The big idea that we are going to look at today is from the field of Physics and it’s called Thermodynamics . Before you get too scared of the big word let me assure you that we’re not going to be discussing any mind bending formulae here.
In fact, here a confession is in order.
The subject of Thermodynamics has fascinated me since my college days. And the fascination was mostly because it provoked more dread than excitement. Perhaps my bad karma from past life, call it Karma-dynamics, made sure that I barely got passing marks in any paper related to Thermodynamics.
So trust me, I won’t even make an attempt to go anywhere near complex equations.
The plan is to learn some basics and use that knowledge to gain useful insights that will help us make an educated guess about few interesting problems. What kind of problems? Here is one for starter –
Why is there disproportionate difference in size between the largest mammal on land (elephant) and the largest mammal in water (the blue whale)? In case you aren’t aware of the difference, here is a visual to give you some perspective. Click here for bigger image.
Eye popping, isn’t it? Blue whale is an ultimate display of mother nature’s marvels.
So let’s start probing by thinking about a simpler question.
If you had an ice cube weighing 8 kgs, and if you had 8 smaller ice cubes each weighing 1 kgs, will there be any difference in melting time?
This is a question that Peter Bevelin asks in his book Seeking Wisdom .
I suggest you take a few moments and think about the problem before reading further.
To be able to solve this, you need to have some basic idea about surface areas and volumes of 3 dimensional bodies. This video will help you get some handle on the fundamentals.
In short, as the volume grows for any object, its surface area grows at a much slower rate and the ratio (volume) / (surface area) becomes increasingly bigger.
You still with me on this? Okay, once this concept is clear, let’s look at the first law of thermodynamics.
The Law of Conservation of Energy
First law encompasses several principles, one of which is the law of conservation of energy, which states that energy can be neither created nor destroyed. However, energy can change forms, and energy can flow from one place to another. The total energy of an isolated system does not change.
Which means that the total energy produced by metabolism (which results from the breakdown of food consumed) inside an animal’s body has to be expended in form of physical activity or heat produced or a combination of both.
Now let’s take Bevelin’s help in connecting above two concepts. He describes an interesting thought experiment in his book –
Assume we make a human 10 times larger than normal. This means he is now 10 times longer, 10 times wider, and 10 times higher…The giant has 1,000 times more meat on the body but only 100 times the skin to hold it …[which] means that his skin surface area is too small to remove the heat emitted from his huge body. He would suffer from overheating since the amount of heat his body produces is proportional to the cube of his length (1,000), while the amount of heat he dissipates through the skin is proportional to the square of his length (100).
If the difference between heat produced and heat released is large, it will raise the core temperature of the animal body which might lead to death if the temperature goes beyond a normal body temperature range.
So we know that heat loss becomes a hurdle for size of a land mammal. But what about animals in the water?
I remember when my grandmother wanted to cool down the hot milk, she would partially immerse the milk vessel in a bigger vessel containing cold water.
My grandmother didn’t know anything about Thermodynamics but when I read Thermo, it explained how the rate of heat loss in water is higher than rate of heat loss in air.
So, extending the logic, we conclude that water mammals can afford less surface area per unit of volume because of their ability to lose heat faster inside water.
Hence we can make a reasonable speculation as to why Blue Whale is so big. Now this may not be the only reason but it shows how multidisciplinary learning can help us construct approximately right answers and that’s what Charlie Munger suggests –
It’s better to be approximately right than precisely wrong.
So far so good, but what’s the use of learning all this Thermo-Shermo if you can’t use it for gaining insights about stocks market investing?
Thermodynamics in Investing
Instead of trying to find an analogy myself, I would redirect you to a blog post written by Prof. Bakshi (in 2005) which takes the first law of thermodynamics and applies it to the idea 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.
You must read the full article .
Apart from this, there are few interesting parallels between the capital markets and the laws of thermodynamics, as described in this post which I found in Capital Ideas Online blog. Here is an excerpt –
In considering energy in nature or markets, it is helpful to think of potential energy, on the one hand, and “working” transformations of energy, on the other. Active forms of energy include kinetic, chemical, electric, electromagnetic, elastic (as in a bouncing ball), nuclear, heat, and sound.
Money available to buy stocks may be thought of as a form of potential energy. When cash piles up in money-market accounts and investment in stocks dwindles, as it did in 2001 and 2002, the situation is similar to a pendulum pausing at the top of its arc. At that moment, the energy seems to have disappeared. In reality, it is there in potential form and quite likely to be converted into movement.
When movement beings, one possible route is into equity funds. At the beginning of 2002, the ratio of assets in equity funds relative to money market funds was 1.5, close to a four-year low of 1.4. A high of 2.6 occurred in the spring of 2000 just as the market was embarking on its terrible 18 month descent.
What about the other laws of Thermodynamics?
Well, the second law of thermodynamics, in simple terms, states that anytime work is done, some energy is used non-productively (not to do work) to simply increase the entropy (disorder, chaos) of the universe. So the entropy of the universe is constantly increasing.
For example, when you burn fuel to heat water, some part (a substantial) of the heat energy will be lost to the surroundings. When you ride a bicycle some part of your energy is lost in dealing with friction.
This entropy is somewhat similar to the transactional cost (brokerage, taxes etc.) that we incur in the stock market. The entropy of stock markets could be the brokers and no-skin-in-the-game money managers.
I am thinking out loud here about analogies between stock market and entropy. However, the problem is that it’s easy to win an argument in my own head. So I invite you to chip with your own interpretations and insights. Be the devil’s advocate and please use the Comments section to challenge my views.
Look at Birkshire Hathway, it may look huge like a one big monolithic cube but in reality it’s more of a collection of loose- coupled smaller cubes. So the heat loss is very efficient for this big organism.
As I have said earlier, it’s good to learn about an idea but it’s absolutely critical to know its limitations too. Let’s see where Thermodynamics doesn’t really explain things but continue to be used and abused.
Thermodynamics and Weight Loss
One of the areas where the law of conservation of energy (calorie) has been overused and misused is weight loss diets and fads.
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.
Nassim Taleb, in his masterpiece Antifragile , voices similar concerns about misplacing the idea of conservation of absolute calories and its limitations in weight loss –
…there is no clear evidence that sugar-free sweetened drinks make you lose weight in accordance with the calorie saved…Somehow those recommending these drinks [1 calorie diet coke] are under the impression, driven by the laws of physics (naive translation from thermodynamics), that the concept we gain weight from calories is sufficient for further analysis. This would be certainly true in thermodynamics, as in a simple machine responding to energy without feedback, say, a car that burns fuel. But the reasoning doesn’t hold in an informational dimension in which food is not just a source of energy; it conveys information about environment. The ingestion of food combined with one’s activity brings about hormonal cascades (or something similar that conveys information), causing cravings (hence consumption of other foods) or changes in the way your body burns the energy, whether it needs to conserve fat and burn muscle, or vice versa. Complex systems have feedback loops, so what you ‘burn’ depends on what you consume, and how you consume it.
The superfluity of communication and information today is drowning us in massive noise. Most of the things that we read, listen or watch is dimly understood unless we have the right tools to detangle the balderdash from the core ideas.
Mental models are tools to scaffold our thinking. While thinking about a problem, mental models provide you a map with which you can quickly course correct your line of inquiry.
Our world and life is full of opportunities, disguised as problems and challenges, which need to be either pursued or avoided. You don’t want to spend a disproportionate amount of time analysing a single problem. Instead the strategy should be to race through numerous problems and quickly identify the solvable ones.
Abraham Lincoln famously quipped –
Give me six hours to chop down a tree and I will spend the first four sharpening the axe.
Spending a lot of time on a single problem is akin to struggling with a single tree with a blunt axe.
And Latticework of Mental Models is that sharp axe. So the idea is to spend more time constructing, overhauling, fine tuning and maintaining your Latticework. Building your own Latticework of mental models is a tremendously useful way to evaluate and upgrade the fabric of your worldview.
Let me wrap up with this thought – Anything that you read “rewires” a part of your brain.
The brain you had before you read this post? You don’t get that brain back. I’m sincerely hoping that the trade-off is worth it. 🙂
Compiling this Latticework series is turning out be enormously exciting activity for me. I hope you too are enjoying it.
Take care, don’t stop learning and keep your axe sharp.