The Bushido of Risk
(Initially published May 10th 2015)
When commentators talk about the various causes of financial debacles like that of Long Term Capital Management (LTCM) in the 90s, they often mention on the one hand the mistakes they make by moving away from their core area of competence (in LTCM’s case that was the bond market, venturing into terrains of very different expertise such as merger arbitrage). But on the other hand they also point to the fact that their portfolio diversification was of low quality, because they were not really doing different things but replicating the same strategy.
But … aren’t we incurring in a contradiction here? Aren’t we asking to stay in the comfort zone and at the same time requesting to visit unexplored places? Metaphorically, aren’t we saying with Bruce Lee “Be water, my friend” while we soberly affirm “From this moment on you are to rock. You absorb nothing, you saying nothing, and nothing breaks you“ with the honorable Frank J. Underwood?
Clarifying this point will help us understand much better when diversification works, why, and what are its limits. And I can not conceive of a better entry point than giving the floor to one of its greatest detractors, the famous investor Warren Buffett, who says: “I think that diversification, in the way it is normally applied, makes very little sense for someone who knows what he’s doing. Diversification is a protection against ignorance”. And he adds, with a somewhat irreverent irony, that “There is nothing wrong with that, it is a perfectly valid option for those who do not know how to analyze a business”.
This is a key concept: diversification as a strategy against ignorance. Now we see what led to debacles like LTCM’s: pretending to diversify by going to domains of tremendously specific knowledge of which he knew nothing. Diversification only works when we reduce our global ignorance, not when we increase it. Now replace “ignorance” with “risk”. We only have a positive outcome if we lower global risk, not if we acquire new risks, no matter how different they may be. The market never rewards you for taking more risks than those that are strictly necessary.
Phil Cooper, my esteemed Private Equity Professor at MIT, no less ironic and irreverent than Mr. Buffett, illustrated it this way: How much would you pay Paddy, a window cleaner who likes to perform Irish dances hanging from the scaffolding on the fortieth floor? Actually, the same as you would pay any other window cleaner.
Diversification as a strategy against ignorance. And not the only one possible, listening to the Oracle of Omaha: we can put the eggs in different baskets … or we can place them all in one and protect it as if it were the most precious treasure in the universe. Because for us it probably is. That is the Buffett of Berkshire Hathaway, but it is not an isolated attitude: it is the creed practiced every day by entrepreneurs in their companies, struggling to make headway in markets that for the inexperienced gaze seem saturated, trying alternatives, learning from their mistakes and pivoting rapidly when new information reveals that they have followed misleading clues. Even when we talk about serial entrepreneurs who have founded many companies, they usually stay in a particular industry: precisely because their knowledge is their differential value (be it technology, geography, key contacts …).
So it may seem that we are talking about irreconcilable paths, two opposing schools among which the Samurai has to choose its code and its destiny. The path of the entrepreneur is to face risk with knowledge. The way of the investor is to face risk with diversification. Nothing would be further from the truth. The entrepreneur frequently concentrates his action guided by experience because his accumulated knowledge means the biggest difference between the firm’s life and death, but diversifies (sales channel, key employees, infrastructure) as it becomes feasible. The investor of a venture capital fund has a portfolio of companies, but these tend to portray a concentration by geography and sector (for example, the Internet, or nanotechnology, or pharmacology) based on their personal experience, knowledge that is also used to add value in collaboration with their portfolio companies’ executive teams. The capitalist in public markets often diversifies because he faces scenarios with complex, recursive, reflective interdependencies that are beyond his control, but as he continues to fight the risks with his knowledge, testing, erring, identifying patterns, and increasing his wisdom, he behaves like a true entrepreneur.
There are several weapons for the warrior: he can wield his katana in a wide protective arc, stab with the precision of his wakizashi, or combine both in the deadly Mushashi technique. But there is only one Bushido.
