We can look at any aspect of life to see that rarely anyone succeeds continuously and over a long time. In the area of business this is quite evident as we encounter in our daily lives that established businesses and brands fail or become obsolete. We can for example compare the composition of stores in a shopping mall with only 5 years before to see the a considerable fraction of the businesses have been replaced or changed in some form. This doesn’t directly imply that certain businesses were ill-managed and therefore ran out of business. The more overarching principle is that businesses need to adapt to change and competition, also arising from new market participants, which inevitably will make victims.
In the title of this article we have mentioned the principle of creative destruction, which is a notion popularized by Joseph Schumpeter to emphasize that innovation will also have adverse consequences for existing businesses. Although this doesn’t complete encompass the message we are trying to convey, it touches upon fundamental components.
Performance in the area of sports and business
To make it less abstract and more concrete we can look in the area of sports. If we for example look in the area of football, we can observe that not a lot of players are consistent and perform at the highest level over a long time span. A player obviously also represents a business interest for himself, his club and country. His earning potential depends on how long the player can perform at a certain level. Although in recent history there are some exceptions of players like Messi and Ronaldo that performed at the highest level over a long time, frequently it is expected that a young star player in the top will remain there for over 10 years, only for this player to eventually fade into obscurity in time. This can of course have various reasons:
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One can have injuries or loss of motivation;
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There is a continuous inflow of young and hungry players, which will inevitably take over the position of some of the established players. But this is also off-set by players that retire;
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The main reason, that is also most relevant to us, is that the player is unable to adapt to changing conditions. Aging also plays a role as a decline in athletic abilities might require a different style of play. Also inevitably, the game and tactics might change due to the dynamics of teams continuously countering each others way of play. A very clear example is that certain positions have mostly disappeared in modern football, like the classic number 10. The result is that a decreasing number of teams will be interested in the style of play of a player, which will also bring down his market value and earning potential.
These mechanisms in sports also apply in other areas of life and business. Practices and ventures that work in certain time frames and situations might become ineffective in others. Basically said, although certain generic ideas are universal, no specific idea will work all the time.
While it doesn’t completely encompass the message we are trying to convey, the concept of creative destruction touches upon the the fundamental points. And although it seems like a trivial concept, it is not and might impact different areas in different ways. We will give some specific and relevant examples in how this principle impacts investors.
Diminishing returns in AI
The most relevant area where we can see this principle at play, and that within a very short time span, is in the area of AI. OpenAI came with ChatGPT in 2022 which was a revolutionary technology and made a huge impact. The larger public became aware of the possibilities of AI and this led into a surge of businesses and investments in this area. This was partly also caused by a ‘Fear Of Missing Out’ (FOMO) as people viewed this as the next big area to invest in. They are obviously not wrong as this is the most disruptive area in the current business landscape. However people need to be aware that the surge in investments leads to stocks in this area becoming expensive while technological developments in general follow a diminishing pattern in which increasingly more time and resources are needed for making notable improvements. This all will mean that the realized return is most likely lower than anticipated and AI companies might not pose the best investments in the short run. We also think this is the case here, although we can only backtest this claim in some years.
Cryptocurrency
Another clear area of temporary large opportunities is/was that of cryptocurrency. It is needless to stay that early adopters of cryptocurrency like bitcoin have realized substantial returns. The price of bitcoin was increasing so rapidly that predictions of the price hitting the $1 million in the very near future were thought to be very plausible. The reality is that the price didn’t come near this point and the strategy seemed to be saturated as unfortunately not everyone can become rich employing the same strategy.
In hindsight it seems to be the wise move to timely allocate a part of the realized returns to other promising areas like chips and AI.
Future in real estate?
As real estate is one of the areas in which we advice clients on, we don’t want to leave it untouched. Real estate poses major challenges in a different way, which need serious consideration. As touched upon in an earlier article, developed economies have recently faced developments in the real estate market which were formerly unknown to them and which provide a paradigm shift in perceptions in this market. Most notably and simply, the value of real estate has increased considerably in the past decade and a shortage is seen in (affordable) housing. Furthermore, property prices have risen up to the point that make them inaccessible for major segments of the population. This obviously has some problematic implications:
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Only a small group of investors can purchase real estate, which means that a notable segment of the population can only rent housing while this is in an environment that is perceived as expensive1;
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The increase in property prices means that investors require a continuous increase in rents, which might not be feasible. This leads to a discrepancy in property prices and rents, as the demand for purchasing housing remains high;
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The government, although from their point necessarily, wants to battle this situation with unpredictable regulations which in practice tend to worsen the situation.
We have already argued in other articles that it is advisable to a certain extent to abandon formerly successful real estate strategies in favour of new/unexplored markets.
Continuous ingenuity and total competition
Although in some regards it is uncomfortable to accept that one needs to continuously and effectively adapt, we think it is a comfortable realization in the bigger picture of things as young participants also need to be able to enter, participate in the market and challenge the status-quo. This creates a certain form of fairness and excitement within the society, as good ideas and endeavours are rewarded. Our motto is success through ingenuity in which we embrace the idea that continuous ingenuity is necessary and to a large extent also fair.
We however see a critical issue in so-called ‘Big Tech’, which is a term for the collection of the largest American technological companies like Google, as they have so many resources that they can acquire ventures that could eventually challenge their position. This leads to a more controlled competitive landscape, which some have even labelled as feudalistic [1]. Besides that we personally disapprove such a system it also has adverse impacts in the investment strategies and decisions. It for example limits start-ups in certain areas like Europe that don’t have companies in Big Tech.
Conclusion
In this article we provided further substantiation on why one needs to beware of the effectiveness of ventures and practices that might have proven their use in the past. It is therefore important to timely discuss these with a competent party that closely follows developments and challenges these practices. This of course needs to be done in conjunction with return expectations as frequently established industries have less return potential than upcoming areas. Also feel free to contact us if you would want to examine in what way we may be of service.
References
[1] Technofeudalism: What killed capitalism – Yanis Varoufakis
Footnotes
(1) Although opportunistic prices might be demanded, the rents will often be a consequence of the property price and therefore necessarily overly expensive in an economical sense.