the paradox of diversification

I read an entry on Fred Wilson’s blog on The Power Of Diversification. I don’t disagree with anything in his column, or the earlier one he links to where he describes basic portfolio theory. But the concept of diversification has always puzzled me a bit. Taken to it’s conclusion, portfolio theory suggests that optimal investment is one that is extremely diversified across all investments – i.e. the market portfolio. That’s often the reason given to invest in market index funds (though optimally diversification should be across asset types that may not be reflected or inadequately reflected in market indices – e.g. bonds, real estate, precious metals, etc.). This is because diversification reduces the impact of company or investee specific risk. Going further, if one diversifies more broadly, you eliminate industry specific risk, geographic specific risk, and so on. Therefore, the optimal investment strategy to maximize your return for any given level of risk is to invest only in the market portfolio, then leverage or deleverage to meet your personal risk tolerance. I’m probably not explaining it all too well – try Wikipedia for a more detailed and better written explanation.

Diversification can be quite a powerful tool. In fact, in certain (rather limited) circumstances, it can even change two losing prospects into a winner, so long as you alternate between the two. Not really the subject of what I wanted to chat about today – you can read more about Parrondo’s Paradox in this NYT archive or on io9. Or just google it.

Anyway, the mention of paradox is fortuitous. I don’t necessarily know if it’s the right term for what I’m about to describe, or whether it really does precisely fit within the definition of paradox. Nonetheless, to me, it seems that advice on diversification seems somewhat paradoxical. And by that, I mean that if you follow the logical conclusion of the lesson taught by modern portfolio theory on diversification, then it doesn’t really make much sense for anyone to specialize say, for example, in early stage technology companies. The greater the departure from the market or efficient frontier portfolio, the less optimal the risk/return ratio. And yet, despite this, there are many, many specialists that take a narrow focus (despite their diversification amongst investee companies), just like Union Square Ventures, who often do quite well, even though portfolio theory suggests that all specialists are using sub-optimal strategies exposing them to more risk than they need to be exposed to for a given return.

I suppose the same could be said of  entrepreneurs who, very often, put all their eggs into one basket – and, to address a point made by Fred Wilson, this is even after they’ve succeeded and accumulated a great deal of wealth. Elon Musk may be a good example of that. I think (but don’t know with certainty) that most of his wealth is invested in two, and only two, highly risky and focused ventures (being Tesla Motors and SpaceX).

Moreover, it would seem to me that if everyone in the world pursued the optimal diversification strategy as suggested by portfolio theory, including, for example, all narrowly focused or industry specific venture capital funds, then the diversity of assets (and possibly asset classes) would, I think diminish. Sort of like the paradox of efficient markets, I suppose.

But who knows. I don’t pretend to be an expert in modern portfolio theory. Would be interested in hearing from those more knowledgeable in the area.

google ventures is up and running

Announcement last night on the Official Google Blog:

Today we’re excited to announce Google Ventures, Google’s new venture capital fund.

At its core, Google Ventures is charged with finding and helping to develop exceptional start-ups. We’ll be focusing on early stage investments across a diverse range of industries, including consumer Internet, software, clean-tech, bio-tech, health care and, no doubt, other areas we haven’t thought of yet.

Perhaps not a surprise, as there were reports (like this one in the WSJ) in mid-2008 that this was in the works. So far, it seems reactions are mixed – not necessarily to Google Ventures per se but to corporate VCs in general. The WSJ had this to say:

Their track records have been mixed. Corporate venture-capital arms have been hampered by challenges that traditional venture-capital businesses don’t face. Venture capitalists invest in private start-ups at an early stage, usually in hopes of a big payout if the company is sold or if its stock goes public.

Many start-ups fear that taking corporate money limits their options and comes with strings that could turn away other potential investors — such as a right to buy the company at a later date. Some funds with less competitive compensation have struggled to retain managers, and corporate venture funds often don’t allow senior employees to invest personal money in their funds, while other venture funds typically do.

This is also echoed by some traditional VCs, including Fred Wilson of Union Square Ventures (who by the way writes a great blog – highly recommended) who concluded in his post:

But I do think that venture investing is not the best use of a corporation’s capital and that it is inevitable that it will produce sub-par returns at best and significant losses at worst.

He cites the same reasons above in the WSJ article and also suggests that corporate VCs will have difficulty retaining talented fund management.

Corporate VCs, like strategic purchasers in M&A deals, may have longer term strategic objectives that, over a longer term, will result in benefits to them. In this regard, corporate VCs can be likened to some extent to strategic purchasers in an M&A context (while traditional VCs can be liked more to financial purchasers). In this regard, one of the advantages of corporate VCs to investees is that they will often have a longer term view of their investment than their traditional VC counterparts – they won’t be under the same constraints to book gains and make their LPs happy or to meet the horizon of their fund. In this case, the very thing that Fred suggests is a weakness of corporate VCs could well be an advantage to an investee company, depending of course on the objectives of the investee.

For the same reason, I’m not sure if it would be valid to say that corporate VCs are or are likelier to (as compared with traditional VCs) fail, because if the focus is on longer term objectives, realized profits as reported on the corporate VC’s income statement might not accurately reflect the actual benefit. At the simplest level, it could allow a company like Google, which has traditionally simply acquired companies that interest it outright, to hedge it’s bets. If the company is wildly successful, and Google wants to buy it outright, it will have saved a few dollars by having put in money at an earlier stage (and presumably much lower valuations). Depending on how things are structured and accounted for, I’m not sure whether the savings in that situation would necessarily be reflected in the measured earnings of the corporate VC. But apart from actual savings, VC investing will also allow Google to gain an insider’s perspective on its investees at an earlier stage and to better assess how things are coming along, and to help them along. This itself may be worthwhile relative to the costs associated with researching potential acquisition targets at a later stage.

I’m not suggesting that in all cases Google will be using Google Ventures as a farm team for potential acquisitions. But even if it isn’t, it may well develop better and deeper relationships with entrepreneurial companies that it could later partner with or enter into some sort of strategic relationship that will enable it to realize financial benefits going beyond those measured in the VC arm’s financials. And it will be better positioned to do so as an investor in the company.

Not to say that life with corporate VCs is all wine and roses. There are often thorny issues to deal with, particularly when it comes to commercial dealings between an investee and an investor, as Fred notes, and things like purchase options (which I’ve seen proposed a few times and for which the answer is a relatively consistent “no” from investees).

All that being said, an article in Wired suggests Google Ventures will act more like a traditional VC:

The fund, to be called Google Ventures, will be wholly owned by Google, but will operate as a separate entity and will seek investment opportunities to maximize returns rather than looking for investments that strictly fit with Google’s strategic vision.

Several high-tech companies have in-house venture capital arms, including Intel and Motorola, But Maris said that Google Ventures will have more in common with traditional venture capital firms.

“We’re making financial return our first lens,” said Maris. But he noted that a part of the appeal of Google Ventures for start-up firms is the relationship to Google and its 20,000 employees.

Interesting. I guess we’ll see. In the meantime, if you’re looking for financing, go to the Google Ventures site.

taking the fun out of blogging

As a lawyer, I understand the need for policies, procedures, practices, etc. when running a business, managing vendors, employees, etc. Of course. Sure. That’s part of work – both my work and the work of my clients. But when I see an article entitled “Blogging Policies and Best Practices for Lawyers and Law Firms” well, gotta say, my eyes start glazing over.

Not that there’s anything particularly bad or wrong about the article. In fact, it offers some good advice on avoiding “ethical minefields”, creating “powerful marketing tools” and ensuring you realize a good return on your “investment”.

Ugh. To be perfectly honest one of the primary reasons I blog is not to realize a return on investment, or to create a powerful marketing tool, but rather just to offer casual observations (or ruminations) on my work or things related to my work. In other words, its a bit of fun, as compared, for example, to writing a formal research paper, journal article, or a 100 page outsourcing contract. For those types of writing, there are many, many rules, requirements and policies to remember and adhere to, amongst other considerations. And relatively speaking, its not quite as much writing that stuff as it is posting what are ostensibly meandering ramblings about the next new thing. Don’t get me wrong, its certainly interesting and challenging work, but its not the type of thing one typically does to relax.

I guess what I’m getting at is along the same lines as the previous post about making blogging part of someone’s job. Its kind of like saying that its part of your job to chat up your friends at work on a regular basis. Its kind of like saying that there should be internal policies governing who you go to lunch with, and what you talk about over lunch. In other words, to me, it seems to take all the fun out of it. It makes it seem like work. It puts you in the mindset that it is work. And, to be perfectly honest, I think it makes it less interesting, because you’re too worried about the time being put into it. Too worried about whether you’re writing for your “target market”. Too worried about “visualizing and addressing your market”. Too worried on making your blog sound “informal and conversational”. Too worried about this, that and the other thing, none of which have much to do with the subject matter of what you’re writing about.

Of course, this is just my take on blogging and what I hope to achieve (or perhaps rather not to achieve) by doing it.