The current financial crisis has brought to the forefront the question of innovations gone bad. Were these new, creative, financial instruments, the ones that have caused the current financial crisis, innovations? If so, why? If not, what makes these different from true innovations. In a recent podcast from Business Week their innovation editor Bruce Nussbaum addresses this issue.

In this podcast, Bruce captures a few of the main issues behind the type of financial 'innovation' that created the complex investment instruments that ultimately destroyed value and about what companies should do in their innovation efforts in a time of 'crisis'.

Innovation Issues

Some of the key points Bruce makes about what makes an innovative 'product' are:

• The creation of these 'products' was the result of a flawed innovation process. There was no iteration in their creation and they were not stress tested. The first actual test showed that they were flawed.
• There was no transparency in either the product creation process or in the products themselves. No one know how they were created and no one knew exactly what they were.
• The 'independent' parties whose job it was to assess the products, the rating agencies, did a terrible job.

In other words, there was a failure in the creative process itself that resulted in fundamentally flawed products. It is similar to a car company introducing a brand new car platform without testing the powertrain and having 1,000,000 engines all fail in the same week. Except in this case, neither the auto manufacturer, the dealer and the driver,NHTSA, Consumer Reports, or Car and Driver magazine editors could lift the hood of the car to even look at the engine. It is invalid to call what the financial engineers did innovative. Inventive yes, innovative no. They took a bunch of 'quants', the mathematicians and analytic scientists, and asked them to come up with a model of human behavior that would allow them to understand risk. This led them down the path of using arcane approaches such as 'Archimemedean Copulas' detailed in books such as 'Measuring and Managing Credit Risk' that no one, except themselves, could understand and, as it turns out, they didn't really understand either.

The point is that innovation is about more than just being creative, inventive and coming up with something new. Innovation is about creating value. It is about those things that are adopted and used because they have real value for the adopter, not things that will blow up in their face after a short trial period. The mistake made by the 'engineers' who created the products, and by the managers, marketers and executives who sponsored (and encouraged) the engineers, was in thinking that value could be created out of thin air. There is a question that is used by scientists and engineers who look at new ideas. They ask themselves first if the thing that is being contemplated violates the laws of physics. If so, you can stop. Clearly, the engineers, and the executives directing the creation of these financial instruments didn't ask themselves the equivalent 'first principle' question. If they did, then they would have known that the outcome would have been the equivalent of betting on a perpetual motion machine.

What to do in a Crisis?

Another main theme of the podcast is the behavior of companies in a time of crisis and the nature of risk. The points that Bruce makes are:

• There is a temptation on the part of companies to cut back on their innovation efforts in times of economic slowdown and tightening budgets. This is a mistake.
• Companies that 'double down' on their innovation efforts during a downturn are much more prepared for significant growth when the downturn ends
• Crisis often releases the forces of creative destruction. Companies that survive will be those that truly innovate during this time
• Innovation is not about risk taking. It is about risk management. Risk taking is fundamental to all business. If you are not taking risks, then you might as well just get out of business.
• Innovation, and its process, increase your future options and allow you to manage them to efficiently make choices. By increasing future possibilities and choices, and there fore your options, you can manage future risks.

This last point is especially noteworthy. Instead of viewing innovation as risk taking, one should view it, when properly implemented, as risk management. Innovation doesn't create risks, it creates options that allow you to manage risks. The reason is that innovation creates new possibilities. Choosing to move forward with a new possibility is like an option that you can exercise or not. If you didn't have that possibility, them you would have no options and risk would increase.

Of course this concept of options portfolios is not new. Most everyone recognizes the value of a portfolio of options. Where companies go astray is in the composition of the portfolio and in the way of making option decisions. An effective portfolio requires volume. Not just volume of items in the portfolio itself, but in the things that were considered to become portfolio items. Clearly, if your portfolio has only one option, and that option was the only thing that was looked at or considered, then that is a highly risky portfolio.

Only slightly less problematic are two other scenarios that happen quite often. The first is the creation of a diverse and plentiful portfolio where everything in the portfolio was 'pre-ordained'. In other words, the things that make it into the portfolio are the things that get worked on and virtually everything that gets worked on eventually makes it into the portfolio. You have what looks like a diverse and plentiful portfolio, but it is 'fragile' in the sense that the elements of the portfolio did not come from a broad pool of opportunities and they typically all have the same risk profile.

The second scenario is the inverse. You look at a broad pool of opportunities, but the weeding and vetting process results in only one or two things making it into the portfolio. Such a situation exists in many companies that use a filtering process to 'weed-out' new opportunities that don't meet various criteria.

An ideal portfolio of options would be one in which the individual items in the portfolio came from a process in which many, many different opportunities were examined and each opportunity went through a focusing and shaping process (rather than a filtering process) to create a number of options that have diverse risk profiles. Such a portfolio is one in which risk really can be managed.