Monday, December 14, 2009

Edison’s Folly and understanding the exposure to negative black swan

What is the worst nightmare of an innovator? We may think it is a fear that the innovation may not take off. But we are wrong. The worst nightmare of an innovator is blowing up big time. Losing not only the investment made towards the innovation but much more. Falling so hard that you don’t get up again, ever. Hence, guarding against a possible “blow-up” is a critical piece of systematic innovation.

Before understanding how to guard against a potential blow-up, let’s understand a “blow-up” through a story commonly known as Edison’s Folly (given step-wise below).

1. By 1887, Edison had grown increasing bored with his electricity business as the business model was proven, competition intensified and legal battles became a norm. Edison developed interest in ore separation process as he saw the high price he had to pay for high-grade steel while building big electric generators and dynamos.

2. Edison starts experiments and files for 5 patents in 1887 improving the process of making high-grade iron ore from low-grade ore. He also writes his ideas in a magazine Iron Age. Mining experts dismiss the idea. A follow-up editorial labels the concept “Edison’s Folly”. Edison founds Edison Ore-Milling Company.

3. In 1889 he finds right kind of deposits on a mountaintop in the rural village of Ogdensburg on the northwest corner of New Jersey. He finds an investor Walter Mallory from Chicago and also puts in more than million dollars of his own money. He told his stockholders that “the sixteen thousand acres of land [at Ogdensburg] will supply the world with all of its ore requirements for seventeen years and the U.S. for seventy years!” Edison & Mallory purchase the land with stockholder approval.

4. Operation begins by fall of 1891. The mill and its machinery simply weren’t up to the task. The crushing rollers were not heavy or strong enough and often broke loose, endangering workers. Ore dust penetrated everything. The bulky steel conveyor system constantly jammed. In the following years nine workers were killed and many more seriously injured by loose, catapulting machinery.

5. Edison sells his electricity business to form GE and gets 12,000 shares. Sells the shares and puts most of the money into ore-milling business.

6. Plat shuts down due to depression in 1893. Edison goes back to his lab and during the idle time files more patents. By 1895 he is back at Ogdensburg armed with $250,000 and a box of new patents, drawings, and blueprints.

7. By 1898 the machinery starts to run dependably at last. A thousand tons of ore a day were being shipped out; if this volume could be continued and ore prices remained stable, the first operating profits might be just around the corner.

8. By 1899 the process matures further and Edison is able to offer a high-grade ore at $4.75/ton as against $7/ton of competition.

9. In 1898, two brothers had stumbled onto the great Mesabi Range in the northern Minnesota wilderness, hundreds of square miles of purest iron ore in the world. It needed only to be scooped from the ground and sent directly to the furnaces. By 1899 Mesabi starts delivering high-grade ore at $2.75/ton.

10. Edison finally closes the shop in 1900.

Nassim Taleb refers to the event such as “finding of high-grade ore in Mesabi” a negative black-swan. You can lose a decade worth of work in no time. We saw earlier that humans are very poor at predicting black swans. Question is – Was Edison aware of the exposure he had to a negative black swan? We don’t know. But I believe it is important for innovators to understand this exposure.

Warren Buffett when asked “What are the fundamental qualities of your successor?” has said, “I hope he is aware that 25 x 23 x 17 x 20 x … x 0 = 0; you had better be aware of introducing a zero in a series. In other words, we need someone genetically programmed to recognize and avoid serious risks.” Question is – is this quality, like Buffett says, really part of your genes? or can it be learned?

Related article: Pre-mortem: Tell me where I’m going to die, so I don’t go there.

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