Recently, I’m deeply thinking about the concept of entropy which led me to realize its broad applicability in explaining investment principles, sustainable business models, and large-scale social trends.
Although the concept of entropy rooted in physics, it can be more abstractly defined as a measure of a system’s disorder or uncertainty. Simply put, entropy represents the number of possible microstates within a system. High entropy indicates numerous possible microstates, while low entropy suggests fewer.
As entropy is a concept that represents the degree of disorder in a system, the mere act of recognizing entropy in a specific system can significantly aid in deeply understanding the system and detecting potential risks that may arise within it.
In particular, various thoughts on this concept are closely related to dealing with complex systems. In complex systems, it is easier to detect the fragility of the system than to predict the probability of a specific event occurring. This is semantically almost identical to the fact that, from an entropy perspective, it is much easier to measure the current entropy of a system than to accurately predict a specific possible state of the current system.
If compounding effects are present in a high-entropy system, that system can potentially lead to non-linear losses. In other words, it is potentially fragile. The investment market is a prime example of this. In systems where compounding effects are at play, the gains or losses obtainable from a specific system are governed by geometric means rather than arithmetic means. In such a system, if you gain 30% and then immediately lose 30%, you end up with a net loss.
To avoid extreme outcomes in this system, the only option is to reduce entropy. For investors, this means regularly increasing cash positions. For businesses, it involves maintaining optionality. From the perspective of a nation or society, it means allowing for the appropriate release of current anger or energy.
To understand and apply the concept of entropy, it’s not necessary to employ various laws of physics or apply mathematical models. It’s simply a matter of measuring the entropy of the system you’re part of. Sometimes, the mere act of measurement alone can help avoid many potential risks.