Hedging Your Innovation Risks Through Proper Budget Asset Allocation
In the world of finance, asset allocation is a commonly used technique to determine where to put an individual’s money to get optimum returns.
It is based upon a rigorous analysis of risk tolerance as well as an understanding for the correlation (or lack thereof) between asset classes. When one asset class goes up or down in value, likely an uncorrelated asset will not. It is the technical term for ancient wisdom that says “don’t put all your eggs in one basket.”
When determining whether or not to invest in R&D, innovation, product tweaks or other offerings, it is helpful to think of your budget dollars and people time as assets, and to put them into classes as well. Why?
Well clearly, these different activities present different levels of risk and reward tradeoff. They are not necessarily correlated to each other, AND they are not sensitive to the absolute dollar amount, but only to a relative one.
There are four types of budget asset classes in your innovation portfolio. These are derived from the relationship between products (services, business models) and markets that are either current or new:
Class 1: Evolutionary Innovation — This is the amount that should be spent on keeping current cash cows and growing brands fresh in the market. It is generally the largest portion of any company’s development budget, and sometimes overweighted in companies that tend to “follow.” This is a hedge against becoming stale in the current markets and categories.
Class 2: Differentiation — The portion used for making a distinction between your products and competing products. Making them more valuable. It’s an investment in perception that is derived from an investment in a “difficult but necessary” new capability for the company. This is a hedge against suboptimization. In other words, it helps you maximize the value of assets in class 1 and maintain ownership of your brand position.
Class 3: Revolutionary Innovation — This is the part of the budget that is invested to find the ground-breaking ideas for products, services and business models that are for brand new (to the world) or emerging markets. This activity is much longer term and involves a different level of process and resource. It is a hedge against future irrelevance or substitution. Most true entrepreneurs start here.
Class 4: Fast-fail Innovation —This is the activity where you go to market and do your testing and learning there. It is the opportunistic segment of your activity (well within your wheelhouse of capabilities/core competencies but far more experimental than usual), where you expect to fail quickly before succeeding with an offering that may literally be refined by your customers’ feedback in market. With these comparable, small incremental investments, you will soon become hooked on the combination of low risk and high-speed/high-reward potential. This is a strategy that hedges against a competitor beating you to the punch on something that has a limited time to act.
In a company with a moderately conservative risk tolerance, we would generally see a budget asset allocation like this:
In more aggressive industries, your innovation portfolio development model might see a higher balance of effort in the upper right side of the diagram and less on the left. In more conservative industries, it’s vice versa. To take the metaphor one step further, automatic “rebalancing” is also important. Once an idea develops in the revolutionary or fast-fail boxes, it may move to the maintenance box after it grows and matures. And budget continues to be allocated accordingly.
Like the markets, the thought process about “where should I invest” becomes a no brainer. It reduces the stress at budget time by getting everyone on the same page as to how to prioritize. It allows your teams to stay focused on generating the ideas and implementing them versus answering the “how much” question.