Prior to the 15th century, maps generally contained no empty spaces. Mapmakers simply left out unfamiliar areas, or filled them with imaginary monsters and wonders. This practice changed in Europe as the great age of exploration began. In Sapiens, Yuval Harari argues that leaving empty spaces on maps reflected a more scientific mindset, and was a key reason that Europeans were able to conquer and colonize other continents, in spite of starting with a technological and military disadvantage. Conquerors were curious, but the conquered were uninterested in the unknown. Amerigo Vespucci, after whom our home continent was named, was a strong advocate of leaving unknown spaces on maps blank. Explorers used these maps to move beyond the known, sailing into those empty spaces so they did not stay unmapped for long.
The same phenomenon occurs in business. In the Innovator’s Dilemma, Clayton Christensen shows why large established ostensibly well-run companies so frequently miss out on major waves of innovation. A key principle in the book is the difference between sustaining technologies, which merely improve the status quo, and disruptive technologies, which offer a new and unique value proposition. Large companies will frequently focus on sustaining technologies, and ignore disruptive technologies that serve fringe markets initially. Ultimately its disruptive technologies that define business history. Yet complacent companies don’t figure that out until its too late.
Companies whose investment processes demand quantification of market sizes and financial returns before they can enter a market get paralyzed or make serious mistakes when faced with disruptive technologies.
There are two parts to overcoming the innovator’s dilemma:
- Acknowledging that the market sizes and potential financial returns of a nascent market are unknowable and cannot be quantified (drawing the blank spaces on the maps) and;
- Entering the nascent market in the absence of quantifiable data- (travelling into the empty space)
Analogous ideas also apply to investing. In Investing in the Unknown and Unknowable, Richard Zeckhauser distinguishes between situations where the probability of future states is known, and when it is not. The former is the realm of academic finance and decision theory. The latter is the real world.
The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.
Human bias leads us into classic decision traps when confronted with the unknown and unknowable. Overconfidence and recollection bias are especially pernicious. Yet just because we are ignorant doesn’t mean we need to be nihilists. The essay has some key optimistic conclusions:
The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive.
Examples in the essay include David Ricardo buying British Sovereign bonds on the eve Battle of Waterloo, venture capital, frontier markets with high political risk, and some of Warren Buffet’s more non-standard insurance deals. Yet since even the industries that seem simple and steady can be disrupted, its critical to keep these ideas in mind at all times in order to avoid value traps.
The best returns are available to those willing to acknowledge ignorance, then systematically venture into blank spaces on maps and in markets.