Mental Models

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.

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.

Latticework of Mental Models: Float

About 12 years back, I first came to Bangalore to join my first job in IT industry. Known as city of lakes and the silicon valley of India, Bangalore was the place to be in.

However, the initial euphoria soon evaporated when I was told by the real estate agent that renting a house required me to deposit an advance. What added insult to the injury was the size of security deposit amount. It was supposed to be 10 months of rent.

Holy cow! That was several times more than my monthly salary at that time.

But it turned out that the practice was pretty common in Bangalore, and still is, which I suppose is not the case in other metros.

It infuriated me that the house owner would conveniently put that advance money in his bank and pocket the interest income too. So in effect he wasn’t just making money from rent, but from free deposit also.

Now here is an interesting question to puzzle over. The security deposit which in effect was a borrowing for the house owner – can we call that money as debt for him?

Yes and No. ‘Yes’ because it’s not his money and he would have to return that money sometime in future and ‘No’ because he doesn’t have to pay any interest on this borrowing.

So it’s a debt but quite different from a traditional debt. Let’s see how.

When I moved out from his house, the money which he returned to me was replenished by the new tenant. So it was a revolving fund. Effectively he would never have to return that money to his tenant, provided he doesn’t run out of tenants, which is unlikely because his house was in busy locality in Bangalore.

The deposit was an income generating asset which costed the landlord nothing. He could very well be using that money for making other investments too, like buying stocks or making down payment for another house.

So this is a very interesting type of debt. It’s called Float.

Latticework of Mental Models: Surfing

In spite of having a coastline of more than 7,500 km with warm oceans and favourable conditions, surfing is not a familiar sport to Indians. It seems we are more fascinated with the swing of a cricket ball than the twists and turns of water waves.

In many western countries including the US and Australia, surfing is a popular sport as well as a recreational activity. Surfing is a surface water sport in which the wave rider, referred to as a surfer, rides on the forward or deep face of a moving wave, which is usually carrying the surfer towards the shore.

A surfer not only is carried by the wave, but it gives an exceptional forward speed to its rider, provided the surfer can get on to the wave at the right time and not get thrown off in between. The second most important thing required to ride a wave is to recognize that the a wave is approaching. Which means 90 percent of the times you would find a surfer lying on his surfing board and paddling slowly, waiting for the right wave.

So why are we talking about waves and surfers in a place reserved for discussing mental models?

Latticework of Mental Models: Network Effect

I clearly remember the day, it was in July 1999, when I was first introduced to the internet. I was so excited to get a brand new email address. I could now send and receive emails.

However, the excitement didn’t last very long. I quickly realized that the email address wasn’t of much use to me because none of my family or friends had any email addresses at that time. Who would I mail?

But slowly as more and more people started using internet, my email address became increasingly valuable.

Similarly, I remember the time when the social networking bug bit me and I signed up for Orkut. But within few years when all my friends had moved to Facebook, I was forced to abandon Orkut and climb on the Facebook bandwagon.

So you’d notice that the utility of certain products and services is directly proportional to its number of users. Another recent example that comes to mind is the social messaging app Whatsapp. There are quite a few other messaging services which offer better features than Whatsapp but majority of people continue to use Whatsapp because all their friends are on Whatsapp.

This is called Network Effect. Now the idea may sound very simple, but it’s actually fairly unusual.

When you board an airplane, do you get excited when you see that the flight is completely full? Or when you visit your favourite restaurant, do you prefer it to be crowded? In these cases, as a consumer you don’t get any benefit if the product or service is also being used by others.

But when it comes to social networks like Facebook, Linkedin and Twitter, members join these networks because other members are in this network.

Latticework of Mental Models: Liking Bias

It was March 2007 and I was desperately looking for a tax saving investment product. Until that year I had been sticking to the old fashioned conservative options like tax saving FDs and LIC policies. But the stock market frenzy of 2007 was rubbing off on me.

So when I received a call from a stranger who called himself a “financial advisor” and showed a great concern for my financial well being, I couldn’t say no to his request for a meeting.

Although the young chap seemed to have just a few years of experience in the industry but his demeanor were nothing less than that of a CEO of a large company. He was well dressed, tidy, confident and articulate.

When we met he took interest in my hobbies and complimented me about my reading habits. Needless to say I took an instant liking to him.

He told me about a new financial product called ULIP (unit linked insurance plan). I had never heard of ULIP, so before committing any money to it I borrowed some time from him and did a quick research on google. The reviews on the internet weren’t very encouraging. Some even claimed of unethical mis-selling by private banks and insurance companies as far as ULIP was concerned.

But my financial advisor seemed to know what he was talking and I liked him. He even told me that one of his elder cousin was from my college. So I went ahead and (mis) invested my money.

Latticework of Mental Models: Permutation and Combination

Here’s an interesting trivia.

If you wear different tie on the same shirt, most people will think that you’re wearing a different shirt. That’s an interesting way to multiply your options without really buying new cloths (except few new ties).

“That’s not a trivia, that’s a Jugaad.”, you might want to say. Anyways, That brings me to an equally interesting mindbender.

If you have 2 shirts (white, blue), 3 pants (black, gray and brown) and 3 different ties (pink, orange, red), in how many different ways can you get dressed? Assumption here is that getting dressed requires you to wear all three i.e. a shirt, a pant and a tie.

Using the multiplication principle we can say that there are total 2 x 3 x 3 = 18 ways to get dressed. Of course some of the dress combinations will look outright funny but our concern here is to find out all possible ways to get dressed. Moreover, today we are getting into Maths discipline and most mathematicians don’t really have whole lot of fashion sense anyways.

So that’s the simplest example of using the idea of combinations in real life. Now let’s say, for some strange reason, we were also considering the order in which you put on the cloths, i.e. it matters to us if one puts on the shirt first instead of tie.

Imagine wearing a tie first and then squeezing the shirt inside the tie, funny right? I told you mathematicians don’t care much about the dressing etiquettes 🙂

Okay, back to the same question again. In how many ways can you get dressed if the order of dressing matters?

Latticework of Mental Models: Switching Costs

How many times in last 6 months have you bought something from any of the these websites –

Flipkart
Amazon
Snapdeal

In my case I have used all three, at least once, in last 6 months. With two infants at home, my wife’s favourite online shopping destination is firstcry.com these days. But when it comes to buying diapers, I order from Amazon. Why? Whichever website offers better discount, we go for it. I am not loyal to any particular online store.

Now let me ask you another similar question. How many times have you switched your bank in last 6 months?

In last 1 year? Or in last 5 years?

Well even if another bank comes with an offer of higher savings interest rates, how many people actually take the pains of shifting all their cash and bank deposits to another bank? Very few I guess. My father hasn’t changed his bank in last 30 years.

But why is it that we change our online shopping stores in the blink of an eye but never really change our banks. Even credit cards or demat brokers don’t see too much churning in their customers base. If you talk to bankers, you’ll find that the average turnover rate for deposits is around 15 percent, implying that the average customer keeps his or her account at a bank for six to seven years.

Latticework of Mental Models: The Bystander Effect

“Madness is a rare thing in individuals – but in groups, parties, peoples, and ages it is the rule.” ~ Friedrich Nietzsche

Just after 3 a.m., March 13, 1964 in New York City, Catherine Genovese, a 28-year old woman, was stabbed to death in a parking lot in front of her apartment complex. Catherine’s murder story could have drowned in the middle pages of most newspapers like many other crime stories, except that it didn’t.

Catherine’s murder wasn’t a quick, muffled death. It had been a long, loud, tortured, public event. The killer had chased and attacked her in the street three times over a period of thirty-five minutes before his knife finally silenced her cries for help.

Shockingly, thirty-eight people, all in the surrounding apartments, witnessed at least one of her killer’s three attacks from the safety of their apartment windows for 25 minutes without calling the police.

The story has since been thoroughly debunked, a case of sensational reporting, but at the time it was written it led to intense interest in the phenomenon from psychologists. Even if there is a ten percent truth to above story, it’s a baffling account of a crime, not because it was a murder, but because “good people” failed to call the police.

Why didn’t the neighbours help? Were they indifferent? Frightened? Why should they be afraid of calling the police from the safety of their own homes? Has the violence on TV and movies made people so insensitive? Was it the beginning of a new epidemic known as large scale social apathy?

Interview with the witnesses revealed none of these explanations was the real reason behind people’s inaction.

Latticework of Mental Models: Reason Respecting Tendency

Next time when you approach an ATM machine and find a queue in front of it, try this hack – tell the person in front of the queue “Excuse Me. May I go before you because I have to withdraw money?”

I am sure you haven’t tried this before, neither have I. But at first look it sounds like a lame idea. Why would they let you go ahead unless you have a genuine reason. Isn’t withdrawing money a redundant excuse? Isn’t it obvious that everybody in the queue is there to withdraw money?

But there might be some merit to above idea because in 1970s Harvard psychologist Ellen Langer conducted a similar experiment. She went into a library, where there was a long waiting queue in front of the photocopier, and approached the first person in the queue and asked, “Excuse me. I have five pages. May I use the Xerox machine?” That would probably infuriate a lot of people because everybody was there to make copies. Naturally most people refused to oblige to Langer’s request.

In the second part of the experiment she gave a reason while making a request. “Excuse me. I have five pages. May I use the Xerox machine, because I’m in a rush?” This time most people gave in to her request and allowed her to go ahead. This is reasonable because if people are in a hurry, you would often let them cut into the front of the queue. But then came the interesting twist in the experiment.

In the final part of the experiment she tried another approach, this time saying, “Excuse me. I have five pages. May I go before you, because I have to make some copies?” Now that’s a lame excuse. Everybody in the queue has to make copies, but surprisingly the result in this approach was amazing. She was allowed to pass to the front of the queue in almost all cases.