Friday, May 15, 2015

Managing Risk with Your Innovation Portfolio
By: Langdon Morris

This article reaffirms the importance of our use of McKinsey’s 3 Horizon Model in balancing your innovation portfolio.

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… 
….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…. 
Four Types of Innovation
Incremental innovations (Horizon 1) 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 
Breakthrough innovations (Horizons 2 or 3) 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 the 
The third type of innovation is business model innovation (Horizons 2 or 3). 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. 
New venture innovations (Horizon 3), which comes about when an entirely new market needs to be explored and developed,...
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.

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