Funders often make risky bets, choosing grants based on an uncertain theory of change, or backing ambitious advocacy campaigns. These risks are necessary and positive for the field, as they can enable significant social benefits. To make sure these risks stay smart, philanthropy can borrow lessons from other fields that grapple with uncertainty.
Diversification, the practice of choosing investments carefully to reduce risks, has helped maximize returns on many different kinds of risky bets. Our paper “Doing Diverse Good: Balancing Risk and Return” describes this approach in more detail and provides some lessons and rules of thumb based on our experiences. These techniques have helped several of our clients choose grants that reduce risk without spreading their funds into so many different bets that they are ineffective.
Here are four rules of thumb that we explore in greater depth in the paper:
- All else equal, choose the independent grant. Just as in financial investing, diversification is a meaningful way for philanthropies to manage the variability of their grant portfolios. It is possible to generate higher returns at lower risk through diversification, so it is worth stopping to consider whether grants that are otherwise equally appealing concentrate resources in one region, one opportunity, one theory of change; or, whether the likelihood they succeed is less correlated with existing grants.
- Beware the engineer’s solution. A neat, logical, and internally consistent theory of change is often a boon to grantmakers when designing a strategy. But investing in only one elegant theory of change can involve unnecessary risk because every grant rests, like the theory itself, on a few underlying premises. In philanthropy, those premises are often highly uncertain. Thus, before finalizing a strategy, identify the premises upon which most of the grants rely, prepare to track them carefully, and seek alternative theories and grants that would not rely on them.
- “A little bit of everything” is not the right answer either. If the engineer’s solution can be too aggressive, granting to “a little bit of everything” can be too conservative. Program officers often find it difficult to turn away from all of the good options they identify in the early stages of planning. But by choosing to concentrate in a few viable theories of change, a philanthropy can create a rigorous framework for diversifying its portfolios. This approach is likely to work far better than under-funding many potentially attractive opportunities for the sake of diversification.
- Avoid the riskiest and safest portfolios. For institutions committed to pursuing the highest risk, highest return solutions, a little diversification can go a long way to increasing the likelihood that the portfolio produces meaningful social impact. And for institutions committed to consistently delivering impact year in and year out, making a few risky bets can increase the potential return of the portfolio substantially without significantly increasing risk. The costs of social returns and safety – in added risk or foregone benefits – can rise exponentially.