Laws of nature

Currently reading the book “The User Illusion” by Thor Norretranders. I highly recommend it. I would like to make a reservation right away: I am not a physicist, so the parallels I draw between physics and finance may seem exaggerated or not entirely correct to some, for which I sincerely apologize in advance.

Since James Watt (Watt) invented the separate condenser in 1769, making steam engines truly efficient, the age of machines began. People liked the steam locomotive, but the efficiency of using steam energy left much to be desired. This inspired the best minds in Europe to search for ways to increase the efficiency of steam engines.

These searches led Sadi Carnot to the concept of an ideal heat engine, and later to the formulation of the second law of thermodynamics. The law states that entropy (a measure of disorder) in a closed system always increases. This means that it is impossible to create a machine that endlessly converts heat into work without loss. Thus, steam physics led humanity to an understanding of the fundamental limitations of nature.

In 1867, James Clerk Maxwell asked the question: Can the second law of thermodynamics be violated? According to Maxwell, people are simply not smart enough yet. He proposed a thought experiment: imagine that inside a vessel with gas sits a small intelligent creature - Maxwell's demon. This demon monitors gas molecules and sorts them using a door: fast molecules are sent in one direction, slow molecules in the other. As a result, one part of the gas is heated and the other is cooled without wasting energy. If such a demon existed, it would be possible to heat a room by extracting warm molecules from the cool evening air without doing any work - creating a perpetual motion machine and breaking the usual scientific vision of the world.

Leo Szilard said that "Maxwell was trapped in his theology," and in 1987 Charles Bennett proved that a demon couldn't do it for free. To sort molecules, it must find, remember and store information about their location. And sooner or later he will have to erase old data in order to continue working, and this requires energy. Thus, the demon with which physicists spent almost the entire twentieth century was exorcised.

And here I saw parallels, because financial markets work on approximately the same principle.

Speculators try to act like Maxwell's demon - opening and closing the market "door" to catch profitable deals. They look for predictable patterns, fall prey to various cognitive biases and apophenia (the tendency to see patterns where there are none), but according to the efficient market hypothesis (EMH), the market is constantly adapting. Any discovered pattern quickly disappears, because the very attempt to use it changes the behavior of the participants.

However, information processing is expensive. To “open and close the door” of the market, traders need to spend time searching and analyzing data, updating models, paying commissions and taxes, and withstanding psychological stress. Ultimately, the vast majority of speculators, like Maxwell's demon, spend more than they earn.

As Andrew Hodges puts it when explaining Gödel's theorem: “To see the truth, you need an observer to look at the system from the outside.” The logic of the market, like the logic of thermodynamics, most often cannot be understood from the inside.

In physics, heat is a form of energy associated with the chaotic movement of particles. It is characterized by temperature, which reflects the average speed of molecules. In finance, the analogue of heat is volatility - a measure of the chaotic movement of asset prices. Volatility is calculated through standard deviation and shows how much the price changes relative to the average value.

Just as high temperature equals more molecular chaos, high volatility means more unpredictable price movements. As the temperature of a system increases, entropy increases, and it becomes impossible to predict the movement of individual molecules.

It's the same in the market - when it becomes volatile, the movement of individual stocks becomes more random, and any models lose their effectiveness.

Ludwig Boltzmann explained that entropy is a measure of how many microstates can correspond to one macrostate: high temperature = high entropy = more possible combinations of molecules. Today this is described by the Maxwell-Boltzmann distribution, which shows that in a gas most molecules move at an average speed, but there are some that are much faster or slower.

When we invest in individual stocks, we limit ourselves to a low-entropy system where small changes can have catastrophic consequences. But if we buy an index fund, we are investing in a macrostate that includes thousands of microstates (companies). In this case, it does not matter to us where individual molecules move, because the entire gas (the entire market) behaves predictably in the long term.

Diversification reduces the temperature (volatility) of the portfolio. The wider the diversification is, the more stable the financial system is. Just like in physics, when a system reaches thermodynamic equilibrium, its behavior becomes easier to predict.

German economist Werner Sombart first used the term “creative destruction.” Joseph Schumpeter later wrote: “Capitalism is a process of creative destruction.” Like energy, wealth does not disappear - it is redistributed. The first law of thermodynamics (the law of conservation of energy) can be reformulated in relation to finance: money does not disappear without a trace - it flows to where value is created. German economist Werner Sombart first used the term “creative destruction.” Joseph Schumpeter later wrote: “Capitalism is a process of creative destruction.” Like energy, wealth does not disappear - it is redistributed. The first law of thermodynamics (the law of conservation of energy) can be reformulated in relation to finance: money does not disappear without a trace - it flows to where value is created. The market is a positive-sum game where a business, through the value created, rewards investors for the capital provided for use.

Those who spend their energy fighting market noise and randomness are wasting their energy. And those who understand and accept the fundamental laws of the market win in the long run. “The market is designed in such a way that the money of the active flows to the patient” — Warren Buffett

The entire history of technological progress is a battle with entropy. People created machines to use energy more efficiently, but eventually came to understand the insurmountable limitations of nature. Financial markets operate according to the same laws. As in thermodynamics, attempts to overcome chaos inevitably lead to additional costs.

The discipline “Personal Finance” is about how to live life meaningfully, productively and happily. You can't make all the money, and it's probably not a good idea to live your life. Why try to “overtake the locomotive” when you can buy a ticket and get to your destination comfortably?

The future belongs to those who are willing to accept its uncertainty. I think this is a good motto for passive investors.

“What the student must learn, if they learn anything at all, is that the world will do much of the work for them, provided they cooperate with it in determining how the world actually works and adapting to those realities.” ~ Joseph Tussman, Professor of Philosophy at the University of California, Berkeley.

Manage your life and personal finances wisely.

There is power in knowledge!