The Model Thinker #13 : Path Dependency

Path dependency happens when current events interfere with future events. There are two extreme models of path dependency.

Imagine you have an urn full of white and black balls and you get to draw one at random from the urn.

If, after drawing a ball, you get to add two balls of the same colour drawn back into the urn before you draw again, you end up with the Polya process. The Polya process models the situation where anything can happen. After drawing 1000 balls, the probability that the urn contains 40% white balls is the same as the probability that it contains 5% balls. Interestly, a Polya process should not be confused with a tipping point as the entropy of the process decreases gradually even if the same coloured balls keeps getting drawn.

If the rules are changed such that after drawing a ball from the urn, you introduce two balls of the opposite colour, you get a path dependent process known as the Balancing Process. In the long run the urn converges to 50-50.

I note with much amusement that leveraged REIT investing has been increasingly the subject of discussions in Telegram and Whatsapp discussions and to be fair, my public speeches and masterclass played a humble role in popularising this form of investing.

At this moment, the popularity of leverage REIT investing may be undergoing a Polya process. As more successful investors come on board and talk about making some money from buying leveraged REITs, it will attract more curiosity from the investment community, if this effect is large enough, it may even push REIT markets further north as more and more investors borrow to magnify dividend yields.

Even so, we need to maintain some humility especially in the face of such remarkable gains in the stock market.

There will come a point in time when the Polya process breaks down and the Balancing process takes over. This may happen after a prolonged period of yield compression. At that stage, folks who invest in leveraged REITs investing make less money and start telling other people that it is overrated and maybe they can do something else instead like growth investing in small cap equities instead.

After this, perhaps a whole new era of growth investing in small caps will herald a new age with a new crop of trainers. The adoption of this new strategy then becomes the new Polya process.

When will this reversal happen ? Will my quantitative models be able to detect this inflection point ? Will I be able to pivot my class to deviate from the REIT strategies that made my students a decent amount of money so far ?

I can't answer these questions right now. I am adding a level of flexibility to give my class the chance to vote between an equity or REIT portfolio in June.