Few markets are more dynamic and rapidly changeable than those of stocks, bonds, currencies and the various other assets that can earn or lose us money. Not only do the markets move in cycles, but the products offered evolve, become more or less complex, and go in and out of fashion.
Path dependency refers to the difficulty that individuals and organizations encounter in acting and reacting to changing environments and coping with new challenges. The idiom "getting stuck in a rut" sums it up pretty well. This concept is highly significant for the investment industry.
This means that treading familiar and well-worn paths can be dangerous in the world of investment. Yet, path dependency is all around us and leads, at best, to sub-optimal portfolios and investments - and, at worst, to losses.
It is important to understand that path dependency does not necessarily equate with inactivity, although it often does. The concept refers to doing things the same way for too long. In the investment world, you may be an active investor, but if you are active in 2009 the same way you were in 1969, you have become path dependent. The instruments, processes and technology that worked so well even a few years ago may now be a pathway to disaster and big losses. Read on to find out how being active is not enough; you have to be active the right way in order to be effective and profitable.
Why Does Path Dependency Occur?
It is very tempting for brokers, firms and private investors to take it easy, or to sit back with a nice, tidy portfolio or investment process and relax. Changing what you do, or how you do it, takes both effort and time. Fear of making mistakes and of the unfamiliar also leads people to keep to the known path. Sometimes, it seems safer to keep to what you know, but this can be dangerous.
Certainly, buying into a complex asset that you do not understand is often imprudent, but sometimes, it is necessary to learn about new asset classes and investments in order to optimize a portfolio. Oftentimes, this can mean deliberately breaking out of path dependency.
In psychological terms, people can get almost addicted to a cozy world in which you can just let things run and hope that you make some money. Such hopes may be rudely shattered as the markets rise and fall; some asset classes and sectors become seriously over- or underpriced and various other aspects of the industry evolve. So, although path dependency provides comfort, the ability to be comfortable won't last for long.
Whom Does It Impact?
Path dependency is a phenomenon that affects both brokers/firms (sellers) and private investors (buyers) in equal measure, but in different ways. What they have in common is the very bad habit of just carrying on as they usually do. Sellers tend to keep to the same mix of asset classes or stocks, largely ignoring the changing times. There are path-dependent brokers who will still put your money into the same mix of stocks and bonds that they used 20 years ago. In the same vein, the path-dependent buyer will still be with this broker! (For some basic ways to rethink your approach, read Revive Your Portfolio.)
What's Out There Off the Path?
Hedge funds are a prime example of the advantages of breaking out of the well-worn path. These funds are controversial, and we won't go into the ins and outs here, but it is quite clear that they should not be ignored. Especially in the recession from 2001 to 2003, some did remarkably well. (To see how hedge funds broke off the beaten path, see A Brief History Of The Hedge Fund.)
Likewise, infrastructure funds, climate-related investments, ethical investments and certificates all have their (potential) place in a portfolio. The old stocks-and-bonds path is a truly antiquated and very constraining one to be stuck on.
In terms of methodologies, there are always new theories, strategies and models coming onto the market. Their quality varies enormously, but it is essential to keep abreast of these, at least to some extent. There may well be something that will really work for you, and you certainly need to keep your eyes and mind open to potential improvements.
Going Too Far In the Other Direction
It is important to understand that the opposite of path dependency is no good either. Investors who are not on any kind of path at all have no strategy or plans and basically lunge at attractive investments as they appear. Or they may have a haphazard jumble of assets that makes no financial sense. What is needed in the investment world is to keep to a path, but not too rigidly. You need to be moving in the right direction, not in a straight line, and that requires ongoing information and flexibility.
What Can We Do About It?
The first step in avoiding path dependency is to recognize whether you have fallen into this trap. If you have been carrying on in the same way for an extended period, whether you are a seller or a buyer, start informing yourself on what's new and figure out how to move from the path you are stuck on to the one you want to (or should) be on. Have the courage to restructure your operations or to confront your broker with the reality of the situation. If necessary, find a more modern and flexible broker or investment house. (You can find tips for what to think about in Evaluating Your Broker.)
Although path dependency is not a term you hear that often, it refers to an alarmingly common, often apathetic and turgid approach to investment that cannot possibly be optimal. The world of money, assets and investment is one that evolves constantly and rapidly. Money that is here today can be gone tomorrow if you invest the same way with the same people and let events overtake you.
If your money is basically at the mercy of the markets and events, you and your broker need to take control and adapt. This may or may not entail radical change. Whatever the case, a flexible approach is essential. It will pay off over time to develop the flexibility and habit of portfolio monitoring, control and adoption that is really in tune with the times.