More Than You Know: Innovation

Innovation has turned much of our world, including investing practices, upside down over the past few decades. So, what is innovation, and why does it happen?

Explaining that is the task Michael Mauboussin set for himself in chapter 18 of “More Than You Know: Finding Financial Wisdom in Unconventional Places.”

He began with Orville Wright’s first flight in 1903, as the pioneer flew 120 feet in 12 seconds. Mauboussin added, “With that, the Wright brothers launched multiple industries and forever altered the nature of long-distance travel.”

That innovation was not purely new, rather it was what the author called “a recombination of known ideas and technologies.” It was a process, one that investors should know, for two reasons:

1. Society’s overall prosperity depends heavily on innovation.
2. Innovation is behind creative destruction, wherein new technologies and businesses create a place for themselves by making previous technologies or businesses obsolete.

Mauboussin also noted a point made by economist Paul Romer, who observed that wealth per capita has gone up sharply even though there are no more raw materials now than at any time in the past. In fact, the same volume of raw materials is being shared by a much larger population. In numbers, the world’s population is 30 times richer now than it was a thousand years ago.

Romer concluded that the increase in per capita wealth came out of our innovation, saying, “We have progressively learned how to rearrange raw materials to make them more and more valuable.” The economist also distinguished between two parts of the value-creation process:

1. The discovery of new instructions, ideas or formulas.
2. The “carrying-out” or execution of those instructions.

To illustrate, he compared U.S. Steel (NYSE:X) in the year 1900 and Merck (NYSE:MRK) in 2000. For U.S. Steel a century ago, a majority of employees would be following instructions. For Merck in 2000, the emphasis would be reversed, with much more emphasis on trying to find new instructions, ideas and formulas.

Mauboussin next noted the distinction between rival and nonrival goods. Examples of rival goods include cars, pens and shirts; when one person uses a rival good, it is not available to others. Nonrival goods, such as software and websites, however, can be used by many people at the same time. In fact, wider sharing may lead to even more sharing, as in the case of social media companies such as Facebook (NASDAQ:FB).

One of the implications of nonrival goods is that they contribute to ongoing innovation. The author noted that innovation involves recombining the building blocks of ideas, and the more building blocks that exist, the more opportunities there are to solve problems. For example, if you have four building blocks, there are 24 possible combinations (4 x 3 x 2 x 1), but if you have six building blocks, you have 720 possible combinations (6 x 5 x 4 x 3 x 2 x 1). That’s 30 times as many possible combinations as with four building blocks.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The point, of course, is that the more building blocks, the more potential innovation. And the more innovation, the faster economic growth. Mauboussin observed that per capita gross domestic product levels in the United States have been accelerating for two centuries, even though the economy has grown rapidly.” data-reactid=”34″>The point, of course, is that the more building blocks, the more potential innovation. And the more innovation, the faster economic growth. Mauboussin observed that per capita gross domestic product levels in the United States have been accelerating for two centuries, even though the economy has grown rapidly.

He went on to note, “We should expect three interrelated drivers–scientific advances, information storage capacity, and gains in computing power driven by Moore’s Law–to continue to spur innovation at an accelerating rate.”

He then focused on one type of innovation, changes in information transmission. Mauboussin cited a book by Juan Enriquez, “As the Future Catches You,” that traced how human symbolic communication had evolved:

• Paleolithic people began painting on cave walls 20 to 30 thousand years ago, but despite their beauty, the paintings could not be reproduced or moved, so they had limited communication value.
• Mesopotamian and Egyptian people introduced written alphabets some 5,000 years ago; that certainly improved communication technology, but only the elite knew how to read and write.
• About 1,000 years ago, the Chinese developed more standardized characters, which allowed them to print books 500 years before Gutenberg’s printing press arrived.
• Just before World War II, binary or digital language emerged, allowing us to capture almost any information in a series of 1s and 0s. Mauboussin added that digital language is simple, and can be coded, transmitted and decoded very quickly. What’s more, it enjoys “remarkable fidelity” and can be stored easily.

Thanks to digital language, there has been–and will be–remarkable changes:

“What does all of this mean for innovation? Because of the flexibility of digital language, we can now identify and manipulate building blocks like never before. Combine this with the growing inventory of building blocks, and the conclusion is that the rate of innovation is likely to accelerate. Changes in healthcare, for example, will likely be sweeping as scientists combine digitization, biological knowledge (the map of the genome), and increased computing power.”

Mauboussin concluded the chapter with a brief nod to creative destruction, which he argued is here to stay. The Wright Brothers of the 21st century have unprecedented access and the ability to develop their own combinations of building blocks. And it will be those who create useful ideas, rather than those who execute the ideas, who will collect the wealth of the future.