Why Diversification Results In Mediocrity

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“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 (s aapl) 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.

33 Comments

Nicholas

Attempting to do a start-up, it has been the “trough of sorrow” for sure, but every once in a while there is a glimmer of hope. A focused idea of what you want your business to accomplish even when that business may not arrive for a year or more, is necessary to creating distinctive products and services. This post reminded me of the principles.

Thankfully, Sunday Apple began to approve the music apps. Keep pushing!

Abstract Badger

Diversity is mediocrity. Focus is excellence. Circuitous and synonymous post, at best, my friend.

Perhaps a course in remedial ecology. Or just a walk down main street.

Specialism and generalism are both valid strategies able to out-compete the other in their
preferred environmental niches.

Niraj

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

How do you know that you know for sure. For Bernie Madoff investors – 20 years of successful returns is a long enough time to know that Madoff was a the right investment. Until you hit the black swan scenario you don’t really know about anything 100%.

To me diversification is really similar to cheap earthquake insurance(enough pieces to start afresh from if something dramatic happened). 100% vested into something is stupid and 10% vested into 10 different ideas is mediocrity. The best formula is 70-20-10 – 70% core where you know the stuff , 20% diversified but related(example if I am technology investor maybe there are some verticals which consume technology I can concentrate on) and 10% totally new

Niraj

Also note: that my answer to a 21 year kid would be different. I would tell him to 100% vest into something. Because
1) he is not that big to lose a lot
2) he is also not that experienced to be able to devote 70% attention and still pass his Critical Success Factor.

My argument’s can easily be applied to Startup’s and Mature companies also

Habib Ullah Khan

You can have your cake and eat it too. How? By making your core specialty not a product or a service but your own corporate culture. If you excel at the culture game you will win the diversification game.

Gorf

I cannot agree fully with your statement, especially at the team level. If you have skill and know how to get to your goal, with the right strategy you can use diversification to make the whole greater than the sum of each individual. It is ignorant to believe skill alone can reach success for one individual for most cases. Teams deliver a better analytical strategy, better contingencies, and better results when built correctly. However, most don’t carry a strong leadership skills. If you use diversification blindly like some corporate houses, then I agree with your analysis. However, if intelligence is added, which it takes one skilled leader witht he right strategic plan to achieve a particular goal, then you have a much stronger result and chance of success. It is however, unsustainable, just like your curve since most organizations get pulled down to the average like everything else.

Shankar Saikia

DIVERSIFICATION AND ECONOMIES OF SCOPE (MONEY BURNS A HOLE …..)

Great post on this concept. There are two different perspectives here – a stock portfolio and a company’s product strategy – they are related at some level and they can be discussed separately as well. I want to comment on this post from the perspective of a company’s product strategy. Some companies start with a core product area (e.g., Oracle in enterprise database software) and then enter related markets (e.g., enterprise applications software). The company leverages economies of scope = the company creates products that are related, therefore enjoying lower costs. You can see this in the auto industry as well – a sedan, a coupe and a mini-van (not sure about a mini-van) use the same chassis etc. Similarly, in enterprise software Oracle focuses on the “enterprise” and in related offerings – databases, apps, consulting – all leverage the database software.

Other companies do NOT enter related markets and I question their strategy. I read about a mobile phone company (Bharti Airtel, India’s largest mobile phone carrier with over 100 million subscribers) that at one time considered getting into the airline industry! (this is documented in a Harvard Business School case study one can buy for about $ 7 (seven dollars!). This same company is now venturing into the retail (groceries) business. About 25 years ago United Airlines got into the rental car and hotel business under the label “Allegis.” One can argue that there were synergies between those businesses since they were related to travel. I have read about a textile manufacturing/retail business that has ventured into the … real estate business.

Summary: if there are no synergies (mobile phones, airlines and groceries????), a company probably should NOT diversify. Sometimes money burns a hole in the pocket and so people want to do something with the money!

Jim

So, what would you offer to someone who got laid off because he focussed on only one technology which no one uses anymore? Diversification is indeed necessary especially when level playing field keeps changing when rules of engagement are rewritten more often. Just my 0.02.

Dave Kist

It’s interesting that someone who works for a venture company, the very definition of not putting all your eggs in a basket, is advocating that diversification is wrong.

If that’s the case, why not just invest in one start-up?
Why invest in a whole bunch of start-ups?

Mike Speiser

I was waiting for that one ;–)

I was very clear in saying that I’m not advocating that you make just one bet. There is random risk, as I noted in the first paragraph. And as an investor you don’t have the operational overhead which allows the investor to gain broader expertise. In Figure 2, I try to illustrate that you should make as many bets as you can before you lose the “edge.” Problem is that there aren’t 30 companies that will win in a single industry, and your edge is not easy to leverage across industries. My hunch is that 1-2 investments per year is about the most any single investor can handle.

At our firm we average less than 1 investment per partner per year. That’s pretty focused. Some angels have made >20 investments in one year, for comparison. And some investments are close enough to each other that you can leverage your knowledge. Before I was a VC, I was an entrepreneur twice. While much of what you do as an entrepreneur is about gaining domain expertise, a bunch of it isn’t. This important difference is what allows an investor to scale more than an operator. However, most investors take that advantage to the extreme and lose their edge.

Jesse Kopelman

No large public companies seem to know this. They focus on growth above all else and the only way to achieve that is through diversification.

Seth

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.

Manpreet Singh

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!

francis idada

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.

Mike Speiser

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 ;–)

Gadget Sleuth

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.

Mike Speiser

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…

Karl Jacob

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”

Om Malik

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.)

Mike Speiser

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

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