A physicist talks investments!

by James Chu
A physicist talks investments!

Have you heard of the observer effect in physics?

This states that an action of observing or measuring something affects the measurement itself. For example, when you measure the pressure of tyres, you release some air, which affects the actual measurement.

The observer effect happens in investments as well.

Let’s say you want to buy an investment. You drive up demand. Potential sellers realise someone wants to buy. They are not desperate (yet) to sell, so they raise the sales price. This is known as “a buyer market”, a well-known phenomenon in property market. The reverse can apply in a “seller’s market”, when sellers are desperate to sell.

When there are enough buyers and sellers in the market, the price settles to an equilibrium point, or “fair price”. Advocates in efficient market hypothesis will keep arguing that stock prices are always at equilibrium and hence fair. But it ignores the fact that the action of trying get a price quote for an investment can affect the price. This effect is negligible for very liquid investments like US treasuries or blue-chip stocks. It becomes more marked for less liquid investments.

A popular investment in recent years, especially in the US, is the “inverse volatility index”. This investment bets that volatility in US stocks will stay low.

As more and more investors pour money into this financial innovation, the investor effect comes into play. The main problem is that index is both a measurement of market volatility and is used to price a tradeable instrument. The investment is an “inverse” index, which means investors are selling the index. Many market participants pointed out that volatility in US stocks remained low in 2017, which reflected a calm market sentiment. But was that the result of a lot of selling in the volatility index, which drove down this volatility measure?

In early February, the US stock market reacted to the strong employment figures and staged a sell off. The sell-off caused a surge in actual volatility in the stock market. The volatility index went up, and the inverse index investors started losing money. These investors started closing their investments by buying back the index. As a result, the index went up further as there were more buyers in the index than sellers. The market saw the rise in the index as a signal of serious panic, and stock market dropped further. We ended up in a lethal spiral.

Many financial innovations are on new types of “alternative assets”. I put them in quotes as there is a question whether these are really assets. If it is something that the market uses also as a measure, be careful of investor effect. You may get caught out as the very action that you make in investing may affect the execution prices and hence your outcome. Our advice is that when you are shown an innovative alternative asset, be sceptical. Contact our investment team via, or call us on 020 7397 2597. Our specialists are happy to take the proposition apart to properly understand the true risk that sits in the investment.

James Chu

James Chu

James is Director of the Markets and Investments Team at Reyker. A CFA member and industry expert, James specialises in Structured Products, derivatives and development of service offerings for Reyker. A face at most industry events, James is sure to provide insight into some of the most controversial topics in the market today.