Creating Strategy in an Unknowable Universe

In his new book The Origin of Wealth, McKinsey & Company Senior Advisor Eric D. Beinhocker argues that the traditional view of economics as a static, equilibrium-balanced system is going through a radical rethinking involving a multitude of disciplines. The new spin: "complexity economics," in which the economy is viewed as a highly dynamic and constantly evolving system that is all but impossible to predict. This excerpt deals with how companies can set strategy when the future is unknowable.

Strategy as a portfolio of experiments

The key to doing better is to "bring evolution inside" and get the wheels of differentiation, selection, and amplification spinning within a company's four walls. Rather than thinking of strategy as a single plan built on predictions of the future, we should think of strategy as a portfolio of experiments, a population of competing Business Plans that evolves over time. We will look at the elements of such an approach shortly, but first, an example will help illustrate what a portfolio of strategic experiments looks like.

Let's return to the Microsoft story and imagine it is now the year 1987, six years after Gates signed the contract with IBM. The still nascent PC industry has just gone through a period of explosive growth. No one has ridden that growth harder than Microsoft. But MS-DOS is now coming to the end of its natural life cycle. Customers are beginning to look for a replacement operating system that will take better advantage of the graphics and greater power of the new generation of machines. A change in the S-curve is coming, and the industry is far from certain how things will work out. Despite its success, Microsoft was still a $346 million minnow in 1987 compared to the multibillion-dollar giants hungrily eyeing its lucrative position. IBM was developing its own powerful multitasking OS/2 system; AT&T was leading a consortium of other companies, including Sun Microsystems and Xerox, to create a user-friendly version of the widely admired Unix operating system; and Hewlett-Packard and Digital Equipment Corporation were pushing their own version of Unix. Apple was also still a threat, consistently out-innovating the rest of the industry, and its highly graphical Macintosh was selling well.

We can imagine the options that Microsoft faced at this point. Option one: Gates could make an enormous "bet the company" gamble by investing in building a new operating system called Windows and attempt to migrate his base of DOS users to the new standard, ideally before a competitor would reach critical mass with its own system. Option two: He could exit the operating-system part of the market, cede that to his larger, better-funded competitors, and instead focus on applications for which Microsoft's small size and nimbleness might be more of an advantage. Or, option three: He could sell the company or otherwise team up with one of his major competitors. While Microsoft would lose its independence with option three, such a move would probably tip the balance of power in favor of whichever company he chose to partner with.

All these options would involve big commitments to hard-to-reverse courses of action and involve major risks. The conventional wisdom is that Gates chose option one, and the big bet paid off, enabling Microsoft to continue its dominance of desktop operating systems and spend the next decade fighting antitrust regulators. But that is not actually what happened. What Gates and his team did was much more interesting—they simultaneously pursued six strategic experiments.

First, Microsoft continued to invest in MS-DOS. Although everyone was predicting the operating system's demise, it still had an enormous customer base. Many customers were very cautious about switching, and each version of DOS was incrementally more powerful than the last. There was still some chance that DOS would continue to morph and evolve and provide what customers wanted for some time.

Second, Microsoft saw IBM as a real threat. Big Blue was still a power house on the hardware side in 1987 and wanted to regain control of the operating-system market. But IBM also knew it would be risky to go it alone. As Michael Corleone said in The Godfather, Part II, "Keep your friends close, but your enemies closer." Gates and IBM agreed to turn IBM's OS/2 operating-system project into a joint venture.

Third, Microsoft saw Unix as a lesser threat than IBM, but a threat nonetheless. Microsoft held discussions with various companies, including AT&T, about participating in joint efforts on Unix. The discussions kept Microsoft's options open and the company plugged into what was going on, but also fueled speculation about Microsoft's Unix strategy. This had the benefit of creating additional uncertainty for the Unix advocates and slowing their progress.

Fourth, in addition to playing the Unix alliance game, Microsoft bought a major stake in the largest seller of Unix systems on PCs, a company called the Santa Cruz Operation. Thus, if Unix did take off, Microsoft would at least have a product of its own in the market.

Fifth, Gates did not pull back on investing in applications, but continued to build that business at the same time, despite the strain on resources. In particular, Microsoft built its position in software for the Apple Macintosh, passing Apple itself, as the leading supplier. This provided a hedge in case Apple capitalized on the discontinuity in the market to push its own operating system ahead.

Sixth and finally, Gates made major investments in Windows. Windows was intended to be the best of all worlds. It was built on DOS and backward-compatible with DOS applications, it was multitasking like OS/2 and Unix, and it was easy to use like the Macintosh. But most importantly, it would keep control of the PC operating-system market firmly in Microsoft's hands. Success with Windows was clearly the company's most preferred outcome.

What Gates created was not a focused big bet, but a portfolio of strategic options. One way of interpreting what Gates did was that he set a high-level aspiration—to be the leading PC software company—and then he created a portfolio of strategic experiments that had the possibility of evolving toward that aspiration.

It is important to remember that in 1987, Windows was far from a certain winner. Version 1.0 was launched in 1985 but sold very poorly, and Version 2.0, launched in 1987, was plagued with technical problems and delays. It wasn't until Version 3.0 appeared in 1990 that Microsoft's future lock on the operating-system market was assured. Annie's hand could have twitched in another direction; if IBM had been a bit faster with OS/2, if the Unix companies had gotten their act together, or if Microsoft had suffered further glitches with Windows, history could potentially have taken a very different branch.

Rather than try to predict the future, Gates created a population of competing Business Plans within Microsoft that mirrored the evolutionary competition going on outside in the marketplace. Microsoft thus was able to evolve its way into the future. Eventually, each of the other initiatives was killed off or scaled down, and Windows was amplified to become the focus of the company's operating-system efforts. At the time, Gates was heavily criticized for this portfolio approach. Journalists cried that Microsoft had no strategy and was confused and adrift; they wondered when Gates was going to make up his mind. Likewise, it was difficult for those working inside the company to find themselves competing directly with their colleagues down the hall. There is no evidence that Bill Gates looked to evolutionary theory or was thinking about fitness landscapes when designing this strategy. Yet, regardless of how the approach was specifically developed, the effect was to create an adaptive strategy that was robust against the twists and turns of potential history. Microsoft has continued this approach and today has a portfolio of competing experiments in areas ranging from the Web to corporate computing, home entertainment, and mobile devices.

There are some general lessons that can be learned from a portfolio-of-experiments approach to strategy. First, management needs to create a context for strategy. Constructing a portfolio of experiments requires a collective understanding of the current situation and shared aspirations among the management team. Second, management needs a process for differentiating Business Plans that results in a portfolio of diverse Plans. Third, the organization needs to create a selection environment that mirrors the environment in the market. Fourth and finally, processes need to be established that enable the amplification of successful Business Plans and the elimination of unsuccessful Plans. We will discuss each of these key points in turn.

Context: creating prepared minds

I once worked with a very gruff, pragmatic senior executive who claimed not to believe in strategic planning, saying that it was a bunch of "pointy-headed nonsense." He was also very successful. He had taken a hodgepodge of industrial businesses in tough markets and managed to squeeze very good growth and margins out of them over a number of years. One day, I saw the advance materials for a strategic planning off-site and noticed that the analyses prepared by this executive and his team were by far the best in the binder.

The next day, I asked him, given that he had claimed not to believe in strategic planning, why he and his team had put so much effort into the analysis. His reply was, "I don't believe in planning. I do this so that we have prepared minds." Once I recovered from hearing this no-nonsense executive quoting Louis Pasteur ("chance favors the prepared mind"), the almost Zen-like wisdom of his remark sunk in. As he explained it, he and his team did not use the tools of conventional strategy analysis to make crystal-ball predictions about the future. Rather, they used the tools to provide context for making real-time decisions and to help them deal with all the uncertainties they knew would come their way. As we continued our discussion, he explained that the strategic planning exercise was a critical way to get his senior team to communicate. It gave them a common frame of reference for their businesses, a shared understanding of the facts, and a language for talking to each other.3

A former senior executive at GE Capital told me about a similar philosophy he had in planning for acquisitions. He saw the point of strategic planning not as predicting the future, but as a learning exercise to prepare people for a future that was inherently uncertain. For example, he noted that he never knew when an important acquisition opportunity might arise. Even though he did not have a plan that said "we will buy companies X, Y, and Z," if company X did come up for sale, his team could get an offer on the table more quickly and with fewer contingencies than anyone else could, thus increasing the probability of success. The members of his team could do this because they had already gone through the discussion about the market, knew a lot about company X, understood how it would impact their economics, and so on. They already had a shared view on what the acquisition would mean for them. In other words, they had prepared minds.

The message is not to tear up your strategy books, but to think of the tools of conventional strategy analysis as having a different purpose. The purpose is not to get to the "answer" of a single focused five-year plan based on predictions of the future, but rather to create "prepared minds." This requires thinking about whose minds it is important to prepare and how one can best go about doing that.

For most companies, this shift in perspective implies a major redesign of the strategic planning process. Most processes are focused on creating plans and making decisions rather than learning. A planning process focused on learning has three major attributes.

First, the process should be focused on structuring in-depth discussion and debate among principal decision makers. Typical planning processes result in underlings presenting slides to senior decision makers in precooked dog-and-pony shows—very little learning goes on in such meetings. Instead, the focus should be on creating a forum in which senior decision makers meet to roll up their sleeves and wrestle intensely with the issues (and sometimes each other). Such forums need to be small (if too many lieutenants are in the room, the senior people won't speak openly) and have adequate time—a full day per business unit per year for the CEO and top team is a good rule of thumb, versus the hour or two typical in most company off-sites.

Second, the process must be fueled by facts and analysis. If only opinions are brought to the table, chances are that everyone will leave the room with the same mental models he or she walked in with. This means intense preparation in the months leading up to the strategy conversation, and while staff and consultants can help, the senior principals need to be fully engaged in the preparation as well. A shared understanding of a common fact base is the single most valuable outcome of the process.

Third, there must be other forums clearly designated for decision making. If the strategy process becomes overburdened with near-term decisions on budgets, setting targets, and allocating capital, then learning goes out the window. The decision-making forums should be linked to, but separate from, the strategic learning process. Again, the focus of the strategy forum should be setting context to inform the design and management of the portfolio of experiments.