Wednesday, October 15, 2008

Creative Destruction (or) Destruction of Creativity?

What is Creative Destruction? And what has creative destruction got to do with investing?

As the name suggests, Creative Destruction is a principle which is used to denote the process of something new bringing about a revolutionary change resulting in the destruction of something old. It can be observed that much of human progress has been the result of one long chain of creative destruction, where innovation has resulted in the death of old.

A great example of creative destruction is the invention of wireless telephone technology, which in spite of its countless advantages, has rendered uneconomical the huge investments made in laying out the landline telephone networks around the nation. From the perspective of landline network owners, this invention has been tragic but for the civilization as a whole this has been an event which marks human progress in its grandeur. It must be noted, however, that someday some new invention will bring about a destruction of this technology, which seems invincible at present, and it will be a change for the better.

Killing Old Ideas:

At the heart of creative destruction lies the ability to kill old ideas and establish innovative ways to accomplish better results. And if you notice, all the new transformational innovations are separated by generations. The reason behind it is that we, as individuals or peer group, are not good at killing ideas to which we get used to. It takes fresh dose of imagination and lack of historical conditioning to think out of the box and question the existing notions.

As an investor, the question that I am interested in is – are we good at killing our own investment ideas and replacing them with better ones as they present themselves from time to time?

Experience of an Investor – Destruction of Creativity:

Consider the following hypothetical situation:

If you expect Rs. 10,000 invested today in the stock of NEW Ltd to grow to Rs 20,000 by the end of one year as compared to the same amount growing to Rs 15,000 in the stock of OLD Ltd., then is it not foolish to still invest in the stock of OLD Ltd.? Who would do something like this?

The answer is - all of us are susceptible to do something like this, especially, when we are already holding the stock of OLD Ltd. and have to book a loss to replace it with the stock of NEW Ltd.

Rationally speaking, that is, we would rather wait a year to recover the quotational loss in OLD Ltd. than book the loss today even if it increases our chances of recuperating the losses and making more money on the capital risked.

Just the other day as I was looking at the constituents of my portfolio it struck me that something that looked cheap (and was cheap), when the Sensex was at an all time high, did not look attractive enough as compared to other opportunities that have surfaced as the stock markets corrected. And I noticed that I should have replaced this with another stock with better risk-reward ratio but simply did not do it as it meant booking a loss of 20% in the old investment.

The end result – we often stay invested in the stock of OLD Ltd. and at the end of one year end up having Rs 15,000 instead of Rs 20,000. As Warren Buffett rightly observed when he said that the worst mistakes are those which do not show up anywhere because we simply keep on repeating them.

Why? Loss Aversion:

The reason behind this irrational response lies in loss aversion, which says that we feel uncomfortable booking losses as it causes regret, even when booking losses might be a rational thing to do.

Error of judgement is not that big an impediment to human progress as is his inability to judge his errors reasonably.

I am sure you would relate to the following and see what I am trying to say. How often have we come across people who are still holding onto the share certificates of the stocks from their IPO allotments from the early 1990s or the favourite IT stock from the IT bubble at the turn of the century, simply because they are still selling well below their purchase price? It is like that they have given up on those investments. It is as if, thinking about those investments results in pain. So, we end up doing the next best thing, which is, do not acknowledge the mistake by holding onto them and waiting for losses to be recovered.

Rationalization Trap:

Benjamin Franklin once famously observed, ‘So convenient a thing it is to be a reasonable creature, since it enables one to find or make a reason for everything one has a mind to do.’

The inability to be good at judging our own errors stems from the need to justify ourselves to others and self. Accepting a mistake makes one feel vulnerable. So, we pay the price in the form of covering up our past mistakes.

The defining ability, however, of any super-achiever, in any area of work, is his ability to accept his failures with as much humility as he does his successes. Moreover, sometimes it is not even a case of mistake just that something that seemed (and might have been) right at one point in time ceases to be so as things evolve.

It is easier said than done. In fact, it was my inability to act in the way recommended above to start with that led to this revelation and not the other way around. But as Benjamin Franklin observed a few centuries ago, "Would you live with ease, do what you ought, and not what you please."

It just happened that I realized one of the things that, as an investor, I ought to learn to do is reshuffle the portfolio on a regular basis even if it means killing my own best loved ideas and booking losses...

1 Comments:

Blogger modeller said...

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8:02 PM  

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