The Real Challenge of Diversification: Choosing the Right Alternatives

We all know — or should know — the importance of wealth investment, which also applies to retirement savings. But what if we are talking about investing in order to develop a sound diversification strategy? Here, we are not talking about investing in diversification itself, but rather about investing in the strategy required to achieve effective diversification.

When faced with several investment alternatives, not only does conventional wisdom tell us that we should select those offering the highest returns, but common sense reinforces this idea. However, before addressing this question, we encounter two other dilemmas: first, ensuring that we have identified all the best alternatives; and second, having considered their critical assumptions in order to properly calculate the expected returns of each one. Let us begin with the first dilemma: ensuring that we have identified all the best alternatives.

How do we know that we have the best possible alternatives? This is a particularly difficult question to answer because, in many cases, we fail to recognize that we are in a situation where the optimal course of action is to have more than one option. The single-path approach is quite common among companies with a strong track record of performance, as they enter what Donella Meadows calls a positive feedback loop: reinvestment and reproduction of the existing model. After some time, this can become something of a bubble, creating excess inventories and surplus capacity that remains unused, ultimately forcing a correction.

We are certainly not trying to argue against success. Rather, we should acknowledge that positive trajectories are not eternal, and that discovering a new successful business model is not an easy task either. Therefore, if we are familiar with Aesop’s fable of the ant and the grasshopper, we will probably understand what I am about to propose.

Aesop’s fable tells the story of an ant and a grasshopper who meet during the summer. While the ant works and saves, the grasshopper simply sings and enjoys itself. When winter arrives, the ant relies on its savings to survive, while the grasshopper finds itself destitute.

Aesop’s fable helps us understand the importance of moderation and foresight in a world characterized by basic cyclical conditions, such as the seasons of the year. However, when adapting it to the business environment — with the exception of the seasonal fluctuations inherent to every business — it can be somewhat limited. To begin with, very few senior executives know — not to mention with precision, but even with reasonable accuracy — when their business model will enter its decline. The strategic issue is therefore not merely about seasons, which, like the seasons of the year, are temporary, but about the business model itself.

If, during the spring and summer of the ant’s life, successful companies were to build reserves or develop alternative options, not only for difficult periods but also for the eventual end of the business itself, they would face another complication: How much should they save or invest? Unlike seasons, which have defined periods, we do not know how long an era of prosperity will last, nor when we will discover another successful alternative.

Strategic Diversification: Beyond “Not Putting All Your Eggs in One Basket”

Today, it is very easy to talk about diversification. We are told that we must diversify, that we should not put all our eggs in one basket, and that we need alternatives. Business owners feel the need to have a business portfolio that is sufficiently diversified while remaining profitable; and that is certainly a good thing. However, most of the time they overlook the rule—or, if you prefer, the valid and reliable procedure—that should be followed when selecting the alternatives that will make up that portfolio.

Undoubtedly, investors rely not only on their innate “business instinct,” but also on their experience and on sophisticated financial models that can be developed by specialists and incorporate numerous scenarios. These tools allow them to evaluate different alternatives. Nevertheless, the biases, prejudices, and cognitive distortions—whether innate or acquired—that every investor possesses can hinder the analysis of good ideas. It therefore becomes imperative to ask: What criteria determine which ideas are analyzed and which are not?

From the very moment ideas are generated, filters exist that prevent some ideas from advancing while others do. In the first instance, investors tend to gravitate toward projects that personally appeal to them, fields with which they are familiar, or areas they assume to be highly profitable, regardless of whether these areas fall within their expertise or simply happen to interest them. Among all the possible ideas, the first question we should resolve is: How can we ensure that our filter is not based on biases and prejudices, while at the same time preventing it from allowing initiatives that are highly unlikely to be technically, financially, or commercially viable?

Controlling Our Biases and Prejudices

Before thinking about the good or bad aspects of biases, it is important to understand that they are a reality. All human beings have biases and prejudices, and, to some extent, they protect us from certain adversities. However, if we are not aware of them, they can also “protect” us from learning new things and even from experiencing some of the best opportunities in our lives.

Honestly committing ourselves to discovering what our biases and prejudices are is the first step toward refining our filters. Fortunately, there are several models for identifying and assessing our biases. Although this is something we could undertake on our own or with our usual trusted team, ideally it should be done together with an independent professional consultant who is not particularly familiar with us. This is important not only because the first step in addressing our “psychological myopia” is to do things differently, but also because the only way to understand the true extent of the problem is through external feedback.

Doing it alone, or with the same people we always work with, would be somewhat like a blind person trying to imagine everything they have never seen — or have ceased to see — throughout their life. It is certainly possible, but far more limited than having someone who can see clearly and describe the details of what is actually there.