Investing is hard. Everyone is chasing risk-free profits, but in reality the most profitable investments are usually the most risky. This is because fast-growing industries are inherently unstable – if they were stable, analysts would look at their history of positive cash flows and bid the price up. Traditionally, you could have avoided too much volatility by investing in slow-moving, low return sectors. But now, it is not so clear whether this is viable since technological change is so rapid. Let’s have a look at the risk/reward tradeoff, and the effects of technology, more deeply.

High risk, high reward

If you want to make a lot of money in a short amount of time, you must take on risk. This is true for a variety of reasons. For example, in any industry where the pace of technological change is fast, it is very difficult to predict future cash flows. Technologies of tomorrow are uncertain – nobody knows with 100% certainty what will happen. In a fast-growing industry, there is a high likelihood that the technologies that dominate the industry in the future are not yet invented. This makes it difficult for analysts to forecast future cash flows for a firm.

Take the semiconductor industry as an example. In the semiconductor industry, no one knows with 100% certainty which technologies will succeed and which will fail – there is a huge amount of uncertainty. This uncertainty means that the best semiconductor firms are likely to be the ones that have a leading market share in an emerging technology. If that technology succeeds, the industry will grow and the market share held by the early leader will be very valuable. A good example is Intel. Intel had a leading share of the market for microprocessors in the personal computer industry. This made Intel very valuable when demand for personal computers exploded. Intel’s market value increased from $2 billion in 1974 to $183 billion in 2000. But was it risk-free? Definitely not.

Low risk, low reward

On the other hand, if you want low risk, you should invest in industries where the pace of technological progress is slow. Geographically concentrated industries and industries with high barriers to entry are good for low risk, low return investments. Industries where the pace of technological progress is slow include airlines, railroads, and the power industry. These are all mature industries where the technologies of today are well-known and the technologies of tomorrow are a long way off.

Other slow moving industries include food, textiles, and legal services. But how safe are they?

Enter technology

The trouble is, technology is changing traditional industries so much that it is becoming increasingly hard to categorize them into low and high risk. As an example, let’s look at the airline industry more closely. In the past, airlines were slow-growing, mathematically stable industries with stable cash flows. This made them very easy to analyze – analysts could predict cash flow for the next two decades or more with a high degree of accuracy. But how stable are they really, now?

Putting aside Covid-19 for a moment, let’s look at technological change. The airline industry is, slowly, becoming more like the semiconductor industry. Airlines now have to deal with a new competitor – the internet. Booking airline tickets is being done online instead of by telephone. In the past, airlines had a captive market and could set prices as high as they wanted. But now there is competition from online travel agencies like Expedia. These companies are able to undercut the airlines on price, because they have lower overheads. They don’t have to maintain an expensive fleet of airplanes and they don’t have to build costly airport terminals. They can sell tickets at a loss and make up the difference later by charging advertising fees or by selling their customer information.

Further, the internet is also making it easier for airlines to sell tickets. Airline ticket sales used to require a visit to a travel agent. Now, airlines can sell tickets directly to customers via their web sites. This is resulting in lower prices and more competitive markets. These reductions in costs and increases in competition are making the airline industry much more like the semiconductor industry. No one knows for sure which firms will dominate the future market for airline tickets. Analysts are unable to predict future cash flows for airlines, making the industry more risky.

No industry is safe. The financial sector has been uprooted by bitcoin and other fintech. Service jobs are being done by robots. Companies can buy corporate narration voice talent as easily now as pencils, thanks to the distributive power of the internet.

What does the future hold?

Greater technological change is the way of the future. So it is natural to wonder – how safe will any industry be? We think it is safe to say that, in the future, there will be no truly safe industries. There will be no no-risk investments. All industries will be subject to at least some technological change. But there are some ways to cope with this.

The first is to give up on stocks, throw our hands up and chase more traditionally stable investments like gold. The second is to diversity so that the risk is shared among many firms. This will make industries less risky, as long as the risks are somewhat uncorrelated.

But the bottom line is simple – in future, expect more industries to be disrupted by technology. If you want to earn a high return on your investment, you must accept a high level of risk going forward.