There is barely any potential for upside with them. But you do hear stories of angel investors who made a fortune by making a very risky bet in those same companies when they were just startups. 

You can’t become a billionaire with the “better safe than sorry” approach that financial advisors preach. Financial advisors lure you with the promise of building your wealth while hedging against their own risk. But their number one priority isn’t to create massive wealth for you. It’s preservation of capital — preventing loss. The implicit goal is to protect themselves against liability.

We have already established that the highest rewards come from the highest risk. But financial advisors don’t want to take the highest risk because more than just your money is at stake. They risk losing their jobs, getting sued and getting in trouble with regulators. So, financial advisors allocate your portfolio to FANG stocks with limited upside and a false sense of safety, or mutual fund baskets of low risk, low return equities. As long as they don’t lose much of your money, you probably won’t be upset at them and they won’t get in trouble. 

There is no risk-free investment with high returns. Think about it. If there was a safe investment with high returns, everyone would want to buy it. When demand goes up, the price goes up. When the price goes up, the return goes down. Simply put: eliminating the risk eliminates the reward. To create massive wealth, you have to get comfortable with risk. And remember, never invest money you can’t afford to lose.

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