Saturday Serendipity

Quote, Mental Model, Interesting find.

Hi there!

Reading time: About 5 minutes

Quote

“In the first 30 years of your life, you make your habits. For the last 30 years of your life, your habits make you.”
― Walter Isaacson, Steve Jobs

Mental Model

Thermodynamics

We have another mental model from physics today. I’ll try to make it as interesting and simple as possible as I know it is not the most interesting topic. So let’s start.

What is thermodynamics?

It is :

the branch of physical science that deals with the relations between heat and other forms of energy (such as mechanical, electrical, or chemical energy), and, by extension, of the relationships between all forms of energy.

Thermodynamics has four laws:

1. Zeroth Law: If two things are in thermal equilibrium with a third thing, they are also in equilibrium with each other.

2. First Law: Energy cannot be created or destroyed; it can only change forms.

3. Second Law: The total entropy (disorder) of an isolated system always increases or remains the same; things tend to get messier over time.

4. Third Law: As you try to cool things down, you get closer and closer to absolute zero (the coldest temperature possible), but you can never quite reach it.

In weight loss

Shane Parrish in his blog The Science of Obesity wrote wonderfully how thermodynamics plays a role in the calorie (energy) factor.

Wait, what about thermodynamics. The law that says energy can be transformed from one form to another but not created nor destroyed.

“The very notion that we get fat because we consume more calories than we expend would not exist without the misapplied belief that the laws of thermodynamics make it true. When experts write that obesity is a disorder of energy balance—a declaration that can be found in one form or another in much of the technical writing on the subject—it is shorthand for saying that the laws of thermodynamics dictate this to be true. And yet they don’t.

Experts think the first law is relevant because it fits neatly with our existing theories about why we get fact—those who consume more calories than they burn will gain weight. Thermodynamics tells us that if we get fatter and heavier, more energy enters our body than leaves it. But the important question, at least from an obesity perspective, is why do we consume more calories than we expend?

I highly recommend you to read this article. It is a great breakdown on why we get fat.

In Investing

This is all fine but how does thermodynamics apply to investing?

Prof. Bakshi wrote in a blog of his as to how the first law applies to investing with regards to risk.

“What is the connection between the law of conservation of energy and the concept of risk in financial markets?

In my view, there’s a big connection. I feel that they are essentially the same – an insight I got after reading the above Loomis’ columns although she herself did not talk about the connection.

The law of conservation of energy states that the total inflow of energy into a system must equal the total outflow of energy from the system, plus the change in the energy contained within the system. In other words, energy can be converted from one form to another, but it cannot be created or destroyed.

Simply change “energy” for “risk” and you’ll have the law of conservation of risk.

The law of conservation of risk states that the total inflow of risk in a system must equal the total outflow of risk from the system, plus the change in the risk contained within the system. In other words, risk can be converted from one form to another, but it cannot be created or destroyed.

Take the simple example of a hedging operation involving shorting index futures. The hedger who shorts the index futures is trying to protect herself from a market decline. Should the market decline, the value of her stock portfolio will also decline, but this decline is expected to be offset by the profit she will make on the short futures position. So far, so good. But, is it?

Is it really that simple? Has the risk to the hedger been reduced? Of course not. The risk of the decline in the price has merely been transferred to the buyer (counter-party) of the index futures. But that’s not the whole story. There is more to it.

By selling the index futures, the hedger has transferred the price risk to the buyer of the index futures but has assumed another risk. That risk is credit risk i.e. the risk that the counter-party may default.

While it’s true that with the presence of organized futures markets with margin requirements and other risk mitigation measures in place, credit risk is much lower at the individual level, this does not mean that the risk in the entire system has been reduced. At the individual level, risk may be reduced but not at the system level.

Risk can be sliced and diced. Risk can be transferred from one person to another. And one form of risk might replace another form, but at the end of the day, the total risk in the system is not going to change.

In other words, just like energy, risk can be converted from one form to another, but it cannot be created or destroyed.”

Another good relation of investing with thermodynamics is the second law in relation to brokers and fund managers. The more entropy there is the more chaos there is. Similarly the increase in activity leads to more entropy. (chaos)

Conclusion

Thermodynamics is one of the big ideas of physics and good mental model to keep in life. It is one of the most concrete ideas and affects our day to day. These 4 laws help scientists understand how heat and energy work in our world, from making ice cream to powering our homes with electricity!

Also feel free to leave a comment if there is anything you would like to add or criticize.

Interesting find

Career advise by Jack raines

That’s it for this week!Thank you for reading!

Enjoy your weekend!