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Schrodinger's Cat


Probabilities are real and they should be treated as such.


Many people have asked me to comment on the Iraq War. I don't think it is my place here to do so (although if you want to ask me directly I certainly have an opinion). But I will comment on it as it pertains to the markets. This comment I hope will convey how I think one should personally look at the markets, asset allocation, and risk.

There is a thought experiment in physics, one created by the brilliant quantum physicist Erwin Schrodinger.

A cat (sorry Todd) is put in a box and sealed. A timing device is attached that will at some point in the next two days release a poison that will kill the cat. We don't know when, just that at some discreet point in the next two days the cat will be dead. So I ask you the question, is the cat dead or alive?

The answer that Schrodinger gives is that it is part dead and part alive. If the question is asked right after the cat is put in the box he would say that it is 99% alive and 1% dead. If the question is asked at 10 p.m. of the second day the answer might be it is 85% dead.

The point is that the world (universe) is a mathematical set of probabilities, but those probabilities are real and they should be treated as such. And they change over time.

For our cat (the markets) this means that if there is a only 10% chance that the cat is dead we can't ignore it because it is less than 50%. We have to truly act as if the cat is 10% dead.

I believe the key to the markets, to maintaining wealth (being prepared and properly allocating capital), and to controlling risk is to evaluate the probabilities and treat each case as that much real.

So in listening to Mr. Bush talk last night, there was not much of a re-evaluation of probabilities as far as I am concerned. We were simply asked to give it more time while the same course is pursued.

So let's assume that the war will be lost two years from now (I certainly hope not), giving it a 100% probability. What would the stock market do in that case (the stock market is a discounting mechanism and as the probabilities unfold it will react regardless of whether or not you do). I think that if we lost the war and Iraq dissolved into civil war and the Middle East became unstable the S&P 500 would drop 30% (I am sure many would disagree with this, but you can fill in your own number).

A year ago the war had a probability of 80% being won. By now that probability has dropped to let's say 60%. If that is the case, you should respond by allocating your capital as if the war is 40% lost. You should assume less risk than you did a year ago.

But given an over zealous Fed that through low real rates encourages people to increase their risk and given a low understanding by the general public of risk / reward, the market is currently not pricing that risk correctly.

And it certainly is not just stocks. Real estate is even more skewed. Florida has turned into La La land where the mere mention of Toll Brothers proposing to build a condominium complex in two years for $1 million a pop has people sleeping in lines waiting to be the first to sign up.

Minyanville is not here to tell you what to do. The only thing we really want to do is to offer an alternative in how to evaluate risk and markets from that which is being force fed to the public by that great sales machine called Wall Street.
No positions in stocks mentioned.

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