By now you’re probably saturated with all the publicity surrounding Peter Thiel’s book Zero to One (Crown Business, 2014). If you haven’t already read the book or a dozen reviews (or seen Thiel on Squawk Box), you might want to take a look at Shane Parrish’s "Eight Things I Learned from Peter Thiel's Zero to One."
Here I’m going to zero in on a single point that Thiel makes with regard to diversification, one that I think merits some reflection. He writes: “You can expect the future to take a definite form or you can treat it as hazily uncertain. If you treat the future as something definite, it makes sense to understand it in advance and to work to shape it. But if you expect an indefinite future ruled by randomness, you’ll give up on trying to master it.” (p. 51)
Finance treats the future as indefinite. In fact, “Finance epitomizes indefinite thinking because it’s the only way to make money when you have no idea how to create wealth. … [T]he fundamental tenet is that the market is random; you can’t know anything specific or substantive; diversification becomes supremely important.” (p. 57)
For venture capitalists, however, diversification is fundamentally flawed; “this ‘spray and pray’ approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single-minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place.” (p. 67)
Thiel admits that “no one can know with certainty ex ante which companies will succeed, so even the best VC firms have a ‘portfolio.’ However, every single company in a good venture portfolio must have the potential to succeed at vast scale.” Each of his funds focuses on five to seven potentially multibillion-dollar enterprises. “Whenever you shift from the substance of a business to the financial question of whether or not it fits into a diversified hedging strategy, venture investing starts to look a lot like buying lottery tickets. And once you think that you’re playing the lottery, you’ve already psychologically prepared yourself to lose.” (p. 68)