The 3 Steps of Innovation

Many of the greatest innovations in history have been unkind to investors. That concept seems counter-intuitive, but if we dig deeper it begins to make sense why. 

Innovations are things that have never been done before. Their potential is both unknown, and unlimited. That makes them easy to promote, and tough to value. That combination is perfect for founders raising money, but not so great for investors expecting a return. 

With the cards stacked so heavily against investors from the get-go, it makes sense that low aggregate returns on innovation should be the norm.  But innovation is a complex and fluid process, it can’t be reduced down to a single blanket statement on expected returns. 

The Innovation Lifecycle

If we zoom out, we can spot some important patterns and trends that occur during the lifecycle of innovation.  While it’s not possible to predict investor returns, it’s a useful exercise to examine the process of innovation and the ways new ideas come to market.

The general blueprint for innovation goes something like this:

  1. Try 100 different ways to solve a problem
  2. Forget the 97 that don’t work
  3. Go all-in on the few that do

And this process isn’t unique to business innovation, your brain works the very same way.

Michael Mauboussin does a great job of illustrating this phenomenon in his book More Than You Know. He starts by saying: 

“From a child’s birth to the age of three, there is a huge increase in the number of synapses – connections between neurons – in the brain. In fact, a child has more than 1 quadrillion synaptic connections, twice as many as an adult. Children have brains that are more active, more connected, and more flexible than those of grownups.”

This is the first step of innovation, try many different ways to solve a problem. 

Try, Try, and Try Again

Every industry can relate to an explosion of interest surrounding key technological breakthroughs. The auto, aviation, computer, internet, and crypto industries all witnessed a flood of new startups with ‘revolutionary’ ideas as each industry developed.

Nobody needs thousands of different car models, but starting with thousands improves the odds that one will find product-market fit. Same story with cryptocurrencies. Today there are thousands of projects, all searching for a better way to transfer value between people. 

We still don’t know which crypto projects will succeed, but history says it won’t be a thousand-way tie. Many will go to zero.

Children do the same thing to solve the problems they may encounter later in life. A child over-allocates resources to its brain in early development, in hopes that some of those connections prove to be useful later on. 

While no child needs all of their synaptic connections, starting with more raises the odds that some will be useful. 

Mauboussin continues:

“…following this synaptic proliferation is a significant pruning process. Through experience, useful synaptic connections are strengthened, and those that aren’t used get pruned. Estimates suggest that young children lose approximately 20 billion synaptic connections each day.”

That’s the second step of innovation. It’s not pretty, and is often remembered years later as the ‘crash’ or ‘bust’ of a particular industry. 

Use It Or Lose It

The internet offers us a great example. The 1999 dot-com bubble led to a crash in 2000 responsible for hundreds of company bankruptcies. By 2002, US equity markets had lost close to $5 trillion of value.

100 years ago, the US auto market saw a similar crash. There are now over 1,000 Wikipedia entries for ‘defunct automakers in the US’, most of which shut down between 1900 and 1925. Only Tesla, Ford, and GM remain today. That puts an automaker’s chance of failure at over 99.7%. Not great odds for auto investors.

Children begin specializing during the ‘pruning’ phase, as they shed their unused synaptic connections. If you’ve spent your formative childhood years playing golf, there’s a chance you may become really good at it. But if not, the odds are heavily stacked against you. 

Same with learning a new language. Before the age of 10, kids tend to pick up new languages easily. After that, the difficulty of learning a new language spikes, and it becomes tough to get rid of first-language accents and speaking styles.

As the saying goes, ‘use it or lose it’.

Mauboussin finishes with:

“This process (of overproduction and pruning) fine-tunes the brain to survive in its particular environment. By the time we are adults, synaptic selection has shaped our brains to succeed.”

The final step of innovation is where the big rewards typically occur – if they occur at all. The businesses that survive the pruning process build on their winning idea and try to strengthen their moats. 

What Doesn’t Kill You

The dot-com crash strengthened Amazon’s competitive position. With no more competition, Amazon took full advantage to create enormous value for both customers and investors. But the survivors of the automobile and aviation revolution didn’t have the same luck.

Warren Buffett famously said in a 1999 Sun Valley speech:

“As of a couple years ago, there had been zero money made from the aggregate of all stock investments in the airline industry in history”. 

Sometimes even the winning innovators can’t come up with the right formula for long-term investor returns. Despite the transportation revolution ushered in by planes, investors failed to capture any of the created value. The production-pruning process of innovation is no sure bet.

Humans work the same way. As our brains reach maturity, they double down on the connections that are useful, guiding us to become experts in a particular domain. Sometimes that domain happens to be a useful one, like basketball. Sometimes it happens to be a useless one, like underwater basketweaving.

Our brain tries to predict the synaptic connections that may prove useful later in life, but there’s no guarantee that our brain will get it right.

It’s easy to get carried away by innovation. Humans have a natural tendency to believe the future will be better than the past, so pitching a bright future to investors isn’t a very hard job.

But the streets of progress aren’t paved with gold, and investing in innovation often goes unrewarded.   

When in doubt, zoom out.