Mental Models

Latticework of Mental Models: Illusion Of Control

Every day, shortly before nine o’clock in the morning, a man with a red hat stands at a busy traffic light and begins to wave his cap frantically. After five minutes he disappears.

One day, a policeman comes up to him and asks: “Sir! May I ask what you are doing?”

“I’m keeping the giraffes away,” replies the man.

The puzzled policeman looks around and tells him, “But there aren’t any giraffes here.”

“Well, I must be doing a good job, then.” says the man proudly.

You would conclude that the man with the red hat wasn’t in the pink of his mental health. However, is it just a case of misplaced understanding of causation vs correlation? Actually, there is more to it.

The man’s belief, that absence of evidence (giraffes) is a proof of his prowess in controlling giraffe traffic, is the result of a behavioural bias called Illusion of Control. It’s the tendency to believe that we can influence something over which we have absolutely no sway.

So where does this behavioural quirk come from? In millions of years of evolution, Mother Nature has hard-wired this cognitive bias in the human brain to increase the chances of survival in a hunter-gatherer environment. It’s nature’s way to deal with uncertainty.

Latticework of Mental Models: Lucifer Effect

Let me ask you a disturbing question.

“Would you electrocute a stranger?”

Most of you would respond with an emphatic no. But perhaps you are underestimating yourself.

I am neither doubting your character nor your sense of morality but empirical evidence suggests that human beings underestimate their own vulnerabilities that can turn them into evil. To support my claim let me take you through a fascinating experiment.

In 1971, Philip Zimbardo, a young psychologist from Stanford University, wanted to study the psychology of imprisonment i.e., study the roles people play in prison situations. So he invited students to participate in an experiment and randomly assigned them the roles of ‘prisoners’ and ‘guards’. Tests showed that all students were normal people and physically and mentally healthy. A simulated prison environment was created to mimic real-life prison conditions, where they lived for several days. As part of the role playing the ‘guards’ behaved aggressively and ‘prisoners’ behaved helplessly. [Read more…] about Latticework of Mental Models: Lucifer Effect

Latticework of Mental Models: Porter’s Five Forces Analysis

Peter Lynch, who successfully ran Fidelity’s Magellan mutual fund for more than a decade, has often mentioned that investors are well advised to buy a business that’s so good that an idiot can run it because sooner or later an idiot will run it. That’s Lynch’s trademark style of saying that some businesses have structural advantages.

The easiest example that comes to mind is when Vijay Mallya ran two different kinds of businesses i.e the liquor business and the airline business. The alcohol business has great economics and aviation industry is known for its horrible economics. It didn’t matter how skillful Mallya was (or wasn’t). The outcome of the events in these two cases proves Lynch’s point.

So how do you find businesses which have a structural advantage? The search should begin by evaluating the industry. If one can answer following questions then he or she can get deeper insights about the industry.

Is this a good industry to look for quality businesses?
Is this is a mediocre industry, but are there companies which are exceptionally good performers?
What are the growth drivers for the industry?
What are the challenges?
What factors might influence how the industry might do in the future?
Who are the dominant players? Why are they dominant?

Of course, one needs to read a lot about the industry and the companies operating in it to answer above questions. But there’s is smarter approach to get quick insights on the competitive nature of any industry. And that brings us to a very important mental model – Porter’s Five Forces Analysis. [Read more…] about Latticework of Mental Models: Porter’s Five Forces Analysis

Latticework of Mental Models: Ludic Fallacy

On October 23, 2010, Francis Crippen, an American national, drowned while swimming in the sea near the shores of United Arab Emirates. He was only 26 years old.

Francis’ story shouldn’t strike you as very unusual. Thousands die every year because of drowning. In fact, your best guess would be that it’s such a non-event that it wouldn’t have found even a single mention in any of the prominent newspapers. However, what I haven’t told you about Francis is that he was no ordinary swimmer.

All three of Crippen’s sisters were competitive swimmers. Being inspired by his sister Maddy, Crippen started swimming at the age of six. Maddy was a 2000 Olympian in the 400 individual medley. Crippen’s other sister Claire was an Olympic Trials qualifier. Teresa Crippen, Fran’s third sister was a member of U.S. national swimming team. Francis himself was a six-time US National Champion and won several international medals.

This is the account of the events that followed on that fateful day.

Video Series: Investing Lessons From Occam’s Razor

It’s a human tendency to address a complex problem with a complex solution. And when it doesn’t work, man starts looking for an even more complex solution.

In an uncertain world, seeking complexity is a big error. Complex problems do not always require complex solutions. Overly complicated systems like financial markets are not only difficult to comprehend but easy to exploit and possibly dangerous.

In investing, less is more.

Warren Buffett, in his 2004 letter to shareholders, wrote…

Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.

Latticework of Mental Models: Denominator Blindness

Imagine you are engrossed in a very interesting book and your concentration is broken by a call from a friend (let’s call him Hobbes). It’s rather unusual to receive Hobbes’ call at this time during the day so, expecting to hear something urgent, you pick up the phone and ask him –

“What’s up, buddy? Is everything alright?”

“Dude, the stock that I bought last month has reported a decline in their quarterly profits by 50 crores! Is that a bad news? Should I sell it?” The panic in his voice is clearly evident.

What would you tell him?

As they say, the most useful way of answering a question is to ask another question in response. And in this case, you must ask Hobbes, “50 crores compared to what?”

“What do you mean ‘compared to what’? Isn’t 50 crores a huge number in itself?” You friend is little confused by your response.

The right answer is that the figure 50 crores needs to be considered in full context. The company’s profit declined by 50 crores but what’s the net worth of the company? Is the net worth comparable to 50 crores or is it something in the order of 10,000 crores? Asked in another way, was the profit decline almost 90 percent? Or was it less than 5 percent of the total profits, i.e. part of the daily noise?
[Read more…] about Latticework of Mental Models: Denominator Blindness

My Lecture on Mental Models

I recently delivered a lecture on Mental Models and how financial advisors and other business owners can use them to grow their businesses. It was to a group of 200+ advisors at a session organized by my friend Sadique Neelgund of NetworkFP.

Talking to advisors always makes me nervous (as you can see in the picture above), largely because my work at Safal Niveshak is all about helping people learn to manage money on their own, thus avoiding the need of advisors. 😉

By the way, in case you haven’t checked out our latest ebook – Mental Models, Investing, and You (2,000+ people have already got their hands to it) please click here to get it now.

Mental Models, Investing, and You (Special E-Book)

The world around us is changing pretty fast. Modern computers are becoming cheaper, faster and more intelligent than ever, which means they are ready to replace a large part of human workforce.

The day is not far when your work and skills will be threatened by artificial intelligence. To stay relevant, you need to ensure that you remain valuable to the society in a way which can’t be substituted by a robot.

And your only chance to remain valuable is by being a constant learner…a learning machine, as Charlie Munger says. In fact, he has been saying this for years –

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.

The question is where do you begin? There is so much to learn all around, and so little time.

Latticework of Mental Models: Scarcity Bias

In 1999, on being introduced to the Internet for the very first time, do you know what I did? Like many others, I created a dozen new email accounts. But once I realised the futility of having so many email addresses I discarded almost all of them and stuck to my Yahoo mail. It stayed that way until Gmail arrived.

Some of the Gmail features were quite attractive as compared to Yahoo but what made the former very tempting was its policy of invite-only registrations. You couldn’t get a Gmail account unless someone with Gmail invited you. This made me want it even more. But why?

Folks at Google certainly understood human behaviour better than anyone else. They used the principle of Scarcity Bias to make their product more appealing.

Scarcity principle states that people assign more value to opportunities when they are less available. In other words, things seem more valuable to us when their availability is limited. This bias stems from the basic human tendency to shun losses.

Daniel Kahneman, who is known for his pioneering work in the field of behavioural economics, came up with the Loss Aversion theory, which explains the root of many of the human psychological biases. The theory says that human beings are motivated more by the thought of losing something than by the thought of gaining something of equal value. This is especially true under conditions of risk and uncertainty.

Put simply, the threat of potential loss plays a powerful role in human decision making.

Latticework of Mental Models: Hawthorne Effect

The Hawthorne plant of the Western Electric Company in Cicero, Illinois, figured out, albeit accidentally that increasing lighting in the plant made workers more productive. Then someone pointed out a confusing detail. Productivity also improved when they dimmed the lighting. In fact, making any change at all seemed to result in increased productivity. That was a surprising finding.

It turned out that the workers seemed to be responding more to the attention they were receiving from management than to any physical change in their environment. With each change, the workers suspected (consciously or unconsciously) they were being observed and therefore worked harder.

This phenomenon came to be known as the Hawthorne Effect. It states that the very fact that people are under study, observation or investigation can have an effect on them and the results.