Ask most people if they’d start a business with an 80% chance of failure and they’ll say no. If you start such a business they’ll think you’re crazy. But starting a business like this is perfectly logical and can make you a millionaire.
No, I’m not talking about plowing your life savings into a business, crossing your fingers and hoping for the best. That would be a fast route to bankruptcy and poverty.
So why start a business that’s most likely to fail?
The simple answer is because of the expected returns. The probability is only one-half of the equation. The vast majority miss the other half, which is the expected return of the business you’re planning to start.
This hypothetical example will you get it right away.
Suppose I offer you a bet. I roll a die. If it lands on 6, you win. If it lands on any other number I win. You will probably refuse the bet because I have 5 times more chance of winning. If I roll the die 6 times, you’ll likely win once and I’ll win 5 times.
But you don’t the odds, so how can you dismiss the bet?
What if you bet $1 each time? If I win I get to keep your $1. If you win I give you $12.
I think you’ll be a little more interested in taking the bet now. In every 6 rolls of the die, you’ll bet a total of $6. You will likely win once, giving you a $12 return. So you made a $6 profit from 6 throws. Your expected return for each roll of the die is $1. That’s a $2 return minus the $1 you bet. You could play this game all day long and make an average of $1 each time.
Your chance of winning each individual roll is only 1 in 6. You know that for each roll of the die you are likely to lose.
But you don’t mind losing $1 for 5 out of 6 rolls. What matters is that you make an overall profit.
If I gave you $6 for winning, your expected return would be zero. You’d bet $1 each time and get an average of $1 return. The game is not worth playing.
If I gave you $3 for winning, your expected return would be -$0.50. You’d bet $1 each time and get an average of $0.50 return. You’d end up losing money, so the game is not worth playing for you. But it is worth it for me.
Note: Probability doesn’t work this neatly. Over the long run, you’ll win 1 in 6 times, but you could easily lose 20 times in a row before getting a run of wins.
How does that relate to starting a business?
It’s exactly the same assessment. I need to know the probability of the business succeeding and the expected return.
While calculating the probability and the expected return is easy with the above example, it’s not so easy to do with a business. You need to make some educated guesses based on your skills, your experience, and what happened to similar businesses.
This is how venture capitalists make money. They didn’t invest in Uber, Twitter, Facebook, and others because they thought the probability of each individual company succeeding was in their favor. They invested because the expected returns were in their favor.
They know that most of the individual investments will fail. They also know that the winners will be potentially massive. Even 5% of winners can make you seriously wealthy.
Don’t bet the farm — this is super-important
When doing this you have to allow room to have a long line of losses. You don’t want to run out of money before you get that winner. This is how some people end up bankrupt.
They bet their life savings on a business that may have a 95% chance of success. But their luck isn’t in. The business failed. Now they’re totally out of money and living in poverty. There is no money left to try again.
Don’t just think of big businesses here. This works on a small scale.
Most of you are willing to pay (bet) $5 a month to join this platform. You probably think you can make more than that from your writing. You are assuming that the expected return is positive, although you don’t express it in those terms.
What if the monthly fee was $100? Would you still pay? Probably not. You will likely assume that you’ll make less than $100 a month from your writing, so your expected return will be negative.
You understand expected returns on some level, as you’re already putting it into action.
Even if you make $0 writing here, you think those $5 a month bets are worth it, because you have a chance of making more for some months. After all, they aren’t going to bankrupt you. If your writing venture fails you still have enough money to try something else.
So, back to my original question. If I could invest $5,000 in a business that had the potential to make me $1,000,000, I’d try it even if the chance of failure was 80%. I’d spend $25,000 for 5 goes. I’d likely get $1 million back. That is the logical way to play the game.
Of course, you should not do this unless you have enough money to see a long string of losses.
This is also why I have a chunk of my net worth invested in crypto. The potential returns are massive compared to the risk of losing. The expected return is in my favor.
This is not financial advice. I’m not suggesting you invest in crypto or start any business. Take professional advice before making any investments.