How a little guy will eat your lunch and run away with your business

If you are a large firm, with strong brands and a dominant industry position, you are secure. You are a Goliath with deep pockets and a small business upstart can be no match for you. There is a lot of evidence to support this view. For example, consider Comcast and Verizon as the Goliaths in the cable industry.  They faced a threat from a small company named Tivo who developed a new DVR. Users loved Tivo and followed it with their hearts and pockets. But in the end, the big cable guys continued to do well whereas Tivo made little money.

The Chink in Goliath’s Armor

Although many such stories hold water, there is bad news for Goliaths. Every Goliath has a psychological chink in his armor that makes him vulnerable? When someone hits this chink, Goliath will fall.

This chink in Goliath’s armor appears when he faces a special set of choices. When he has to choose between an innovation that lowers profits and status quo he makes bad choices. Although the rational behavior would be to take the lesser of the two evils (live with a lower profit), he resists this path. In doing so he exposes the psychological chink in his armor that can stun him into inactivity. This is what I have termed the Dark Side of Innovation.

Vanguard Story

Vanguard exploited this chink in Goliath’s armor to rise from being a small and unknown company to being a leader in the mutual funds industry. It faced Goliath such as Fidelity and State Street in a mature industry and yet succeeded.

Before 1975, all mutual funds used to be active funds. The fund managers used to trade securities to beat their benchmark index such as S&P 500. The belief was that if you can get in and out of the market at the right times you could be ahead of the index. For this strategy, fund managers used to charge high management fees. The business was quite lucrative.

Bogle’s Research

Vanguard’s CEO Jack Bogle found something surprising. The funds that aimed to beat the index most often failed to do so.  This occurred because of two reasons. First, active management did not deliver consistent superior returns. Second, high fees that funds charged lowered returns for the investors. Active management was a fool’s errand. Nobody had thought of that until Bogle had this epiphany. He offered a better solution: why not just buy the entire index (and hold it). This would provide index returns without high management fees. His promise – 80% lower fees on index funds.

How a Little Guy Will Eat Your Lunch and Run Away With Your Business

This path spelled disaster for major fund houses. If they followed Bogle and converted their funds into index funds, that would reduce their revenues by over 80%. If they didn’t, and investors were swayed towards index funds, they may lose a lot of business. Their choice was to embrace a profit destroying innovation or ignore it. They not only ignored it but also berated Bogle for the mediocrity he was peddling. They didn’t believe anyone would buy such a poor product that offers ‘average’ performance. And in doing so they exposed their psychological chink that made them underestimate the power of the dark side of innovation. As a result, when Vanguard offered index funds, competitors did not follow. This allowed Vanguard rise to be the leader of the industry.

How Can You Find the Chink in Your armor?

So what is the secret of finding this psychological chink in your armor? You have to be aware of profit-destroying innovations and how companies create them. Vanguard created one by changing a deep-rooted belief in the industry. The belief that you can consistently beat the index was at the heart of the profits of the mutual fund industry. When Bogle assaulted this belief, he created a profit destroying innovation.

Which deep rooted belief holds the key to profits in your industry? Is there a small company trying to change it? If yes, that little guy may eat your lunch and run away with your business