Archives for April 2016

Latticework of Mental Models: The Two Systems of Thinking

“What’s 2 + 2?”

You can’t help but think of the answer instantly. Your mind throws the number “4” on your thought screen. It’s actually impossible to not think of the answer here, unless you haven’t learnt to count to ten.

The answer is almost like a reflex. It was an instance of fast thinking. In fact, you don’t even need to consciously think about it. It just happens to you. This is the result of what scientists call reflexive brain.

Now if I ask you, “What’s 38 multiplied by 27?”

For most of you, except if you’re a math wizard, your brain goes blank. It doesn’t give you any instant answer. You’ll have to take a pause and calculate the answer with some efforts, and if you’re like me you won’t be able to do it without pen and paper. Here you have to involve a part of your brain which is known as the reflective brain. You experience a slow mode of thinking as you proceed through a sequence of steps to solve this multiplication problem.

Reflexive brain is quick and it tends to jump to conclusion. Reflective brain is much slower, requires effort, it’s logical and, as we’ll see later, less prone to error.

Daniel Kahneman, a nobel laureate who is also known as the founding father of modern behavioural economics, in his book Thinking Fast and Slow, has termed these two modes of thinking as System 1 (reflexive) and System 2 (reflective).

Latticework of Mental Models: Active Reading

The summer season is here and irrespective of the fluctuations in the market temperature, the real mercury is rising everyday. In this sweltering heat, one of the things that brings an instant smile on my face is when I think about how I spent my summer holidays when I was a kid.

This thought sends me down the memory lanes of all those good old days when I played with friends all day, watched favourite cartoon programs on TV, and forgot all about school and homework.

My summer holidays were jam packed with activities like playing carrom, card games, checkers, chess, monopoly, cricket, and most of all – reading comics. I loved reading comic books. By the time I reached 8th standard, I had amassed a collection of more than 300 comic books. I even ran a small library which unfortunately had to be closed down after 10 days of operation.

The lesson learnt – kids like borrowing comics but don’t like returning them. 🙂

Anyways, when I look back at my childhood days, I realize that reading comics was one of the most pleasurable activity. I am sure many of you can relate to me.

When I entered college, those 30 page comic books were replaced by 500 page novels. But one thing remained unchanged about my reading habit. Most of my reading was for pleasure. Except of course college text books which I passionately disliked. For that matter, whenever I read anything which had a potential to challenge my cognitive resources, I forgot most of it by next evening. That explains my belief about studying for exams just a day before.

However, as I started working, my interest increased in the area of personal development, investing and personal finance, I found myself picking business and investing related books every now and then. But my years of poor reading habits – reading only for pleasure – had become a serious roadblock to derive any meaningful benefit out of these new kind of books.

Latticework of Mental Models: Checklist

Few months back, I was visiting a friend in the hospital. He was getting discharged after a minor surgery. While helping him pack his stuff I casually flipped through his discharge summary papers. Most of the medical jargon in the file didn’t make much sense to me but one particular thing caught my attention.

Under details of surgery, the last line read – “Mops/instrument counts were correct”. The first thought that came to mind was – are these guys so concerned about their instruments (and even cotton mops) that they count it after the operation? Many of those instruments are anyway disposable and can’t be used again. So what’s the big deal about counting them?

Later I came to know that counting all the instruments and mops is part of their protocol. It’s to make sure that they haven’t left any items inside the body of the person being operated. It was an important step in their written ‘list of things to check’. Made sense.

Hundred of people die every day because of unavoidable blunders (like leaving an instrument inside the patient’s body) by surgeons.

In US alone the number of deaths following surgery is 75,000 per year which is more than the number of road accident fatalities. And these are the cases which are avoidable because they emanate from human errors. The failure rate is disproportionately high and can’t be ignored.

But medicine has become a field of extreme complexity. And not just medicine but many other fields have grown so far beyond the usual kind that avoiding daily mistakes is proving impossible even for our most super-specialized.

So how do you approach this problem? This is the question that intrigued Dr. Atul Gawande, professor of medical surgery in Harvard Medical School, and his quest to find the solution ended at a totally unrelated place. The aviation industry.

Ask Vishal

“He who has a why to live for can bear almost any how.” ~ Friedrich Nietzsche

If there is one big lesson I have learned in my life on how to get better at something (anything), it is that of asking questions…and a lot of them.

Now, asking questions does not come naturally to me. All my school and college life, I rarely asked questions for the fear of looking like a fool for the next five minutes.

But I have learned it the hard way – through failures, missed opportunities, and (almost) a broken heart – that he who asks a question is a fool for five minutes, but he who does not ask a question remains a fool forever.

Anyways, now my life revolves around answering questions – and a lot of them that come in daily from Safal Niveshak tribe members. Questions related to investing, personal finance, career, and life.

[Read more…] about Ask Vishal

Latticework of Mental Models: Arbitrage

In 1954, a temporary shortage of cocoa in US caused its price to increase from 5 cents to 60 cents per pound, a whopping 12 times.

As a result, Rockwood & Co., a brooklyn based chocolate products company, found itself in a sweet spot. They were sitting on 13 million pounds of excess inventory of cocoa which instantaneously became a huge asset because of cocoa price increase.

So selling the inventory to make a handsome profit was a no-brainer except that there was just one catch to it. Rockwood & Co. followed LIFO (last in first out) inventory valuation which would have created a 50% tax liability on profits from sale of inventory.

Young Warren Buffett — Buffett in his early 20s

So to avoid this tax, they came up with an ingenious way to exploit the temporary opportunity. They extended a share buyback offer which allowed the shareholder to tender a share in exchange for 80 pounds of cocoa. This maneuver, according to 1954 tax code, was perfectly legal and didn’t invite heavy tax liability.

This caught the attention of a 24 year old investment analyst who was working in New York for Graham Newman Corp. It was obvious to him that one could buy Rockwood shares for $34, sell them back to the company for 80 pounds of cocoa beans (worth $36), and then sell the cocoa beans making an instant profit of $2. Considering the transaction could be done in less than a week, it worked out to a sky-high annualized return.

“For several weeks I busily bought share, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.”, recounts Warren Buffett, the protagonist in the story above, “The profits were good and my only expense was subway tickets.”

What Buffett did is called an Arbitrage. It’s a process of identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. In the very early days the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets.

Value Investor Interview: Samit Vartak

Note: This interview was originally published in the March 2016 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.

I recently interviewed Samit Vartak of SageOne Investment Advisors for my premium newsletter, Value Investing Almanack.

Samit is one of the founding partners and Chief Investment Officer at SageOne, and is responsible for ensuring SageOne’s adherence to its core investment philosophy and discipline of risk management. As you would read in the interview below, Samit believes in risk management not by seeking extreme diversification or buying sub-par businesses at low multiples, but by building a reasonably diversified portfolio of high quality businesses having long term competitive advantages in attractive and high growth industries.

Samit returned to India in 2006 after spending a decade in the US working initially in corporate strategy with Gap Inc. and PwC Consulting, and then with Deloitte and Ernst & Young advising companies on business valuation and M&A. This experience forms the backbone that helps him better understand businesses and their fair value. Samit is a CFA® charter holder, an MBA from Olin School of Business of the Washington University in St. Louis and holds a Bachelor of Engineering degree with Honors from Sardar Patel College of Engineering, Mumbai University.

In his interview with Safal Niveshak, Samit shares his wide investment experience and how small investors can practice sensible investment decision making.

Latticework of Mental Models: Theory of Constraints

Few years back, while I was employed in a IT MNC, my office commute route involved a stretch of road which had quite a few traffic signals. One of these traffic signal was very nasty. It would sometimes take upto 20-30 minutes just to cross this one. A real bottleneck.

Soon the government decided that there should be a flyover built over this traffic signal. When I heard the news about flyover, I felt that it would solve the bottleneck problem.

3 years and few crore rupees later the flyover was finally ready. But did it solve the problem?

Partially. The bottleneck dissolved at that one particular traffic signal but all that flyover did was shift the bottleneck to the next traffic signal. Overall there was no improvement in my commute time.

This is what happens when you fail to look at a problem in a holistic way. Building the flyover wasn’t the complete solution.

When they thought of building the flyover, authorities were not really addressing the bottleneck, they were focussed on the location of the bottleneck. And in this case the bottleneck was a moving target.

This holistic way of looking at problems is called systems thinking. And Theory of Constraints is an important mental model to assist you in developing systems thinking. It’s the science of looking at the properties of bottlenecks in a system and how they behave.