Path Dependency: Why Past Success Doesn't Guarantee Future Fortune - 2021-12-30

This morning, I read a story about a man who discovered Bruce Lee, Jackie Chan, and Jet Li. A legendary figure in the Hong Kong film industry, right? Yet, despite this incredible track record, he ended up bankrupt in his old age after a film investment flopped. This story highlights a critical issue: path dependency.

This man, I believe, fell victim to relying too heavily on his past success in a single, highly competitive industry. Even if you've succeeded in nine out of ten films, one failure can wipe you out. His long string of wins likely lulled him into a false sense of security. He had deep industry knowledge, but he overlooked the critical vulnerabilities that could lead to financial ruin. This is a stark reminder: no matter how much you know, if you ignore the potential pitfalls, your fate is sealed.

This isn't just about the film industry. It's a lesson for all of us. We need to constantly be aware of the risks that could jeopardize our financial well-being. I'm writing this as a reminder to myself as much as anyone else. Earlier today, I was focused solely on high-dividend stocks. Nothing wrong with that strategy in principle, but I underestimated the market's volatility. Even though the market was already low, it continued to drop, resulting in significant paper losses for me.

The founder of Pupugao once shared that he only faced financial difficulties in his early days. After that, he prioritized managing cash flow, a crucial lesson. Similarly, a Chinese education company, anticipating potential failure, wisely maintained enough funds to refund student tuition and cover staff severance pay. This foresight allowed them to weather the storm when the government cracked down on the industry.

We tend to repeat what has worked for us in the past. If you made money gambling, you might think it's a viable long-term strategy, despite the inherent risks. If you've profited from investing in low price-to-book (PB) or price-to-earnings (PE) stocks, you might stick to that approach even when market conditions change. The problem is that these strategies can become rigid and inflexible. A high PE ratio, for example, is just a snapshot in time. If a company's earnings grow by 30% the following year, that seemingly high PE of 30 will actually drop to 23. Focusing only on the current PE without considering future growth is meaningless. A company with a PE of 20 that experiences a 30% drop in earnings will see its PE rise to nearly 30. Investing by simply comparing current PE values without considering future performance is pointless.

This path dependency is evident in many industries. Traditional car companies clung to fossil fuels for too long, even with the growing environmental concerns and price volatility. The shift to electric vehicles was resisted, despite the fact that charging infrastructure and winter range limitations were solvable problems. Kodak, ironically, invented the digital camera but failed to capitalize on it, clinging to film. Nokia made the same mistake in the smartphone revolution.

Even industries reliant on fossil fuels for energy, like fertilizer production, seem resistant to change. Why not invest in massive solar panel installations to power their energy-intensive processes? This would lock in their energy costs and eliminate their dependence on fluctuating fossil fuel prices.

The lesson is clear: if you've made money doing something, pause and analyze the potential downsides. What could cause your business to fail? What are the vulnerabilities? Could excessive borrowing amplify the risks? Don't let past success blind you to future threats. Continuously learn, adapt, and challenge your own assumptions. The world changes rapidly, and clinging to the past is a recipe for disaster.