Black Swan Portfolio

Long tails and black swans, I think there is a lot in these concepts to understand portfolios. I think it gives us a tool to use portfolio value distribution shapes as one criteria to guide decision making. Most of us are aware of using monte carlo and real options analysis methodologies to assess project value, which we then bring together into portfolio views to asses relative risk, total risk and value, usually looking at some sort of normally distributed portfolio value. I think there is something in these distribution shapes that we need to start paying attention to.

In financial risk management big financial institutions have started looking into these long tail or black swan circumstances to better understand downside risk and have better value at stake numbers. We, innovation people, deal with growth management and hence more with identifying portfolio opportunity, meaning that upside potential is more important for us to identify than downside risk. This is due to the fact that our downside risk is usually relative low compared to say financial industry, where a long tails may cause losing it all instead of just losing R&D investment and maybe losing growth.

However, long tails are not only about downside potential, additionally they are sources for tremendous opportunities, since they represent things that are very unlikely to happen but if they do they have significant consequences. Unfortunately, our standard balanced portfolio concept (as well as the way we evaluate projects) has a tendency to drive the portfolio into a normally distributed shape, consequently missing all the long tail opportunities. We can all agree that most of the transformational opportunities are in these long tails, and they represent things that all business leaders want to capture. The question is how do we find, assess, manage and communicate these in our portfolios?

There is a great presentation on innotiimi site on these long tail innovations that cause trouble in our portfolios. http://innotiimi.wm.fi/dokumentit/0811260300_black_swans__radical_innovation.pdf

Efficient Frontier for Innovation Portfolio

Since Markowitz came up with the Modern Portfolio Theory in the 50's it has been used as the tool for financial asset management. In innovation portfolio management, however, portfolio theory has been largely focused on balanced portfolio that very seldom operates at the efficient frontier. The only efficient frontier approach in innovation portfolio that I have ever come across is related to resource use. Where the objective is to maximize return for a given resource use, and risk is then often balanced to have a nice spread between high risk and low risk projects. From MPT perspective this is not an efficient frontier solution for these innovation portfolios. Efficient frontier maximizes returns for a given risk. Resources are just an input that sets limits to the realization of the return. Additionally in innovation portfolio there is always a nice correlation between resources and returns that is always of diminishing returns. With modern tools all these variables can be pulled into one nice package, which allows looking at portfolios in a more flexible way, where risk, resources and return choices can be looked at once. This brings flexibility into decision making and enables a way to manage risk at portfolio level in innovation. To demonstrate this I combined monte carlo simulation with the efficient frontier optimization (using crystal ball) and ran the simulations for different budget constraints for a simulated innovation project portfolio. Each dot in the graph represent a mix of projects that is the efficient frontier solution for the portfolio for a given risk and budget. The result is shown in the image above. This approach allows making choices between risk, investment and returns for various optimal solutions for any given project portfolio. I find it very useful in understanding the potential of my pipeline. However, I have not seen this being used int he innovation industry and would be interested in knowing if anybody else has used this for their portfolios?