33 Comments

Summary:

When in doubt, diversify. That’s the underlying logic behind diversifying. The benefits of diversification with respect to risk come at a cost —  that of losing whatever edge you might have been able to gain from skill. If you seek extraordinary performance, focus on what you know very well, have conviction and take a stand. It’s the right way to build a product or to build a company.

“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.” -Warren Buffet

kitchen_sink

When in doubt, diversify. That’s the underlying logic behind diversifying everything from your stock portfolio to the number and types of businesses in your company, and often implicitly drives product development organizations. The argument behind diversification is that there is too much randomness in the world to have an edge based on skill.

While there is unquestionably some truth to the idea that the world is often too random to literally make just one bet, the widely held assumption that diversification is a free lunch is just plain wrong.  Just as there is benefit to be derived from diversification with respect to risk, there is a cost, too —  that of losing whatever edge you might have been able to gain from skill. Diversification is a strategy to regress to the mean — that is, to be average. For those pursuing excellence, focus is a far better strategy.

Regression towards mediocrity

The notion of regression comes from Sir Francis Galton‘s “Regression Towards Mediocrity in Hereditary Structure.” Over time, regression towards mediocrity came to be known as regression to the mean. I prefer Galton’s description: Diversification usually leads to mediocrity.

Figure 1 shows the tension between the “edge” gained by focus (y axis) and the gains from making numerous “bets” (x axis). Conventional wisdom has it that any particular bet you make may earn returns greater than or less than the mean — as the number of bets approaches 100 percent of possible bets, you end up with the mean by definition. Many investment strategies explicitly seek to be average; index funds do so by algorithmically approximating entire indices. If you lack the knowledge or time to do the work yourself, and your goal is simply wealth preservation, such a strategy may in fact make sense.

Figure 1:  Investment Edge vs. Number of Bets:  Regression to the Mean

diversification

However, if you’re trying to earn excess returns or build a great product, diversification is the enemy. In Figure 2 I have offered an alternative visual of how a knowledgeable investor might perform. I believe an investor can leverage knowledge he has about a particular industry or company to beat the average on a risk-adjusted basis. There is still uncontrollable risk, so I’m not arguing that an investor should invest in just one stock. On the other hand, there is a cost that comes with the security of diversification; you pay for that insurance. Too much, in fact.

Please note that my belief, even though it squares with that of Warren Buffett’s, flies in the face of conventional economic wisdom. And that I am not a professional investment adviser.

Figure 2:  Investment Edge vs. Number of Bets:  Excess Returns Through Focus

focus1

If you seek extraordinary performance, focus on what you know very well, do your homework, have conviction and take a stand. It’s the right way to build a product, to build a company — and to be an exceptional investor. Clearly even focused investors make a few bets; you can make a few very well-researched bets per year. But can you really make 30 bets per year, per person, and keep coming out a winner? Great entrepreneurs iterate, but my experience with great entrepreneurs is that there’s usually an ethos and sense of clarity behind what they’re trying to accomplish. It’s not about tossing spaghetti at the wall.

Focus increases your ability to understand what matters

The problem with diversification is that the effort required to master something is so great that every spare neuron spent on something else gives the person with focus an upper hand. Diversification is attractive because it’s safe and requires little effort.

Warren Buffet and many of the best investors I know favor making a few very well-informed bets rather than opting for significant diversification. Diversification strategies like funds of funds are responsible for allowing Bernie Madoff to exist. Good limited partners (LPs) do a great deal of work to pick a relatively small number of investment vehicles, which involves significant research before and oversight after an investment (both of which can quickly uncover Madoff-type scams). Good LPs put their money behind investors who do the same, and good VCs put their money behind entrepreneurs who have a point of view, domain expertise and conviction to realize the impossible.

Focus is not inconsistent with intellectual honesty. It does not mean ignoring feedback. It simply means that your bets are well selected and that your conviction to find a way to make something work is high enough to overcome the inevitable hurdles of building a company, product or investment portfolio.

Focus forces brutal prioritization

Making few bets forces you to make hard decisions. It’s extremely hard to measure the value of something against some abstract and absolute notion of value.

Proponents of diversification argue that it takes the edge off of making a mistake. That would be a good argument if people acted the same way independent of their ownership in an outcome, but human beings do alter their behavior based on how much skin they have in the game. When costs and benefits are divided amongst too many people, accountability is lost. Excessive diversification makes participants passive, dependent on the actions of others who are dependent on the actions of others, and so on. It turns them into, at best, free riders, and at worst, suckers.

Focus brings clarity

While everyone else is chasing diversification, those who make a few well-placed bets learn at a faster pace. They have clarity as to what matters in an investment, company or product. This clarity attracts others and makes things clear for them, too.

When Steve Jobs took over Apple again in the late 1990s, he first pruned the organizational ranks. He then pruned Apple’s product line down to just four. He communicated Apple’s culture to employees, partners and customers with the Think Different campaign. From that clarity came the iPod and the iPhone.

Making fewer bets requires conviction. It requires the courage to stay the course. And it requires the support and resources to take the long view. If you do these things, odds are that you’ll do something worthwhile.

Mike Speiser is a Managing Director at Sutter Hill Ventures. His thoughts on technology, economics and entrepreneurship will appear at this time every week.

By Mike Speiser

You're subscribed! If you like, you can update your settings

  1. Baltasar Gracian y Morales said it first: intensity beats extensity. Thanks for the reminder.

    Share
    1. Excellent quote. Thanks.

      Share
  2. Or – sitting on the fence all the time divides more than your attention.

    Share
    1. Hilarious!

      Share
  3. Mike

    It is funny that this approach applies to pretty much everything in life.

    Take writing a blog post as an example. Diversify too much from your core skills/capabilities and you end up writing a crappy post that no one really wants to read. Stay focused on what you know, and people reward you with attention. I have often experienced that … thankfully readers let me know and self correct me on the job :-)

    But just thinking a bit wider. you can see that in what is going on with the big media and smaller brands. I think at the New York Times, Krugman, Kristoff et.al come as focused and strong and as a result draw all my attention. Others are muddled and not as much fun to read.

    I think focused has helped in other things too: Sopranos and Entourage are extremely focused in their approach and story and subject lines. As a result there is great quality and engagement. (I am not dismissing talent of the crew and actors and directors etc.)

    Share
    1. I agree with you 100% Om. Some of this Renaissance Man thinking is driven by U.S. college admissions — to get in you must have diverse skills and interests.

      Malcolm Gladwell does a great job helping us understand why the Ivy League values breadth in his 2005 New Yorker article, GETTING IN — short summary is that it was originally used as a back-door way to cap admission of certain groups: http://www.newyorker.com/archive/2005/10/10/051010crat_atlarge

      Share
  4. Mike I think you are dead on with this post. Since everyone is sharing their quotes on this topic the one I most often tell entrepreneurs is “the number one killer of startups is lack of focus”

    Share
  5. [...] miniature electron microscope. Test your website’s loading speed through multiple locations Why Diversification Results In Mediocrity How much food can you really grow in a city? You’d be surprised. Poll: Bay area startup [...]

    Share
  6. Focus is a good thing, but in this economy, diversifying a little bit isn’t a bad idea, assuming you have good management across all the separate departments.

    Share
    1. If you want safe, why not buy US Treasury bonds? If you put some percentage in a truly safe store and took a “risk” with the rest, why is that not comparable or superior to diversification? Such an approach would certainly preserve capital better…

      Share
  7. francis idada Sunday, July 12, 2009

    In the area of stock investing, numerous studies have shown you are dead WRONG. Even now the S&P 500 is used as a investment benchmark.

    But to agree with you, in areas where you have absolute control and information, focus will pay off. In product development and the like focus on your core competence is the smart choice but in investment where you have limited information on the companies (even if you focus there are too many extraneous factors) diversification is the best bet.

    For people like warren buffet who have the resources to take sizable control of companies and there increase their knowledge stock of information and control of the company they can afford to focus but with retail investment, where resources are limited, investing in a company is more of a gamble.

    Share
    1. As I said in the post, conventional [academic economic] wisdom differs with my point of view. I’ve studied numerous papers that argue for massive diversification of assets for optimal risk-adjusted returns — I’m not convinced. Massive diversification means average returns.

      Roger Lowenstein’s biography of Buffett details a 1984 debate at Columbia Business School between economist Michael Jensen and Warren Buffet. The crux of the argument is that Jensen argues for the efficient market hypothesis (EMH) which says you cannot beat the market on a risk-adjusted basis while Buffett argues that it is possible. In fact, Buffet has. And long before he had sizable stakes, board seats, and favorable securities not available to the general public (like some of his more recent investments).

      I had Michael Jensen in business school and he makes a compelling argument — one that I believed for many years. But the papers require accepting so many assumptions that you end up with tons of precision but little accuracy.

      For example:

      + How do you measure risk? Beta? How do you measure the FUTURE beta of a stock or do you use historic beta? And is the foundational assumption that systematic risk can be removed from total risk through diversification even right? Doesn’t recent experience suggest that we might want to re-think that assumption?

      + What’s the expected return of an equity investor? The Ibbotson average equity return since 1929? Why is the past the right guess at the future?

      + What is the risk premium an investor expects over a risk free alternative? And what is the future return of a risk free asset? Are there risk free alternatives?

      + If everyone believed the EMH, then everyone would invest in index funds. If everyone invested in index funds, what would index funds follow? In order for EMH to work, does some large percentage of the world have to be stupid?

      + How do you integrate recent advances of behavioral economics into the rational man assumption in modern economics — as in the documented and consistently irrational behavior of people over time? And what happens when there are bubbles caused by “irrational exuberance” and busts caused by excess fear? As Taleb points out in “The Black Swan,” fortunes are made in lost in a fraction of trading days. The efficient market hypothesis just doesn’t apply when people are acting totally irrational.

      Buffett makes money because he invests in what he knows, has an independent yardstick for value, and has the courage to believe in himself in everyone else is drinking whatever flavor Kol-Aide. Much of this strategy is outlined in Buffet’s favorite book, The Intelligent Investor (http://www.amazon.com/Intelligent-Investor-Book-Practical-Counsel/dp/0060155477).

      Having said all of that, I agree that the experts in the economic domain overwhelmingly disagree with my point of view and that the onus is on me, not them, to convince everyone otherwise ;–)

      Share
      1. Meant specific risk not systematic risk in the first point.

        Share
  8. great stuff. i think a lot of this is true.

    Share
  9. Manpreet Singh Sunday, July 12, 2009

    A very wise idea indeed. I’ve personally felt how valuable focus can be in making choices and decisions. This reminds of me of Sun Tzu’s Art of War where he mentions that the best way to fight a larger enemy with a spread out army is to focus your efforts at one point rather than to spread out. Very much true for making personal decisions, choices and for determining strategies within your startup or organization.

    That being said, stock investing is a little different. Diversity too much and you’re definitely going towards average. But selective diversification can be a great risk-mitigation tool. Think of it is a tool to move the slider on the risk/reward line. Especially useful because as any successful investor will tell you – the most important thing in long term investing is not fast rewards but to control your losses and to stay cash positive!

    Share
  10. I think you paint too harsh a picture of diversification, at least in the context of investments.

    Actually, rereading your comments, I agree that many things are enjoyable/effective when they are specialized. If Bush focused on Afganistan, we wouldn’t have had the mess in Iraq and be in a better position against the Taliban now. But I don’t think you explore the consequences in full. The Madoff scandal illustrates that even when smart people (investment advisers, regulators, and investors themselves) focus on something, they can still have a blind spot. That’s part of being human. Indeed, had people truly stuck with the diversification principle, we wouldn’t be seeing so many sad stories of wiped out savings. Perhaps you could argue that they should have been more focused about how they invested their money, but like any discourse championing one human trait over another, there’s an air of snobbery to that position. It’s something I think you take for granted. Yes, we could benefit from focused risks at times but, as the passengers of the Titanic can attest, other times prudence should win out.

    Share

Comments have been disabled for this post