Why? Because Warren has no additional use for his £1,000! It makes marginal difference to him when he adds it to his billions. But for you, it may mean a month’s rent, or groceries, or wages for your staff.
Therefore, the utility of a £1,000 gain is higher for you than for somebody who already has billions of pounds.
So, although in an absolute sense £1,000 is £1,000, the value will differ from person to person depending upon what utility that £1,000 provides him.
Look at it another way – if you were flat broke, owed 6 months on your rent and had more overdue bills than you had income coming in….and I offered you £10 million pounds – it would be completely life changing for you. You could pay all your debts off, take care of all of your family and friends, send your kids to good schools, and follow your passions without any monetary fears.
However, if you already had £10 million, and I gave you another £10 million, it wouldn't be life altering for you. Why? Because you already have £10 million pounds!
So the value of monetary gains to a person depends on the additional utility it provides him/her.
Let’s go one stage further. You see, if we can establish that the value of a gain or loss differs from person to person depending on their circumstance, we can infer that the level of risk associated with the gain or loss differs as well.
What do I mean?
Well, let’s assume that instead of me giving you £1,000, we play a game where you can win it. Both you and Warren Buffett are playing.
The game is a simple coin-toss. It costs £1,000 to play. If you win, you get £2,000 (and so a £1,000 gain); if you lose, I get your £1,000.
Now let’s assume that your total life savings amount to £1,000. So, it will cost you your life savings to play.
For Warren Buffett, he can pay 100’s of times over and the losses would not affect his ability to do whatever he likes with his remaining billions. (Let’s for now forget that Warren Buffet would not play this game, with an Expected Value of 0, and save that for a later post!).
For you, if you lose, and you have a 50% chance of losing, bang goes your life savings.
So, the risk of playing and losing for you is many times higher than it is for Warren Buffett.
Therefore, when taking personal risk, you need to consider your total personal wealth, not just the transaction at hand.
And, unless you have a 100% certain positive outcome, don’t risk your total wealth. It’s akin to playing Russian roulette. It doesn’t matter what the prize is, the value of survival is infinite!
You should only risk your money for a gain in proportion to your “informational edge.” The more confident you are, based on evidence, the more of your wealth you can risk. I will be exploring this topic in much more detail in later posts.
What does this mean for you?
Well, on a personal level, consider the utility of money that you are putting up for the chance of a gain or for something in return.
For example, if you have life savings of £10,000 and you want to buy a car for £10,000, consider the alternatives (utility of alternatives) that £10,000 could be used for. Could you invest in something that provides a return, like bonds? Could you use it to test ideas for a new business? Could you use it to pay off debt that is costing you £££’s in interest every month?
What about if you run a business, or have to allocate capital to business projects?
Well, when investing in a new project/product, consider the alternative projects and the ROI they might achieve. Consider the total wealth of the company when investing in a new project. What are the reserves of the business? How many months could it survive if the new project didn’t product revenue or if additional revenue streams dried up?
Never play Russian roulette; don’t risk the life of the business for a gain. Remember, to maximise n chances of business success, the rule is to not go bust, i.e. survival.