Lessons from the Small Bets Cohort (Part 4/6)

Selection criteria are very important for us as individuals because unlike VCs, movie studios, book publishers, we can’t scale our time the way they can scale their capital. We can’t make 1000 bets. We only have time for a handful of bets at any one time.

Ergodicity

Daniel shows a thought experiment in which a million participants, all starting with $100, flip a coin over and over. If they flip heads, they increase their net worth by 60%, and if they flip tails, they reduce it by 40%.

This seems like a favorable game, where the more you play, the more money you’ll end up with.

And looking at a line graph of the average wealth over time, it does appear that the players are getting wealthier.

But surprisingly, the vast majority of players lose nearly all their money, and the average is pulled up by an outlier.

This means the system is not “ergodic”. An ergodic system is one in which the effects on the collective level are reflected on the individual level.

As individuals, we care about what happens to us on an individual level. Even if things are getting better on a collective level, that’s no comfort when we become ruined on an individual level.

So we want to make bets, not be someone else’s bet. Or, we want to look for ergodic games.

Risk of ruin

The reason that the vast majority of players lost money in this game, is that it only took a small streak of tails to lose everything. No matter how lucky they had been in the past, even if they had turned their 100 into 1,000, a streak of 3 tails(12% chance) would bring them down to just 64 dollars. And once they were down to 64, it would take a streak of 6 heads(1.5% chance) to get back up to 1,073.

So each player was just one unlucky streak away from losing most of what they had, and any large fall made the odds of them recovering very poor.

These players had met their game-over state, a point at which regardless of the favorable odds of the game, they didn’t have the resources to keep playing it.

Small Bets change the game

That same game can be made favorable for the average player, by reducing the amount of money the player puts on the line in every coin flip.

Instead of putting 100% on the line, as in the initial example, imagine if the players only bet 20%. Now, a streak of 3 tails isn’t nearly as big of a setback. Their wins won’t be as dramatic, but their chance of ruin is almost negligible, meaning they can stay in the game much longer and benefit from the favorable odds.

How to avoid our absorbing barrier

Absorbing barrier, game over state, ruin. The point at which you stop playing the game, and in this context we’re talking about the game of business.

Our #1 goal is to avoid the absorbing barrier. That can be financial ruin, or it can be psychological - losing motivation, getting discouraged. Or it can just be running out of time - that’s an absorbing barrier we all have.

#2 goal - get some small wins. Daniel disagrees with the “shoot for the moon, land in the stars” philosophy, and argues that instead of going for huge wins right away, you should go for low-hanging fruit to get some small wins. Each win helps make the next thing easier. Success brings success.

Selection Criteria

These are Daniel’s suggested selection criteria for individuals who want to make a lot of small bets with finite time and resources.

Can I bring it to market with small input?

If it fails, will it get me close to my absorbing barrier?

Daniel favors small weekend projects, which won’t drain resources or demoralize you if they fail

Does it have a fighting chance of paying off?

Even the most prolific makers might only make 10 things in a year. You can’t just do 10 random things. Before you bring a project to market, decide how much you expect to make from this thing. “I expect to make 1000 dollars from this thing. I want to make it 10 dollars. How can I get 100 customers? I need to get 10,000 views to my site with 1% conversion. How am I going to do that?”

And then maybe adjust expectations until it feels realistic.

Can I build and market on my own?

Working on things alone lets you build and abandon quickly, not needing to explain anything to a partner.

Will it get me into any long-term obligations?

You can lose interest in a project, so think about whether you can hand it off or do something to avoid upsetting your customers. Better to take projects that won’t lock you in.

Does it have high running costs?

Info products are great because it’s virtually free to keep them running. If you can leave something up forever, time works in your favor. If it’s expensive or burdensome to keep it up, you might just kill it.

Does this already sell in the real world?

Changing people’s behavior is hard. Getting people to do something or pay for something they’re not already accustomed to is hard. Don’t delude yourself into thinking you’re going to convince lots of people to change their behavior.

Pricing

Pricing is about psychology. We have certain expectations about how much a book, an ebook, an iPhone app, etc should cost. Regardless of how much value your product delivers, it’s hard to convince people to pay more than what they expect as the fair range for that kind of product - ie hard to sell a book for $100 when people expect books to be between $10 - $30.

Err on undercharging so you get more customers, traction, testimonials, word of mouth, etc.

One-off payments are basically the life-time-value paid upfront, which is good for you. And they’re usually easier to sell.