AI Genius's Painful Investment Failure: A Simple Formula Could Have Changed Everything

[Block Media Reporter Lee Jeong-hwa] Why did the hedge fund managed by a 20-something genius from OpenAI fail?

Various analyses are emerging on Wall Street regarding the collapse of the AI-focused hedge fund "Situational Awareness," managed by Leopold Aschenbrenner.

Financial analyst Martin Shkreli appeared on a YouTube channel on the 31st, diagnosing that "Leopold's excessive use of leverage and disregard for the Kelly Criterion were the main reasons for his failure."

The investment formula that the genius overlooked was a very simple equation that even a middle school student could understand.

Four Reasons for the Collapse

Shkreli listed four reasons for the failure: excessive leverage of up to four times, investment in illiquid private stocks, attacks from competitors, and betting that ignored the Kelly Criterion.

Leopold's fund raised four times leverage through a prime broker based on approximately $45 billion in assets (of which $10 billion was in Anthropic shares and $30 billion was cash), inflating the total position value (GMV) to $120 billion.

As the market declined, a loss of 25% (about $30 billion) occurred, causing the fund's net assets (Equity) to shrink to just $5 billion. The brokerage firms had no choice but to seize the fund's assets to prevent their own losses and initiate a forced liquidation (Fire sale).

In particular, investments in private stocks like Anthropic often act as a "death knell" for large hedge funds. When large amounts are dumped into the market while liquidity is dry, stock prices can plummet. Brokerage firms had to go through an "advertisement" process to quietly signal to the market that they were sellers. Rumors of someone selling stocks at rock-bottom prices spread rapidly through the market.

No matter how excellent the fundamentals of AI companies were, ultimately, it was the 5% vulnerable "FOMO buyers" who took on 3-4 times the debt that determined the stock prices. These buyers panicked at the slightest rumor or minor negative news, triggering a sell-off. At this moment, Leopold's competitors also began to attack him.

The 'Darwinism' and Hyenas of Wall Street

Shkreli described the brutal behavior exhibited by Wall Street institutions during the fund's forced liquidation as "Darwinian" survival of the fittest.

When rumors spread that Leopold's fund was experiencing a liquidity crisis, other funds on Wall Street began to short-sell the stocks held by Leopold. This exacerbated and accelerated the decline in stock prices. Shkreli described this as a common Wall Street practice of "shooting against a fund."

The stocks in crisis ended up in the hands of large capital firms like Citadel, Millennium, and Jane Street. The final bidder, Citadel, scooped up these stocks at more than a 10% discount.

By simply selling without disturbing the market, they secured an immediate book profit of $3-4 billion. Citadel, led by Ken Griffin, has positioned itself as a savior of Wall Street and a "shadow bank," amassing immense wealth during such crises.

The Only Mathematics to Prevent Bankruptcy: The Kelly Criterion

Shkreli pointed out that the fundamental reason most traders and individual investors, including Leopold, fail is due to "overbetting" that ignores the Kelly Criterion.

The Kelly Criterion is a mathematical formula introduced by J. L. Kelly at Bell Labs in 1956, which indicates the optimal betting size that maximizes long-term capital growth while reducing the probability of bankruptcy to zero.

Even in games with favorable win rates of over 50% or 60%, it is safe to adhere to the appropriate proportion suggested by the Kelly Criterion. If one bets excessively at levels of 2-10 times the appropriate proportion, long-term volatility will inevitably cause assets to converge to "0," leading to bankruptcy. The analysis suggests that even a genius like Leopold faced a fatal downfall because he ignored the mathematics of adjusting position sizes.

Practical Example of the Kelly Criterion

The Kelly Criterion can be easily explained using a "coin toss" game that even middle school students can understand. Let's assume I have 10,000 won in pocket money and a magical coin with a 60% chance of landing heads. If it lands heads, I earn the amount I bet (1x profit), and if it lands tails, I lose all the money I bet (1x loss).

In this case, the Kelly Criterion calculates the optimal investment proportion as Optimal Investment Proportion = Win Rate -- (Loss Probability / Profit-Loss Ratio).

• Win Rate = 0.6 (60%)
• Loss Probability = 0.4 (40%)
• Profit-Loss Ratio = 1

Substituting into the formula yields 0.6 -- (0.4 / 1) = 0.2. Thus, to avoid bankruptcy and grow my pocket money the fastest, I should only bet 20% of my total assets, which is "2,000 won."

Just because the winning probability is 60% doesn't mean I should go all in with 10,000 won; a single stroke of bad luck could leave me with 0 won. By consistently maintaining a 20% investment ratio, even if I face losing streaks, my assets won't be depleted. I need to keep playing to maximize the benefits of a 60% win rate. If I overbet and lose money with a 40% chance, I will have to leave the game empty-handed.

In actual investing, there is a risk that the win rate I analyzed could be incorrect. Therefore, professional investors often use the "Half Kelly" strategy, investing only half of the 20% suggested by the Kelly Criterion, which is 10%. This approach may reduce the theoretical maximum return by about 25%, but it can reduce asset volatility by 75%. Investing according to the Kelly Criterion helps prevent extreme losses and maintain psychological stability.

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