This article is the second of this new weekly series called Latticework of Mental Models, which will be authored by my friend and partner in writing the Value Investing Almanack, Anshul Khare. Anshul will write on various mental models – big ideas from various disciplines – which can help you think more rationally while analyzing businesses and making your stock investment decisions.
Have you ever wondered why Mark Zuckerberg (founder of Facebook) always wears the same grey t-shirt? Do you remember Steve Jobs’ black turtleneck that he wore for all his stage appearances?
These billionaires could afford anything in the world. Then what’s going on here? I’ll give you a moment to think about it and come back to it later in this post.
Last week, we delved into the characteristics of complex systems and discussed few ideas to protect ourselves from unintended consequences produced by complex adaptive systems.
However, just because we have discovered a tool to address a problem doesn’t mean that we should go on using it for every problem. Charlie Munger nailed it when he said –
To a man with hammer everything looks like a nail.
We don’t want to be that ‘man with hammer’. So what am I suggesting here?
Perhaps you have heard it numerous times before but let me just make you read it once more – “An ounce of prevention is better than a pound of cure.”
How about dealing with a situation just by avoiding it?
To answer that, let me start by introducing the mental model for today. It’s called Occam’s Razor, named after 14th-century English logician, theologian and Franciscan friar, William of Ockham. Wikipedia explains –
Occam’s razor is a principle of parsimony, economy, or succinctness used in logic and problem-solving. It states that among competing hypotheses, the hypothesis with the fewest assumptions should be selected. Other, more complicated solutions may ultimately prove to provide better predictions, but—in the absence of differences in predictive ability—the fewer assumptions that are made, the better.
Don’t get bogged down by it’s complex sounding name because complex is what it is not! Simply stated it means – all things being equal, the simplest solution tends to be the best. Let’s explore this idea further.
In investing, simplicity is the way to long term success. Warren Buffett supposedly has a ‘too-hard’ bucket on his desk and majority of the ideas that he comes across end up in that bucket. He says –
The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective….We haven’t succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself.
In his 1990 letter to shareholders, he wrote –
After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.
Buffett has been emphasising on the idea of simplification for a long time. This is what he wrote in his 1993 letter –
…we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us.
Charlie Munger agrees –
People calculate too much and think too little….we have a passion for keeping things simple. If something is too hard, we move on to something else. What could be more simple than that?
As simple as possible, but no simpler. Search for simpler business that requires fewer assumptions and fewer hypothetical scenarios to work out. After all the research, due diligence and sufficient margin of safety, the investment decision should look almost like a no-brainer.
You don’t get paid anything extra for cracking difficult cases or figuring out a hidden moat in a convoluted business model. And the funny thing is that even if you solve a complex problem with multiple variables, you can never be sure that it was completely your skill and not dumb luck.
In engineering it’s the “KISS principle” (keep it simple, stupid) – avoiding complexity and overspecification.
Avoid Unknowable and Unimportant
The first step to simplification is to understand the futility of running after things that are unknowable and unimportant. Buffett explains –
There are two questions you ask yourself as you look at the decision you’ll make. A) is it knowable? B) is it important? If it is not knowable, as you know there are all kinds of things that are important but not knowable, we forget about those. And if it’s unimportant, whether it’s knowable or not it won’t make any difference. We don’t care.
Where the interest rates are going, what the stock market is going to do next, etc. are all important but unknowable. Avoiding the activities heavily influenced by unknowable is an act of simplification. Similarly, before attacking a problem ask if it is worth solving?
Focus, Focus, Focus
Second step to simplification is focus. When one tries to accomplish too many things simultaneously, he/she ends up doing all of them poorly.
Decision making is simpler when we focus on one thing at a time. Multiple researches have shown again and again that human brain is not optimized for multitasking especially when you are working on complicated and unfamiliar tasks.
This is what Buffett says about focus in his 1997 letter –
..serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse…Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.
Don’t forget the Pareto Principle – “80% of your profits come from 20% of your activities.”
Focus on those top 20% activities and de-prioritize the bottom 80%. And this is why Buffett’s philosophy of sticking to your circle of competence makes so much sense.
Invert, Always Invert
Third trick for simplification is to start backwards. Instead of trying to arrive directly at the solution, start eliminating the options which aren’t correct. You get enormous advantage by narrowing down your problem space and then you can bring your attention to more productive regions.
Keep asking ‘why not’ until you reduce the problem to more fundamental body of knowledge. Ask: Why am I doing this? What really matters? Will more information affect my decision?
Here is a simple but brilliant insight from Sherlock Holmes –
How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?
In fact, in Peter Bevelin’s A Few Lessons from Sherlock Holmes, the detective is quoted as saying –
There never was a sounder logical maxim of scientific procedure than Ockham’s Razor…before you try a complicated hypothesis, you should make quite sure that no simplification of it will explain the facts equally well.
Sometimes people confuse intelligent simplicity with being dull. It’s not. The art of being wise is the art of knowing what to overlook. And it’s not just true for problems and situations but people also. Stop giving attention to the wrong people. I don’t know who said this but it made a ton of a sense when I read it –
You can never do enough right things with wrong people.
And that’s precisely what Buffett has done in his business and personal life. He always chose to work with people whom he liked and trusted. As a result he rarely had to deal with nasty problems created by bad people.
When it comes to investing, the world’s best behavioural economist, Professor Daniel Kahneman, suggests that we should simplify our financial plan –
Keep it simple and aim to beat inflation. Don’t try to beat the market. When it comes to investing, less is more. And if you try to do more, you’ll often end up with less.
Do you have 100 different stocks in your portfolio spread across 5 different demat accounts? I urge you to simplify. Make fewer decision, make better decisions. This give us enough room to think about each decision deeply and reduces the chances of making a mistake.
And now you can guess the reason behind Mark Zuckerberg’s and Steve Jobs’ preference for wearing the same attire. It is a great example of simplifying life. Making decisions is exhausting. The more decisions you make the less will power you have. It’s called decision fatigue. Zuckerberg and Jobs understood this. They used Occam’s Razor to slice out the need for wasting mental energy everyday on unnecessary elements, what to wear being one of them.
In fact, building a latticework of mental model is nothing but a way to simplify your decision making process. What could be simpler than to just run through your checklist of mental models while solving a problem?
The mental model of Occam’s Razor has been accepted widely among many disciplines. I was surprised to find out that there is even a programming language named after Occam. It was created as a means to keep the programming process simple.
Bear in mind that Occam’s Razor doesn’t prove anything. Also, while it is a very useful mental model, it should not be seen as a substitute for good empirical testing. It relies on subjective assessment of simplicity, rather than an objective tests in evaluating arguments. It’s not a rule. It’s more of a guide or a suggestion. You may get tempted to make it ‘the hammer’ for nailing every problem you see. Don’t assume simplicity where there is none.
While Sherlock Homes was looking first for the simplest, most natural explanation for a case, he also believed in not over-simplifying complex matters, especially when dealing with systems with complicated interactions.
Then, while Albert Einstein also believed in the power of simplicity, he understood its limitations –
Everything should be kept as simple as possible, but no simpler.
Here’s a short video illustration that we made for Occam’s Razor.
Click here if you can’t see the video above.
Before wrapping up, let me reiterate – acquisition of knowledge at first may seem like a daunting task, but it’s amazing what you can achieve with a slow and steady progress – one idea at a time. Even people with ordinary intelligence can outthink the smartest people if they develop certain thinking habits.
With another mental model in your armour today, you’re already quite ahead on your way to compounding knowledge. Remember, becoming a better thinker won’t just help you in investing and business. You will soon realize that its positive effects have started overflowing into other areas of your life as well. The odds are high that you will end up leading a very satisfying life.
I hope that this journey towards worldly wisdom that we have started together, will be inspiring and fulfilling for both of us.