Received wisdom says that if you are a small firm, you are no match for the mighty Goliaths with deep pockets. Examples of firms such as Tivo who create a new category but lose out to larger players is often shown as the example of small companies are at a big disadvantage. But there is some good news for start-ups: Every Goliath had a psychological chink in its armor that makes him vulnerable? When you hit this chink, Goliath will behave like a deer in the headlights?
The Dark Side of Innovation -A Chink in Goliath’s Armor
When large firms face two choices – embrace an innovation that lowers it profits or avoid it and risk dying – firms behave in a less than rational manner. The rational behavior would be to take the lesser of the two evils (live with a lower profit) but firms resist this path with all their might. In doing so they demonstrate the psychological chink in their armor that can stun them into inactivity. This is what I have termed the Dark Side of Innovation.
The Story of Vanguard
The rise of Vanguard from being a small peripheral firm to being the leader in the mutual fund industry is a tale of how one firm used this psychological chink in Goliath’s armor to win in a mature, difficult and fragmented industry.
Before 1975, all mutual funds used to be active funds. The fund managers used to regularly 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.
The David called Jack Bogle
Vanguard’s CEO Jack Bogle found that on an average the entire mutual funds industry underperforms the index. This was because the average fund performs in line with the index but the high fees lower the final returns to the investor. The fund management fees of active mutual funds do not bring the promised return. He offered a better solution: why not just buy the entire index (and hold it). This would reduce management fees give you better returns than the average fund investor. His promise – 80% lower fees on index funds.
Bogle Exposes the Chink in Goliath’s Armor
This path spelled disaster for major fund houses. If they followed him and converted their funds into index funds they would deliberately cut their revenues by over 80%. If they didn’t, it was likely that investors would not want to buy these funds and this problem would go away. 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 and let Vanguard rise to the be the leader of the industry.
How To Find A Chink In Goliath’s Armor?
So what is the secret of finding this psychological chink in Goliath’s armor? You have to create a profit destroying innovation. Vanguard used one method to create such an innovation – 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.
A Critical Question
Which deep rooted belief holds the key to the profits in your industry? Can you change it to expose the chink in Goliath’s armor in your industry?
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