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Of Dollars and Data


It was 1935 and the Austrian physicist Erwin Schr\xf6dinger had a problem with Albert Einstein. Einstein had just released a paper with two fellow scientists that discussed the concept of superposition, an idea that seemed somewhat absurd to Schr\xf6dinger. Superposition implied that an atom (or any quantum system) was simultaneously in multiple states until the point of observation. Once the system was observed, its true state would be revealed to the observer. This implied that the act of observation changed how the universe behaved. In order to convey his skeptical view on the matter, Schr\xf6dinger devised a thought experiment (emphasis mine, minor changes for clarity):

One can even set up quite ridiculous cases. A cat is penned up in a steel chamber with a Geiger counter and a tiny bit of radioactive substance, so small, that perhaps in the course of the hour one of the atoms decays, but also, with equal probability, perhaps none of it decays. If it decays, the counter tube discharges and releases a hammer that shatters a small flask of hydrocyanic acid. If one has left this entire system to itself for an hour, the cat still lives if no atom has decayed. However, the first atomic decay would have poisoned it\u2026the entire system would express this by having in it both the living and dead cat.

Schr\xf6dinger argued that since the atom\u2019s state of decay is unknown, the cat\u2019s state of being alive or dead is also unknown. Only once you have opened the steel chamber could you determine whether the cat was living or deceased. You have probably heard of Schr\xf6dinger\u2019s cat as a thought experiment, but you may not have realized how useful it is for thinking about asset prices.

Most of the time when we want to know the price of something we can use the market or comparable assets. When you go to buy and sell an S&P 500 ETF, the price is known and displayed for you. When you go to sell your home, a proper appraisal and similar homes can be used to determine the approximate selling price. This is likely to be true 95% of the time or more.

However, when markets become abnormal, pricing an asset is no longer straight forward. Instability emerges and you quickly realize that you won\u2019t know the price of your asset until you go to sell it. Just like Schr\xf6dinger\u2019s cat, we don\u2019t know what the state of something is until we observe it. It is in the act of selling that we have \u201copened the steel chamber\u201d to see an asset\u2019s true price.

I know you might think this is a grand leap of faith, but it\u2019s not. History is riddled with examples of individuals thinking they knew the prices of their assets, only to get a rude awakening when they tried to sell. The Nobel Laureates behind Long Term Capital Management learned this the hard way when their bets on bond spreads turned against them in 1998. As Roger Lowenstein writes in When Genius Failed:

Disturbingly, the traders said there was no demand for Long-Term\u2019s trades, despite their seeming soundness. The Tokyo partners reported a similar story: there simply weren\u2019t any buyers.

LTCM had assumed far more liquidity and ease of exit from their positions than what they eventually realized during the 1998 crisis. They had no idea the buyers would disappear and the stable prices would go with them. As you know, if there are no buyers and you need to sell, you only have one option\u2014lower your price.

You might think that this situation will never apply to you. You aren\u2019t trading foreign illiquid securities, right? But, what about something closer to home (literally). If you are a homeowner and you think you will always be able to sell your home at a reasonable price, I would advise caution. The Vanderbilts discovered this bitter truth after spending $11 million in 1892 to build the famed Marble House only to sell during the depths of the Great Depression for $100,000! That is a 99% haircut on one of the most beautiful homes ever built. I understand that the Great Depression was unlike any other time in American financial history, but that doesn\u2019t mean that your home is exempt from price discounts during financial calamity.

And it is during such financial calamity when the harshest truth about asset pricing becomes apparent: those times when you are most desperate to sell are the same times when prices are most likely to be in flux. When you are the neediest for cash is also when it is most difficult to sell an asset at a fair price. Consider the unfortunate experience of Jews trying to emigrate out of Europe during the start of WWII. From Wealth, War, and Wisdom (emphasis mine):

These middle-class Jews had less to lose than the wealth, and often they were more amenable to emigrating. Many of them faced with this cruel dilemma of a persecuted minority opted to sell and get out. Of course when they went to sell their businesses and homes, they found it was a buyers\u2019 market and the proceeds they received were half of what the true value was. ...