It was 1935 and the Austrian physicist Erwin Schrödinger 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 Schrödinger. 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, Schrödinger 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…the entire system would express this by having in it both the living and dead cat.
Schrödinger argued that since the atom’s state of decay is unknown, the cat’s 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 Schrödinger’s 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’t know the price of your asset until you go to sell it. Just like Schrödinger’s cat, we don’t know what the state of something is until we observe it. It is in the act of selling that we have “opened the steel chamber” to see an asset’s true price.
I know you might think this is a grand leap of faith, but it’s 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’s trades, despite their seeming soundness. The Tokyo partners reported a similar story: there simply weren’t 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—lower your price.