Financial Market Observer Effect

I was recently reading Four Pillars of Investing and one part really stuck out to me. A hedge fund manager doing back tests on data could beat the market consistently but was unable to understand why these techniques failed when tried on Wall Street.

To a physicist the answer might seem obvious. It’s known as the observer effect.

Trading is a physical action with an observable effect on the market i.e. people see the shares being traded, the stock price may change. It’s impossible to take money out or put money into the market and not create ripples hence the discrepancy between what happens in real life and back tests. Back testing is a popular method in testing investment strategies but it’s no substitute for the real thing.

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