What Schrodinger's Cat Reveals About Risk

Back to Insights

Like the cat in the physicist's box, exchange-traded assets exhibit properties of quantum superposition.

Austrian physicist Erwin Schrodinger proposed a thought experiment in 1935. The purpose was to spark a discussion among fellow scientists on the Copenhagen interpretation of quantum mechanics. It states, "A quantum system remains in superposition until it interacts with, or is observed by the external world."

Schrodinger begins with a cat, a container of poison, and a radioactive source in a sealed box. If an internal monitor detects radioactivity, the container of poison opens, killing the cat. According to the theory, at some time, the cat is simultaneously alive and dead. If one were to look into the box, the cat would then be either dead or alive.

The Black Box of Finance

French Mathematician Benoit Mandelbrot concluded through his study of financial markets, "Finance is a black box covered by a veil." He declares, "The precise market mechanism that links news to price, cause to effect, is mysterious and seems inconsistent."

Like Schrodinger's box, the internal mechanisms of financial markets is unseen. We only perceive the inputs of news and the outputs of price movement. The process from information to result remains an enigma.

States of Liabilities

Another similarity to Schrodinger's cat is that exchange-traded vehicles act as both assets and liabilities. Purchase a stock or futures contract as an asset, and at any time, it can become a liability due to volatility. If we were able to look into the box of financial markets, we would discover if a vehicle was an asset or a liability. Until then, it is both.

The real issue is that the markets move based upon crowd anticipation. Sometimes it seems intuitive, and other times, many are left bewildered with the result. Therefore, it is impossible to know if you just paid for an asset or a liability at the time of acquisition.

Quantum Risk

In 1933, Erwin Schrodinger won the Nobel Prize in Physics for his work on quantum mechanics. The wave equation he created predicts what a subatomic system will do in the future based on its current state. As a linear equation, it supports the non-classical characteristics of the superposition of states.

The observations of vehicles in a financial market are similar to the ones described by Quantum Superposition. The Physicists Paul Dirac explains, "It requires us to assume that there exist peculiar relationships between these states, such that whenever the system is definitely in one state, we can consider it as being partly in each of two or more other states."

In finance, risk is the possibility that an investment's actual gains will differ from an expected return. Our investment simultaneous shares properties of both an asset and a liability, making the risk of investing more like a quantum system than a probabilistic one.

Spooky Action

Albert Einstein referred to Quantum Entanglement as "spooky action at a distance." The Washington Post offers a more relaxed definition, "When two interacting subatomic particles become entangled, any change induced in one will be inflicted upon the other, no matter how distantly they're separated."

Entanglement arises in circumstances where we have partial knowledge of the state of two systems. In the case of trading, these systems are risk and reward. Each state of uncertainty in investing entangles with each state of the return.

If we change the return, the risk must change. Likewise, if we change the volatility, the reward must change. The point is that with financial markets and uncertainty, we are dealing with the peculiarity of quantum theory.

Consistency

2004 Nobel Prize in Physics winner Frank Wilczek states, "In quantum mechanics, you can do the same thing many times and get different results." The same idea holds for investing in financial markets.

My first real trading experience was a FOREX challenge at a hedge fund. As an engineer, no one expected me to win against professional traders. Spoiler alert, I didn't. Instead, I came in second place.

What I learned is what Mr. Wilczek so eloquently explains, "you can do the same thing many times and get different results." One of the rules was not being able to share your total returns until the end. Finding a good currency pair, I went from $10,000 to $19,500 in 4 days. Assuming that was low, I pushed hard on day 5. That same currency pair that paid so well before took me down over $4,000—ending the contest with a $5,000 gain.

Conclusion

Financial markets and by association, their risks have many similarities with the quantum world. A strange place that does not behave as expected. Instead, lulling us with periods of small change only to hit us over the head with surprise movements later.

Share with a friend:



© 2020 Todd Moses

The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.