Thinking Like a Portfolio Manager
by Isaac Were, Co-founder
If you manage P&L and have hiring authority, you’re both an investor and operator. Most of your decisions put capital to work against actions that are accountable for revenue. That’s quite the responsibility since businesses live and die by revenue.
Being a good operator is straightforward. You’re focused on executing against (typically tangible) operational objectives. On the other hand, being a good investor is less straightforward. Reason being that anyone who owns a book of business has a large portion of their spend go towards W2 wages. And contrary to Cost of Goods that go into your product or service, the W2 portion doesn’t have a return that’s easy to measure, except perhaps for your sales team.
So while many business leaders may consider their employees assets to the business, they don’t think like asset managers when it comes to allocating their hiring budget. Instead, they end up hitting the pitfall of separating human assets from financial assets. In most cases, this separation makes sense, especially for accounting purposes on a balance sheet. But let’s take a step back and consider a general definition of an asset for a business.
An asset is a resource with economic value that a business owns or controls with the expectation that it will provide a future benefit. Clearly, by this definition, employees are assets. Each person has an economic value in the hiring marketplace, and if they navigate a useful interview process, then there’s an expectation that they’ll create future benefit for the company.
If you can get on board with the fact that employees are assets, then there’s a lot you can borrow from modern portfolio theory to get the most out of your W2 allocation. To start, we should highlight the most well known tenet in modern portfolio theory: in a diversified basket of assets, the covariances of the assets determine the risk of the portfolio more than the risk of each individual asset.
Before this principle becomes meaningful, we have to understand what variance represents in an employee. Earlier, we established that employees were assets mostly because there’s an expectation of them creating future benefit for the business. Well, the higher the chance an employee has in varying from that expectation of future benefit, the higher their variance is; or- the more risk they represent.
So then what’s an employee’s covariance with another employee? Imagine you’re taking a risk on a software engineer coming out of a bootcamp. They may have learned fundamentals well enough from the bootcamp to adapt and thrive, or they might not be able to keep up. Now, if you hired someone from the same exact bootcamp class, the covariance would be very high. In other words, the risk is super similar and increases the risk of the portfolio.
So we’re encouraged to take risk on hires, but vary the type of risk we’re taking. After all, you can’t ever get 2X the expected output from your team without taking risk on people. And if you think about risk like a portfolio manager, then diversity maximizes upside while controlling downside.