The second law of thermodynamics and your portfolio
December 12, 2018
Nobel prize winning physicist and world famous lecturer Richard Feynman may be known best by his endless cross-discipline curiosity. This curiosity and exploration into new fields resulted in many novel and useful discoveries. Expanding on the mental models theme we discussed two weeks ago and crossing disciplines into the realm of physics, this article explores the second law of thermodynamics and how it applies to your investment life.
The law is the law
Laws of physics are not a case of rules that are meant to be broken. That’s what makes them laws — they’re consistent, observable and evidence-based. Even though they are written explicitly in terms of physics, these laws often apply in other aspects of life, from business to government to society. The second law of thermodynamics is fairly intuitive and easy to observe. It simply states that all systems tend towards disorder. Disorder in physics is referred to as entropy, so the technical definition of the law reads as “entropy always increases over time.”
All things tend towards disorder
We’ve all seen examples of robust systems, businesses, organizations and investment strategies that over time decay, devolve or simply stop working. Think about a process or system in your work life. There may be only four or five ways to correctly operate that system and produce the intended results. But when you take the reverse, there are a nearly infinite number of ways to operate it incorrectly or knock it off track. Entropy may creep into the process via distractions, environmental changes, software bugs, hardware errors, negligent employees, fraud and many other elements. Given enough time every system is prone to these disruptions; chaos is the eventual and natural result.
The same phenomenon is at work in your portfolio. Left to its own devices, it will devolve. It will need periodic infusions of attention and energy to keep things on track. Most investors are not fully equipped to track down or anticipate the inevitable disorder, however small or large. Even when they have the ability they may not have the willingness or the time. We wrote about this in our article Time Willingness and Ability.
Change happens more often than expected
An investment portfolio is under continual siege by significant external influences and changes. Companies are bought, sold and merged together. Private companies go public and public companies go private. Regulations and tax rates change. New companies emerge. Others fade.
Indexes change, too. Facebook was reclassified this year from a technology business to a communications business. Anyone who held a technology-focused index investment, like VGT or XLK, sold Facebook this year when the index methodology changed.
Markets change. Asset classes surge or sink. Interest rates shift. For instance, yields are finally at a level where some bonds are once again becoming attractive. See our recent article on where to hold cash.
When these changes happen, a portfolio needs analysis, rebalancing, tax optimization, not to mention processes to assure compliance, make valid trades, control costs and track results. Without these measures, entropy continues to spread and results decay.
You change too
People and families change. Income levels fluctuate as people change jobs or switch industries. Kids grow into adults and start playing a role in the family finances. Houses are bought and sold. Marriages prosper or fail. Parents age. Needs for liquidity go up and down depending on renovations, businesses being founded, college payments and/or wedding plans, to name a few.
Investment advisors play many roles. One is to recognize and defend against portfolio entropy, no matter its source. We’re here to keep investments in order and in line with the changes in your life and the world at large by leveraging our experience, technology platforms, creativity and control.
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