Managing Risk with Your Innovation Portfolio

By: Langdon Morris

Probably the single greatest threat to most small businesses is “concentration risk,” also known as “keeping all your eggs in one basket.” In this chapter excerpt of of The Innovation Formula Langdon Morris discusses innovation portfolio design, and how it translates the goals and intents of your aims and strategy into a set of risk-managed innovation projects.

By definition, business involves risk, and managing that risk well requires that you understand it. And one of the key nuances to understand is that there is not just one type of risk, but many. This is articulated nicely in a recent report from Linda Martinson, Chairman and President of Baron Funds, the investment management firm.¹ She noted that in managing their investments they track not only business risk, the possibility that things may go wrong with a company, but also what she refers to as “system risk,” the broader perspective of macroeconomic change, which we have described in Chapter 2 as the driving forces of change, among which we highlighted technology, science, culture, population, and climate. The third type of risk that Martinson discusses is “portfolio risk,” which refers to the need for an investment firm such as Baron to diversify its investments so that the poor performance of any single investment cannot drag the entire portfolio too far down.

This is probably the single greatest threat to most small businesses. It is also technically known “as concentration risk,” and is perhaps more easily understood as “keeping all your eggs in one basket.” (In case you’re not familiar with the metaphor, the point is that if you have all of your eggs in one basket, and you then drop the basket, you probably lose all of the eggs.)

What is concentration risk?

Concentration risk has been a subject of focused and eventually quite sophisticated research by economists and finance experts since the mid-twentieth century, when investing became professionalized, and investment managers began to grapple with the problems of investment risk that would affect middle class investors who were accumulating modest life savings.²  The new class of professional managers needed systematic ways to assess the risks of various types of investments so that they could create investment portfolios that would achieve targeted investment returns at well-understood risk levels for their clients.

We know this today as the work of balancing our retirement portfolios by selecting a mixture among various sectors and types of investments, mostly stocks, mutual funds, and bonds, so that when we’re ready to retire we actually have enough money to live decently for a few decades.

The design intent of any investment portfolio, whether it’s your retirement portfolio, the company’s treasury portfolio, a venture capital portfolio, or your innovation project portfolio, is identical: to manage risk strategically by choosing a variety of investments from across different marketplaces which have a variety of performance characteristics, such that you attain the appropriate level of overall risk while attaining the necessary level of return.

Those who worked for Enron (to take one very sad example) know how dangerous concentration risk can be, for the company had unwisely invested much of its employees retirement funds in its own stock, so when the firm’s frauds led to its collapse, the retirement savings of a great many employees were lost along with it.

Most small businesses face the same sort of risk, because by definition they’re usually only in one or a few businesses, and if things were to go bad they might not have much, or anything, to fall back on. Concentration risk is one of the major reasons why the mortality rate for small business is so high (the other being just generally poor management). It’s worth noting in passing that the mortality rate for big business is pretty high also, and it’s climbing precisely because the big firms are also struggling to adapt to change, just as small business are. All the statistics indicate that big firms going out of business at a record and accelerating rate.

Consequently, one of your missions as an entrepreneur/innovator is to create future product and service options that reduce your concentration risk. The actions we discussed in the previous chapter concerning the various ways that you can search for innovation opportunities explains the process of identifying what those very options may be.

But that’s not the only thing you have to do as an innovator, because you also have to protect your existing market domain, which means that you have to organize yourself to innovate in your core business at the same time that you explore new or adjacent business opportunities. This is a complex problem, and one of your primary tools for managing it is your innovation portfolio, the subject of this chapter.

We already discussed this earlier when we explored the cone of uncertainty and the three different types of innovations, those relevant in the short term from now to about two years out, those relevant from two to about four years, and those beyond four years. These three categories constitute an innovation portfolio, but there are also other ways to organize or structure an innovation portfolio, so if the cone of uncertainty approach to sorting concepts into three time horizons doesn’t fit well with the rhythm or structure of your business or your market, then you should of course feel free to find a different organizing scheme.

Each of these portfolios has of course a different risk profile and a different reward profile, and this way of thinking about it may also be relevant for you.

For example, in other writings in which we focused on large firms we’ve suggested that they must create and manage four portfolios: incremental innovations to protect market share for the short term, breakthroughs to prepare long term disruptions, new business models to leverage new technology, and new ventures to extend the enterprise laterally and broadly into the future. Each of these portfolios has of course a different risk profile and a different reward profile, and this way of thinking about it may also be relevant for you.

Four Types of Innovation

Incremental innovations are generally small changes to existing products and services. Companies typically invest in incremental innovation in order to preserve or sustain existing market share, or perhaps to make modest gains in market share. In fact, most companies invest the majority of their innovation efforts in incremental projects to preserve their position.

Breakthrough innovations are higher risk, and much like venture capital investing, when successful they result in much higher rewards. The distinctive character of successful breakthroughs is that they change the entire structure of the marketplace, which is, after all, the very definition of a breakthrough. Breakthroughs therefore create significant competitive advantage for the organization that creates them.

In the absence of a rigorous portfolio management process, the logic of business decision making will tend to drive a company’s investments toward safer incremental innovation, and may entirely choke out the search for riskier breakthroughs.

The third type of innovation is business model innovation. In this case the objective is not specifically to develop or sell new products or services, but rather to provide a different and better sort of experience to customers. Business model innovations are important because so many of today’s new technologies are creating business model innovation opportunities that are being used to improve the customer’s experience by changing how people access new information, how they shop, how they communicate with one another, and also by altering the nature of communication between customers and companies. On the business model matrix that we discussed in the previous chapter, the leaps that enable you to move up and to the right are often business model innovations.

For example, the world’s discount air carriers, led by America’s Southwest Airlines and Europe’s Easyjet and RyanAir, have entirely changed the economic equation of air travel by designing a fundamentally lower cost operating model.

Wal-Mart became the world’s largest retailer by applying new technologies in supply chain management and distribution to create a chain of retail stores that are continuing to lower prices. The company then exploited digital communications technology to communicate in near real time with manufacturers in China and elsewhere in the Far East that now make the majority of the company’s products.

Apple’s iPod MP3 player was only a modest success until the company introduced the iTunes store, which created an entirely new business model to distribution digital content.

The fourth type of innovation is new venture innovations, which comes about when an entirely new market needs to be explored and developed, and the best way to do that is through a new brand and perhaps even a new company. New venture innovations are of course long-term oriented.

Each of these types of innovation is managed a different way, as each requires a different approach to project selection, capital allocation, ongoing monitoring, and the actual staffing of the innovation design effort. Consequently, each of these four is also managed through a different innovation portfolio.

There are other ways to think about innovation portfolios, and authors whom we admire, including Clayton Christensen,³ Larry Keeley,⁴ and Rob Shelton,⁵ have proposed creating portfolios consisting of sustaining innovations that protect the existing business, disruptive ones that alter market structure, and internally- directed process improvements, or innovation across ten different types across finance, business process, product and service offering, and delivery.

Clearly defining your expectations about your innovation portfolio is the only way to move beyond sheer blind luck opportunism and toward a rigorous innovation process.

What’s most important, in our view, is that you find the structure or model that works best for your organization, and that you use it as a rigorous guideline to give shape to your innovation investment efforts. As with the necessity to develop a clear point of view about the future and about how you expect the major drivers of change to impact on your business, clearly defining your expectations about your innovation portfolio is the only way to move beyond sheer blind luck opportunism and toward a rigorous innovation process. Such a structure enables you to manage tightly to what you’ve selected so that you can reap the both the learning benefits and the equally important benefits of the innovations themselves.

Whichever model you choose, the design of your innovation portfolio translates the goals and intents of your aims and strategy into a set of risk-managed innovation projects. This tells you, in effect, what you’re going to do at a much more detailed level than a strategy document can, for identifies specifically the types of projects you want to engage in, the time horizon in which you expect results to emerge, and the scale and scope of the financial and human resource investments you intend to make.

As the leader of the business and of the innovation investment process, you might consider that in this role you are now not only owner or leader, but also the chief innovation targeting officer, or the chief risk design officer.

Overcome Concentration Risk

The principle of an innovation portfolio is consistent with any sort of investment portfolio, whether it’s stocks and bonds for your retirement account, or a portfolio of any investments that the treasury group in a big company’s finance department uses to get the best return from the available cash flow.

Venture capitalists design yet a third type of portfolio, typically investing in 10 or 20 high-risk companies in the expectation that a least a couple of them will break through to produce significant returns within a few years.

The underlying premise of this type of investing is that investors must anticipate the future direction and needs of the market, and then seek investment opportunities that match this future vision, recognizing that while failure is common because of the high risks, the right combination of qualities and characteristics can also lead to huge successes.

As we noted above, there is certainly virtue and value in being right, but it’s not entirely necessary to be right as long as you’re paying close attention to what’s happening. There is also great power in in taking an explicit position about the anticipated future of the market and identifying the specific reasons that support that position, because by its very explicitness it provides a foundation, a point of comparison. As events unfold you can then compare your expectations with what actually occurs, and this is tremendously valuable because you can then course correct and fine tune your actions to move into accordance with emerging realities.

Your own predictions, in other words, give you a quite precise way to match expectations with reality and to adjust if and as they diverge. And the likelihood that expectations and actual events will diverge is quite high.

Some years ago a venture capitalist was relating an interesting story about an investment portfolio he had created, which consisted of twenty companies, and he talked about the successes and failures that had occurred. He noted that ten of the companies had failed, which in this line of work is pretty much to be expected. He went on to explain that they had followed their original business model, but events had proven that the models themselves were not fitting to the markets that emerged. This was a fair and honest assessment of ten worthwhile attempts.

But then he talked about the other ten, the firms that had been successful in varying degrees, and this is the key. He noted that while each of them had had a business plan and a distinct business model from the outset, in each of these ventures the initial model had proven nonviable, and the leaders had then created and followed a revised business model based on the conditions which they had encountered in the market. They had changed course, in other words, in response to events and trends. They had adapted.

The point for us is of course that you can only adapt if two conditions are present. First, you have to be willing to change. If you stick the plan even when the plan is going bad or when the plan is definitively a bad fit for market realities, then the result is foretold by the very fact of your stubbornness. The military has a way to explain this: “No battle plan survives contact with the enemy.”

The underlying challenge is that in many situations stubbornness is a virtue; you have to use heightened discrimination, and a rigorous process to discern when it’s good, and when it’s the short route to failure.

The second condition is that you have a clear picture of what you’re intending to do and what you’re expecting to result from it so that you can tell if and when your expectations are being met or not met. The ability to respond quickly to exploit the alignment between expectations and reality, or to adjust to the lack of alignment, is perhaps the single most critical characteristic of strong leaders. Changing the plan, in other words, requires that you a plan in the first place.

The best entrepreneurs are the ones who will recognize when the plan is wrong and change course.

And hence one of the essential characteristics of any management team that leads a startup organization is perceptiveness, the capacity to recognize the truth of a situation and to respond appropriately. Venture investors, experienced ones, know that the likelihood that the initial business plan or model is correct is often much less than 50%; they also know that the best entrepreneurs are the ones who will recognize when the plan is wrong and change course.

Conversely, the weaker ones will remain attached to their original ideas and drive their businesses right up to and even over the edge of the cliff, and many will do so without sensing that the edge is there because they’re so focused on executing to the plan that they fail to realize that it’s a bad plan.

Here we have, metaphorically, another powerful argument for maps. For good maps will indeed identify where the cliff edges are, or are likely to be.

Astute managers of young companies are those who are fully prepared to adapt to changing market conditions. Hence, the successful young company evolves in conjunction with an emerging market, intending to position itself as the preferred solution provider as the market expands. Its leaders listen closely to whatever information they can gather in order to find out where the cliff edge is, and where the sweet spots in the market are. They also search actively for new information (again, this was the topic of the previous chapter).

So the relationship between the venture investor and the entrepreneur is one in which the investor provides capital and guidance, and it’s up to the entrepreneur to apply that capital not in blind pursuit of the plan, but in a measured process of acting and responding, probing and listening.

As a small business leader you probably don’t have venture capital backing, though. You may have put in your own money, or perhaps your capital comes from ongoing operations. But no matter where it comes from it’s precious, and the best way to use it for innovation is to set up a learning system so that you can probe, explore, experiment, and find out where the best future opportunities will be, and then get there before your competitors do. This calls for a rigorous process of portfolio design.

Stay tuned, in the next chapter excerpt, we’ll take a closer look at the process of designing and developing your own innovation portfolio.

By Langdon Morris

References

1.Baron Funds, March 2014 Quarterly Report.

2. The original work was done by Harry Markowitz. Markowitz, H.M. (1959). Portfolio Selection: Efficient New York: John Wiley & Sons.

3. Clayton Christensen. The Innovator’s Dilemma, Harvard Business, 1998.

4. Larry Keeley. Ten Types of Innovation. John Wiley & Sons, 2013.

5. Tony Davila, Marc Epstein, and Robert Shelton. Making Innovation Work. Pearson Education, 2006, 2012.

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