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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.

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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?
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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.

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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.

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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.

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Latticework of Mental Models: Asymmetric Information

Exactly eleven days after buying my windows smartphone, I realized my mistake. Unfortunately, the ten day return window (no pun intended) had already closed.

So I listed it for sale on couple of online used item marketplaces (OLX, Quikr etc.). To my utter surprise no one was willing to pay more than 70 percent of the original cost for my brand new phone. Was my phone model so bad?

But I found that almost all the other similar deals for used electronic gadgets (which were only few days old) were being sold at significant discount to MRP. I was quite sure that many of those sellers, like me, were selling because they didn’t like the product, and not because there was some defect in it.

Then why was the used-item-market heavily discounting the price for an item which was almost brand new? I also noticed that there wasn’t much difference between the price of a 1 year old phone a 1 month old phone of the exactly same brand and model.

Another observation – the number of listings for relatively newer items were very few as compared to the ones for 1-2 years old items. Why so?

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Latticework of Mental Models: The Halo Effect

Complexity is the indispensable thread in the fabric of world of business today. As a result, in spite of all the secrets formulas and all the self-proclaimed thought leadership, success in business is as elusive as ever. Unlike hard sciences there are no immutable laws in management because managing business isn’t a science.

Rajiv Bajaj, Managing Director of Bajaj auto, said this in one of his talks

I joined the company [Bajaj Auto] twenty years back. In my college I was trained to think ‘Just in Time’ because it was supposed to be one solution for all the problems. And then somebody said, Just in Time is not enough. They said there must be Kaizen, World class manufacturing, Toyota production system, Kawasaki system, automation and robotics. Then they said you must also know CAD, CAM, simultaneous engineering, re-engineering, six-sigma, TQM, and you must wear six hats, follow seven habits, look for blue oceans, be a bit of a maverick and indulge in management by walking around. Every time I learnt something new, I found myself back at the starting point. There was always the new book on the shelf, and there was always the new consultant on the seminar circuit. And these guys would do anything to keep themselves in demand and keep all of us confused. So I decided to ignore all of these.

Rajiv Bajaj turned around Bajaj Auto from a loss making company in the year 2000 to the most profitable auto company in world and it’s pretty clear from his talk that he didn’t do it just by blindly listening to those management experts and celebrity CEOs who claim to have the next new thing.

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