On Abnormal Markets and How to Prevent Forced Selling
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.
You might think that this situation will never apply to you. You aren’t 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’t 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’ market and the proceeds they received were half of what the true value was. Nevertheless they took what they could get and fled Germany as virtually penniless refugees but still having one priceless possession, their brains.
While I hope you never have to experience anything so drastic, the cruel world of price discovery can befall anyone. I experienced this when I tried to sell a $1,000 guitar amp before moving to NYC. I thought, conservatively, I would be able to get $500 (half the price of a brand new amp), but when I went to sell it I found few buyers. In the end I got $240 and went on my way. It can happen to anyone.
Fighting Against “Schrödinger’s Price”
The best way to prevent yourself from selling at a loss is simple: have ample liquidity. If you have large enough cash reserves (i.e. emergency savings) to support your liabilities during economic crises, you will never be forced to sell. In fact, if you have enough cash on hand, you will be able to dictate the prices you can buy assets for.
But, how much emergency savings is enough? I have heard amounts that range from 6 months to 2 years worth of expenses. I maintain a little over 6 months worth, but I am young and have few liabilities (i.e. mostly rent and food). I don’t know what is right for you, but I always like to remind myself that cash during a panic is like having water in the desert. More won’t necessarily hurt you, but it can go a long way toward your peace of mind. Thank you for reading!
This is post 91. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data