In modern financial theory, risk is crudely defined as the standard deviation of expected returns. This is an ambiguous definition because expected returns cannot be measured empirically. Financial theory makes the simplifying assumption that returns are lognormally distributed and therefore the average historical return can be used as an expected return for the future. There are volumes of sophisticated scientific theory dedicated to proving this concept out, but it flies in the face of logic and the well-known disclaimer in any performance presentation: >"Past performance is not indicative of future results" We think of risk as energy is thought of in Thermodynamics. The four laws of Thermodynamics govern the behavior of energy and its transformation in physical systems. We will use the first two laws to govern how we think about and define risk in the financial markets 1. First Law of Thermodynamics (Law of Energy Conservation): This law states that energy cannot be created or destroyed in an isolated system. It can only change its form or be transferred from one system to another. In other words, the total energy of an isolated system remains constant. We often say that risk cannot be destroyed, only transformed and that saying is derived from this law. Overall, the global financial system is a closed system made up of spenders and savers. To entice savers to give capital to spenders risk must be taken and a return should be earned. Interest rates are the foundation of the returns that entice savers to part with their money. Spending and Savings always reach an equilibrium point and the only question is at what interest rate. Therefore the total risk in the system never changes, only the price of that risk. ^ffc8e1 2. Second Law of Thermodynamics: The second law introduces the concept of entropy, which is a measure of the disorder or randomness in a system. It states that the entropy of an isolated system tends to increase over time or remain constant in reversible processes. In practical terms, this means that natural processes tend to move towards a state of greater disorder. Hyman Minsky said it best when he said "stability is destabilizing." Human nature is disorderly so it is only natural that any system in which we are the main actors would always be careening towards disorder. **Case Studies:** - [CHG Issue #150: Trees and Forests](https://cedarshillgroup.substack.com/p/chg-issue-150-trees-and-forests) - [CHG Issue #119: When Reality Doesn't Meet Expectations](https://cedarshillgroup.substack.com/p/chg-issue-119-when-reality-doesnt) - [CHG Issue #118: The Principle-Agent Problem](https://cedarshillgroup.substack.com/p/chg-issue-118-the-principal-agent) - [CHG Issue #117: The Game of Life](https://cedarshillgroup.substack.com/p/chg-issue-117-the-game-of-life) - [CHG Issue #109: The Wall](https://cedarshillgroup.substack.com/p/chg-issue-109-the-wall) Explore Further: [[CHG Risk Factors]] | [[Risk Premia]] Tags: #evergreen Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>