Financial Markets as a Dance Against Entropy: Lessons from Thermodynamics and a Philosophical Approach to Investing

Good Morning Ladies and Gentlemen

“I can’t tell you how to get rich quickly, but I can tell you how to become poor quickly by trying to get rich quickly.”

Attributed to either Warren Buffett, Charlie Munger, or André Kostolany

As announced last week, this week’s edition of “Stefan’s Weekly” takes a slightly philosophical turn as we explore some of the insights that thermodynamics can provide when analysing financial markets. The foundational knowledge for this exploration comes from Prof. em. Dr Leonard W. ter Haar (Leo). Without his guidance, I would not have been equipped to write this article, as I lacked the essential understanding of physics required to analyse financial markets. Leo has conveyed this knowledge to me in an accessible manner, for which I am truly grateful. This piece aims to offer not only a fresh perspective but also a light-hearted, philosophical approach to the topic. I hope it resonates with you, and that you enjoy the read.

Enjoy the Journey

Anyone seeking to understand financial markets typically looks for economic explanations. They examine factors such as interest rates, corporate earnings, the money supply, inflation, and business cycles. However, a deeper insight may be found in a scientific field that, at first glance, appears unrelated to stock markets: thermodynamics. The value of this analogy lies not in equating financial markets with natural laws, but in offering a fresh perspective on the forces that influence prices, wealth, and market cycles. The thermodynamic approach allows us to perceive markets as dynamic systems in which energy, entropy, and equilibrium are in a constant state of dance.

The central observation is that nearly every natural system adheres to a fundamental principle: energy does not accumulate on its own. In the absence of effort, order naturally gives way to disorder. A tidy room eventually becomes cluttered, a hot object cools down, and a pressurised bicycle pump or bicycle tyre loses air. This tendency for the world to distribute energy and equalise differences is evident everywhere. A similar principle can be observed in financial markets, where capital does not remain indefinitely concentrated. It flows from one area to another, seeking opportunities, reacting to information, and continuously moving toward new states of equilibrium.

From this viewpoint, the market should not be seen as a static valuation mechanism but rather as a dynamic organism. Every trade, each investor decision, and every new piece of information impacts the state of this organism. As such, markets are never truly in equilibrium; they are perpetually moving towards an equilibrium that is never fully attained. No sooner is new information absorbed than additional information emerges, altering the target once more. In this regard, financial markets function as open systems. Their environment, encompassing the economy, politics, technology, and society, continually provides them with new stimuli. It is precisely this openness that prevents stagnation.

The role of information is particularly intriguing. In thermodynamics, entropy introduces disorder and uncertainty. In other words, it describes the tendency of systems to evolve from ordered to more disordered states, while in market activities, new information serves a similar purpose. Corporate reports, inflation data, geopolitical developments, and technological breakthroughs initially generate uncertainty. Market participants interpret the same information in diverse ways; some perceive opportunities, while others identify risks. This divergence leads to price movements, heightened trading activity, and increased volatility. From a thermodynamic standpoint, the system’s entropy escalates. Only after this information has been processed and integrated into prices is a temporary sense of order restored. However, this order is short-lived, as the next wave of new information is already on the horizon.

This perspective on markets shifts how we perceive volatility. Many investors view price fluctuations as uncomfortable and often associate volatility with risk. However, the thermodynamic analogy offers a different interpretation. In this context, volatility can be likened to a system’s temperature. A high temperature indicates a significant flow of energy. Applied to financial markets, this suggests that information is actively being processed and capital is seeking its optimal allocation. Thus, volatility should not be seen as a flaw in the market; rather, it is a sign of its vitality. A market devoid of volatility would ultimately be stagnant, lacking in change, learning, and opportunities.

This passage explains a mechanism that has influenced investors for centuries: market rotation. Time and again, we witness phases where capital becomes concentrated in select sectors. Currently, that sector may be artificial intelligence; previously, it was internet companies, and before that, real estate or commodities. When a specific area yields impressive returns, it naturally attracts additional capital. Expectations surge, valuations increase, and optimism proliferates. However, just as heat flows from a hotter object to cooler ones, capital will eventually move out of overheated segments. The market seeks equilibrium once more. Consequently, we observe rotation across sectors, regions, and asset classes. Capital does not vanish; it merely shifts its position within the system.

A deeper truth about the role of prices emerges here. Prices are not simply numbers displayed on a screen; they serve as the mechanism through which the market processes information and allocates capital. They coordinate the decisions of billions of individuals. Rising prices draw in capital, while falling prices discourage it. In this regard, prices function like a thermodynamic control system, ensuring that the market adapts to new conditions and continuously reorganises itself.

Another implication of this perspective relates to diversification. Uncertainty is an inherent component of complex systems and cannot be entirely eliminated; it can only be meaningfully acknowledged. This leads to a crucial insight: the less predictable the future is, the more essential it is to establish a robust structure capable of withstanding a wide array of developments. Diversification embodies this principle precisely. Rather than betting on a single scenario, it spreads risk across multiple investments, thereby enhancing a portfolio’s resilience to unforeseen events. For investors, this suggests that diversification should not be viewed merely as a risk-management strategy but rather as a reflection of intellectual honesty. No one can accurately foresee the future, nor can anyone predict which information will shape the markets tomorrow. Hence, a portfolio should not hinge on a single prediction, but rather on its capacity to adapt to numerous potential outcomes.

This consideration highlights the inherent danger of concentration in investment portfolios. While a concentrated portfolio may yield spectacular gains, it simultaneously diminishes the number of potential positive future outcomes. To put it in thermodynamic terms, the portfolio’s entropy decreases, resulting in fewer states where wealth can thrive. This increased concentration heightens vulnerability to surprises. In contrast, a broadly diversified portfolio expands the range of potential future scenarios, enhancing its resilience against unforeseen shocks. Therefore, diversification should not be seen as a lack of conviction; rather, it is a strategic approach to improving the probability of survival in uncertain conditions.

This is where the concept of ergodicity comes into play. The idea behind it is that the long-term evolution of a system ultimately does not depend on where it began. Financial markets are not ergodic. While this may sound theoretical, it has enormous practical significance. Many financial models rely on averages to assess how wealth typically evolves. However, investors do not exist within averages; they navigate their unique personal timelines. A total loss for any investor renders the long-term average returns of others meaningless. Since wealth accumulates multiplicatively, those who fall to zero cannot participate in future returns. This leads to perhaps the most crucial principle of successful investing: avoid ruin. Capital preservation is not merely the opposite of return; it is, in fact, its essential foundation.

This insight fundamentally transforms our approach to portfolio construction. It suggests that the primary risk does not stem from ordinary price fluctuations but rather from events that can irreversibly damage overall wealth. By structuring capital to minimise the impact of individual mistakes or shocks, investors can significantly enhance their long-term potential for successful wealth creation. Consequently, the focus shifts from maximising possible returns to ensuring sustainable wealth development.

Viewing rebalancing through the lens of thermodynamics offers valuable insights. Financial markets seldom progress in a consistent manner; while some assets flourish amid euphoria, others may lag temporarily. These tensions and imbalances present opportunities. In this context, market movements are not merely accepted but are strategically utilised for long-term wealth accumulation. Investors sell positions that have become relatively overvalued and reinvest in areas that appear undervalued. This approach transforms volatility into sustainable wealth growth. A significant advantage of this strategy is that it does not rely on forecasts; it is grounded in established rules and disciplined practices rather than predictions.

When viewed through this lens, market cycles cease to be perceived as mere random fluctuations and instead emerge as natural responses of a system that continually adapts to new information, capital flows, and expectations. Expansion and contraction are fundamentally intertwined. Optimism and pessimism should not be seen as opposing forces but rather as different phases within the same adjustment process. Boom and crisis ultimately represent two sides of the same coin, both contributing to the rebalancing of the relationship among information, expectations, and capital.

Perhaps the most profound insight from the thermodynamic perspective is that successful investors are not necessarily those who most accurately predict the future. Rather, it is those who position themselves to navigate an unknown future effectively. Investors who acknowledge that uncertainty cannot be wholly eradicated, but is instead an inherent aspect of markets, fundamentally alter their approach to investing. They do not seek certainty but rather robustness. Instead of attempting to forecast every market movement, they focus on constructing a system capable of benefiting from, or at the very least surviving, various future scenarios.

From this perspective, financial markets can be viewed as vast thermodynamic machines, perpetually engaged in information processing, capital redistribution, and the quest for equilibrium. Entropy introduces uncertainty, which in turn generates volatility. This volatility creates investment opportunities, leading to capital movements. These movements, in turn, establish new equilibria, which are quickly disrupted by incoming information. This cycle continues endlessly. This is precisely what keeps markets vibrant and fuels wealth and economic progress over the long term.

Ultimately, the thermodynamic analogy offers a simple yet profound insight: the true key to success lies not in predicting the future of music, but in adapting fluidly to its changing tempo. Moving in harmony with maximum entropy creates an agile dance, while ergodicity ensures that no single misstep will permanently remove a dancer from the floor. Through disciplined rebalancing, an investor can transform the market’s chaotic rhythms into a structured, wealth-building waltz. This arguably represents maybe the most important lesson investors can draw from the principles of thermodynamics.

Ladies and Gentlemen

Feel free to send your messages to smk@incrementum.li. Many thanks, indeed!

I wish you an excellent start to the day and weekend!

Yours truly,

Stefan M. Kremeth
CEO & Head of Wealth Management
Incrementum AG – we love managing assets

Tel.: +423 237 26 60
Cell: +41 79 303 48 39
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9494 Schaan/Liechtenstein
Mail: smk@incrementum.li