Sorry cat people but I didn’t make this up… In the mid-twentieth century Erwin Schrödinger proposed a thought experiment to explain a complicated idea in quantum theory. The full story involves a box, radioactive isotopes and an unfortunate feline friend. If you’d like to read more you are welcome to go to forbes.com but Schrödinger’s illustration was meant to “make one thing very clear: the act of observing a quantum systems can, in fact, very much change the outcome” So that got me thinking,
Can the act of observing financial systems also change the outcome?
I propose we examine the question with a similar thought experiment.
Let’s say you have a very smart friend who has made a lot of money investing in the stock market. One day you decided to ask him how he does it and to your surprise he shows you. He’s done all kinds of research, back tested thousands of strategies, run millions of simulations, and finally discovered how to beat the markets. He tells you his secret formula and BAM you’re a millionaire just like him.
Of course, not just like him because he’s been at it for a while now and has all the money he could ever need for what he wants. After some time, he decides to scratch an altruistic itch and teach everyone his secret sauce to trade the markets. He even goes on the win a Nobel Prize for his discovery, however. You start to notice that you’re not getting the returns you had become used to. Soon enough you notice the strategy can’t even beat market weighted benchmarks…
What could be happening? You haven’t change anything in the strategy, but the strategy seems to have lost its edge. You are wondering why it ever worked in the first place if it doesn’t work now.
If you are a follower of Schrödinger’s logic, the act of “opening the box” has changed the field. In the real world a similar phenomenon occurs and has been wrapped into the Efficient Market Theory (EMT). The basic idea states that current prices reflect all known information related to trading. If we do a little math, EMT + greed = wide-spread adoption of the strategy, but how would that change the markets?
Just like in Schrödinger’s thought experiment, the strategy (or cat) may have been alive or dead before the box was opened. Once the lid came off the box, the financial equivalents to quantum systems shifted beneath the very physics the strategy worked on. Once the whole market knew how to make money like your friend, the investors and traders began changing their strategies. So, “what are the financial systems that allow financial strategies to work, why do strategies succeed at times and fail at others?”
At the heart of financial markets exist the fundamental values of the investors. It’s why investment wizards like Peter Lynch say, “Know what you own and why you own it,” rather than “be smarter than the seller you buy from.” When a plan or strategy touts itself as the force causing asset growth and investors abandon the real values driving growth, there may be reason to believe “the cat is dead.”
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