Bringing order to your investments

Have you heard of the concept of entropy? I'm sure many of you have but in the context of science. The dictionary defines it as 'a way of measuring the disorder in a system'. That sounds science-ish but in a theoretical way and it's not easy to see why you and I should be interested in it in any practical sense.

However, I changed my mind when recently, I read a great blog post about entropy on the Farnam Street website (fs.blog), an awesome blog about which I have written about earlier. fs.blog describes itself as 'Brain Food'. It's an online publication that is named after the street on which Berkshire Hathway's headquarters is located in the small city of Omaha in the United States. While it's not dedicated to investing or to Warren Buffett, anyone who reads it will notice a kind of connection, a commonality of themes between the ideas on the blog and the way Buffett and his deputy approach investments.

One of the posts that Shane Parrish, who runs the website, has written is 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 thing that he explains, and something which I did not appreciate earlier, is that the tendency towards greater entropy, towards disorder, is a statistical phenomenon. What does that mean? 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 simply a lot more random events that tend to disorder rather than order.

Looking at personal finance and investing, there are many, many more things that can happen that are undesirable than there are desirable ones. Therefore, on chance alone, it's far more likely that something undesirable will happen rather than something desirable will. 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 than order. Just as a room left unattended is more likely to become messy over time, an investment portfolio without attention is susceptible to degradation. There's no point blaming any individual event.

As fs.blog puts it, this is what it means that disorder is probabilistic: 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.

Apply this to investing. Just as there are significantly more disordered states for molecules than there are ordered ones, in investing, there are many more unpredictable events, market movements, and potential pitfalls than there are clear, predictable patterns. This means that the inherent nature of investing is one of uncertainty and volatility, with many, many factors contributing to changes. Similar to how energy naturally gravitates towards a disordered state, investments, without intervention, can trend towards underperformance. This can be due to various reasons like 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.

On the face of it, this seems like an argument for too much action. However, it's actually one for keeping one's eyes and ears open and doing the minimum required. While the trader/punter kind of person tends to too much action, mutual fund investors tend towards too little action, and letting things slide. Apart from some interesting tidbits about how paying no attention leads to some bonanza, not paying attention to one's investments is going to lead to poor returns and missed opportunities.