I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Wednesday, November 30, 2011

Strategic IT: Picking Winners is Hard, Cutting Losers is Harder

Previously, we looked at how we can separate Strategic IT from Utility IT, position the Strategic portion as an investment arm of the business, and manage it as a portfolio. Successful portfolio management requires that we have investment flow (regular promotion and demotion of opportunities), hedging strategies, and to behave as activist investors. If we do this well, Strategic IT becomes "investment" rather than "operations", a driver of business returns, and a source of innovation to the business.

But "doing this well" is hard. It's worth looking at why that is.

Let's start with the basic premise of portfolio management. Most descriptions of IT portfolio management go something like this:

  1. We put all the ideas for IT solutions into a review/approval funnel.
  2. Only the Very Best Ideas get approved.
  3. Those that do get developed and delivered.
  4. We reap massive profits.
If only it were so simple.

If you've ever managed investments of your own - even just a periodic redistribution of your retirement account - you know how difficult it is to manage a portfolio. We have very accurate historical data on the performance of specific companies, funds, and indexes, but we have no idea how any specific investment will perform in the future. Every investment is a leap of faith that our assessment of the opportunity and attendant risks is accurate, that governance is true and honest, that management have the expertise, that regulation is effective, and so forth. These might be informed leaps of faith, insofar as we've done our due diligence on the opportunity and its competitive landscape, as well as alternative investment opportunities before us. But as we don't know what tomorrow holds, it's still a leap of faith.

These same characteristics apply to Strategic IT investing, if to differing degrees. Compared to a securities investor, the Strategic IT investor has a more intimate relationship with the people managing execution of an investment, and is in a position to apply hands-on governance. But the Strategic IT investor doesn't have anywhere near the diversity of investment vehicles. The Strategic IT investor is essentially making very specific, targeted investments.

This means that Strategic IT investing is a business of picking winners. And if there's one thing we know about investing, it's hard to pick winners. Many researchers have argued that random walk investing performs no worse than picking winners. With index and sector ETFs making it easy for investors to match the market, it comes as no surprise that most capital is managed passively, not actively.

There are no passive instruments in Strategic IT investing. We're investing in a specific business through IT. Our investments are active by definition. We have to pick where and how we're going to place our bets, and just as importantly where and how we're not. We're in the business of picking winners. And no matter how much somebody touts their "rigorous and high standards for choosing investments", active investment management is hard. Go as John Paulson or Jon Corzine how hard it is to always pick winners.

And the challenge in portfolio management goes beyond simply picking winners. In our pursuit of picking winners, we're going to pick losers. In fact, we're going to pick a lot of losers.

So it is more apt to say that portfolio management is a process of picking winners that sufficiently outperform our losers. The objective isn't to avoid picking losers and only pick winners, but to recognize our losers quickly and minimize their impact on our portfolio.

Investors tend to hang on to losers for too long. It's tough for investors to admit a loss, because it's tantamount to admitting a mistake. Jason Zweig described it best: "it isn't that I've been proven wrong, it's that I haven't been proven right yet." For the Strategic IT investor, the emotional difficulty of parting with a loser is going to be reinforced by corporate cultures that insist that "our projects never fail". It will be impossible to fail fast and frequently if we can't come to grips with our mistakes.

Although we may very well need "rigorous and high standards" for choosing Strategic IT investments, it's perhaps more important that we have the discipline to quickly exit losers. This is why it is important that we have investment flow in our portfolio: as a portfolio manager I want to be able to fluidly enter and exit investments so that I can quickly cut my losses and redirect people and capital toward things I believe to be better opportunities. It also makes the case for activist investing: as a Strategic IT investor, I want to be able to continuously and consistently scrutinize my portfolio so I can continuously reassess and reinforce the viability and relevancy of my investments.

Even if we do this well, we still may never have an "optimal" portfolio. Our results will still be subject to forces and events we cannot foresee at the time we make an investment. And we'll pass on opportunities that turn out to be winners. But we will be much better at scuttling our losers. We'll be better at failing fast.