Just as there are more disordered states, than ordered ones, for molecules, in investing, there are many more unpredictable events, market movements and potential pitfalls, than clear, predictable patterns. So the inherent nature of investing is one of uncertainty, and without intervention, investments can move towards underperformance.
Have you heard of the concept of entropy? I’m sure many of you have, especially those with a scientific background. The dictionary defines it as ‘a way of measuring the disorder in a system’. It is possibly difficult to correlate entropy and finance, or understand how it would interest you as an investor. However, I changed my mind recently when I read a blog about entropy on the Farnam Street website ( fs.blog), which describes itself as ‘Brain Food’. It’s an online publication named after the street on which Berkshire Hathaway’s headquarters is located in Omaha, United States. While it’s not dedicated to investing or to Warren Buffett, CEO of Berkshire Hathaway, anyone who reads it will observe a connection or a commonality of themes between the ideas on the blog and the way Buffett and his deputy approach investment.
In one of the posts, Shane Parrish, who runs the website, has written on entropy. As he puts it, ‘All things trend toward disorder… Left unchecked disorder increases over time. Energy disperses, and systems dissolve into chaos.’ The important point that he explains, and something I did not appreciate earlier, is that the tendency towards greater entropy, towards disorder, is a statistical phenomenon. It means that entropy emerges from the aggregate behaviour of a large number of events, rather than from the specifics of any individual or event. Things happen randomly, and there are a lot more random events that tend to move towards disorder rather than order.
If we consider personal finance and investing, there are many more developments that are undesirable rather than desirable. Therefore, on chance alone, it’s far more likely that something undesirable will happen. This perspective mirrors the nature of entropy in that systems tend to evolve towards a state of higher entropy or disorder. In investing, without planning, monitoring and action, one’s financial position is more likely to move towards disarray. Just as a room left unattended is more likely to become messy over time, an investment portfolio that goes without attention is susceptible to degradation.
There’s no point blaming an individual event. Explaining the meaning of ‘disorder is probabilistic’, fs.blog states: For every possible ‘usefully ordered’ state of molecules, there are many, many more possible ‘disordered’ states. Just as energy tends towards a less useful, more disordered state, so do businesses and organisations in general. Rearranging the molecules—or business systems and people— into an ‘ordered’ state requires an injection of outside energy.
Just as there are significantly more disordered states, than ordered ones, for molecules, when it comes to investing, there are many more unpredictable events, market movements and potential pitfalls, than clear, predictable patterns. This means that the inherent nature of investing is one of uncertainty and volatility, with many factors contributing to changes. In the same manner that energy naturally gravitates towards a disordered state, investments, without intervention, can move towards underperformance. This can be due to various reasons, such as changes in the industry, management mishaps, global economic shifts, and unforeseen external events. Just as molecules require an external energy input to be arranged into an ordered state, investments require continuous monitoring, analysis, and intervention to achieve the desired goals and results.
On the face of it, this seems like an argument for too much action when it comes to investing. However, it’s actually one for keeping one’s eyes and ears open and doing the minimum that is required. While the trader/punter type of investor tends to get involved in too much action, mutual fund investors tend to opt for too little action, allowing things to slide. Apart from interesting tidbits about how paying no attention leads to bonanza, not paying attention to one’s investments is bound to lead to poor returns and missed opportunities.
(The author is CEO, VALUE RESEARCH.)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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