Credit Sesame discusses how consumers can learn from Sam Bankman-Fried.
At the beginning of 2022, you may have wished you were Sam Bankman-Fried. By the end of the year, not so much.
Sam Bankman-Fried is the founder and former CEO of the failed cryptocurrency exchange FTX. His fall from grace was spectacular. He went from being worth tens of billions to living with his parents. From innovative whiz kid to punch line. From entrepreneurial role model to disgraced thief.
As unique as that journey was, SBF’s downfall has financial lessons for everyone.
1. Don’t put all your eggs in one basket
SBF’s loss of his personal fortune is a spectacular demonstration of the importance of diversification.
At one time, SBF’s main business venture, the cryptocurrency exchange FTX, was valued at over $32 billion. On paper, that meant SBF should have been more than set for life. His family should have been financially secure for generations to come.
There was just one problem. Virtually all of that wealth was tied up in one venture. Even sound investment ideas can go wrong, but this venture was built on a shaky foundation.
There’s no magic number as to how many stocks you should have, but you should avoid situations where the failure of any single company would significantly damage your wealth. Look at the diversification of investment themes. If too many of your investments rely on one industry or trend, a lot can go wrong all. The business of FTX was reliant on the popularity of cryptocurrencies. When the value of cryptocurrencies plunged in early 2022, the whole house of cards started to tumble.
2. Liquidity is the key to sustainable wealth
Net worth is important, but it’s no substitute for liquidity. You need access to enough cash to pay your bills. Having too much money tied up in long-term investments can hamper that.
Both the downfall of FTX and early-2023 bank failures are examples of this. What they have in common is that institutions had tied up too much money that could not be accessed at full value when needed.
When people who had deposited money in the FTX crypto exchange or Silicon Valley Bank or Signature Bank wanted their money back, it simply wasn’t available. That caused a panic, leading to more depositors wanting their money, leading to an even bigger problem.
For an ordinary investor, this a reminder not to tie up so much wealth that you can’t pay your bills. Investing in a retirement account or buying a house are good ways to build wealth. However, if you commit too much of your income to a mortgage or a 401(k) plan, you might be unable to make ends meet. Then you may face a choice between bankruptcy or taking a loss to cash in investments.
3. Investing and speculating are not the same thing
It turns out that FTX managed to secure hundreds of millions in investments from organizations that didn’t bother to do a detailed inspection of its business model or bookkeeping.
This type of behavior is surprisingly common when it comes to cutting-edge and trendy spheres like cryptocurrency. People may not fully understand it, but they want in. All they care to know is that it’s hot, it’s making money, and they don’t want to be left behind.
Some professional investors were guilty of making huge bets on FTX, so it’s no surprise that retail investors may also rush headlong into an investment craze. Remember, if you don’t understand how a company makes money and haven’t looked at the financials in detail, you aren’t investing. You’re speculating.
4. Good bookkeeping pays off
Tech start-ups like to make a virtue out of moving too fast to sweat the details. When it comes to running a multi-billion dollar venture, it turns out details like good bookkeeping are important.
After FTX fell apart, one thing that increased the difficulty of sorting through the wreckage was that the company lacked normal accounting procedures. At one point, SBF said he had “misaccounted” for $8 billion in customer funds.
You can probably comfort yourself knowing you can never lose track of $8 billion. Still, careful bookkeeping is also crucial at the household finance level. Balance your checkbook, and review every transaction on your bank and brokerage statements. Sooner or later, you need to know where your money is.
5. Face the truth sooner rather than later
When FTX ran into financial trouble SBF made public statements claiming there were no real problems while hoping to raise enough new money to cover client losses.
Ordinary people also have trouble facing up to their financial troubles. But that makes things worse. Facing up to a bad investment or a debt problem is an opportunity to take positive action. This can be the first step to regaining control of your finances.
It’s also important to be honest with the people around you. Could you let your family know what financial difficulties you’re having? It may be easier to fix a problem if you don’t have to keep it secret.
6. Beware of pyramid schemes
Though it was wrapped up in the shiny new packaging of a cryptocurrency exchange, it is alleged that FTX had elements of a classic pyramid scheme.
Pyramid schemes date back a century, yet people still fall from them. They are also known as Ponzi schemes, after a businessman famous for defrauding investors in the 1920s.
A true pyramid scheme is an illegal investment scheme that relies on recruiting more and more members to generate profits rather than legitimate business activities or products. Here’s how it works:
- A person at the top of the pyramid creates a new investment opportunity, promising high returns for investors.
- The person recruits a small group of initial investors, who are asked to make a payment to join the scheme.
- Each of these initial investors is then encouraged to recruit more people to join the scheme, usually by promising a percentage of their profits in return.
- As the pyramid grows, each level becomes larger and larger, with more and more investors joining and paying money to the people above them in the pyramid.
- Eventually, the pyramid becomes unsustainable, as there are not enough new investors to support the payouts promised to earlier investors.
- At this point, the people at the top of the pyramid have already made a large amount of money, while the vast majority of people at the bottom have lost their entire investment.
It is claimed that SBF funneled client deposits in FTX to a hedge fund he owned, Alameda Research. He used some of that money on himself. Alameda, in turn, invested heavily in an FTX cryptocurrency token, which for a time helped prop up the value of that token.
When cryptocurrencies cooled off, money stopped flowing in and the value of Alameda’s investments suffered.
The failure of this type of scheme was true in Charles Ponzi’s time and true of Enronand Bernie Madoff. FTX may have been the latest twist on the scheme, but be on guard, it surely won’t be the last.
If you enjoyed 6 financial lessons from Sam Bankman-Fried you may like,