CHG Issue #172: Classification in a Quantum World

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Classification is central to so much of what we do, yet we spend very little time thinking about it. It starts in school: we are sorted into grades based on age, then we sort ourselves based on various superficial characteristics such as sex, interests, and skin color. As we get older, we increasingly classify ourselves by more discrete properties as we refine our own interests and self-image. As we come of age, we sort ourselves by whether we go to college or not, what vocation we pursue, what religion we adhere to, and what special interests we care about. As we age these choices, or classifications come to define us until we hit that mid-life crisis where we wonder whether those superficial labels are really what we wanted to be.

We price risk in the financial markets by arbitrary classifiers such as equities and bonds. For example, equity is considered riskier than debt because it is junior in the capital structure. This means that equity takes losses before debt; but where is the dividing line between equity and debt? Well, today it is dictated by the market. In CRE, as lending standards have tightened equity is the residual left over after the debt capacity is exhausted. Therefore, the definition of equity is dependent on the definition of debt, both of which can change depending on market conditions. In better times, lenders extend well into what they otherwise considered equity; however, they always tell their investors and boards they are being prudent.

Classification helps to standardize things which enables a higher frequency of intercourse which leads to more growth, both socially, through relationships, and commercially, through transactions. However, as we learned last week too much growth can be detrimental to culture and relationships. Standardization is linear, but we don't live in a linear world, we live in a world increasingly experiencing exponential change. Traditional classification schemes become outdated quickly in an exponentially changing world. Just look what is going on with the public and private markets. The arbitrary distinction of public and private has driven trillions of dollars of wealth to be diverted in different ways. Now, financiers are trying to change the classification of private into public to reap the increase in valuation.

Transformation

The only way you survive is by continuously transforming into something else. It’s the idea of continuous transformation that makes you an innovation company. Ginni Rometty, Former CEO of IBM

Transformation is a choice we all face, whether in mid-life or in a strategy meeting, we are constantly faced with choices that can take us down a different path than the one we are on. We usually pursue transformation strategies when the status quo has become unacceptable or there is an opportunity too good to pass up. For example, commercial real estate properties that have been classified as office properties have been struggling since the pandemic. Occupancy and rents have failed to fully recover as the working from home phenomenon has become standard practice. Therefore, investors have identified an opportunity to transform these properties into a new classification, in many cases multifamily, which is performing much better today. This strategy is typically classified as "opportunistic" or "distressed" investing, and it draws its power from our inherent desire to break free from the strictures of the arbitrary classification schemes we find ourselves trapped in and grow into something newer and better.

The most dangerous phrase in our language is ‘We’ve always done it this way.' Grace Hopper, PhD Computer Scientist and U.S. Navy Rear Admiral

This tension arises from the inability of classification schemes to accurately capture the essence of things. One of the problems is that these schemes are too superficial, for example, our essence is far more than our skin color and sex. We see this tension manifested in society today with the attempts to redefine these classification schemes, however by adding more categories we seem to only increase the tension. More superficial categories can't solve the problem that we aren't looking at the smallest discrete unit of ourselves. When we do this we find ourselves in a quantum world as was revealed in the famous "double-slit experiment" performed by British polymath Thomas Young in 1801. We discover a world where terms like duality, superposition, uncertainty, and entanglement are used to explain reality. This is mind-boggling and downright scary, so we retreat to the relative comfort of our arbitrary classification schemes however the complexity of reality remains.

So much of finance is dependent on how we classify things. In Issue #163, Reframing the Bond Market we saw how modern portfolio theory has evolved from simple stock-bond classifiers to a three-factor model, and today to all sorts of factors and risk premium harvesting. Classification is useful for enabling commercial transactions; however, it is inherently reductive and creates a fragile system that is vulnerable to change.

It is no coincidence that the rise of the internet age in the late 1990s and early 2000s saw some of the biggest accounting frauds in history take place. Our accounting standards were created when the economy was mostly manufacturing and agriculture-based and most companies were asset-heavy. As the economy transformed into an asset-light, service-based economy, those standards did not keep up and proved to be inadequate. ?

I think we can all agree that we should resist the urge to think of ourselves in terms of arbitrary labels such as Republicans and Democrats because they are poor representations of the truth. However, that is exactly what we do all the time. Once again after the recent election we are questioning what went wrong with all the polling. Well, polling is based on sampling a small portion of society and then extrapolating that sample based on classifications to produce a representation of broader society. This method works well in the laboratory where the environment and conditions can be controlled, but it works poorly when used in a complex system like society and the financial markets.

In the same way, we shouldn't think of investments, companies, or anything else financial based solely on arbitrary classification schemes. These schemes work until they don’t, which is the very definition of fragility. These techniques worked well in the laboratory and helped advance science to the point where physicists were able to harness the power of the sun. However, those same techniques applied in the financial markets give us false confidence which serves to create a fragile environment which we have seen manifest with the increasing frequency of financial crises.

The advent of artificial intelligence chatbots is the latest advancement which harnesses the power of modern machines to make large scale statistical inferences off huge datasets and has taken hold of our collective imagination. These inferences are made in the same way that pollsters make their inferences, arguably without the bias and error that human agents introduce, but still based on classification schemes that we may not know much about. Reality is too complex to capture at the smallest discrete unit which necessitates classification and introduces fragility.

In other words, what happens if the definitions and classifications we have come up with are wrong? What if I am a white, registered Republican that didn’t vote for Trump? Or what if Tesla isn’t an auto manufacturer? What happens if stocks and bonds are negatively correlated?

The reality is that we live in a quantum world where things can exist in dual-states and our constant need to simplify is necessary for regular social and commercial relations but is inadequate for building resilience.

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