First principles thinking is one of the most effective mental tools for solving problems, especially the hard ones. And no one embodies this philosophy of first principles thinking better than Elon Musk, founder of PayPal, SpaceX, Tesla Motors and SolarCity.
Musk, in one of his interviews, said –
It’s most important to reason from first principles rather than by analogy. The normal way we conduct our lives is we reason by analogy. We’re doing this because it’s like something else which was done or it’s like other people are doing. It’s mentally easy to reason by analogy rather than by first principles. First principles is the Physics-way of looking at the world. What that really means is that you boil things down to the most fundamental truths and then reason up from there. That takes a lot more mental energy.
For example, somebody could say that battery packs are really expensive and that’s just the way they’ll always be because that’s the way they’ve always been in the past. No! That’s pretty dumb. If you apply that reasoning (analogy) to anything new then you won’t be able to get to that new thing.
For batteries people say, historically it has cost $600 per kilowatt hour and it’s not going to be much better than that in the future. First principles thinking would say, what is the market price of the basic constituents of the battery? It’s got Carbon, Nickel, Aluminium, and some polymers for separation. So breakdown on the material basis and ask, “If we bought that in London metal exchange, what each of those things cost?” Oh! It’s like $80 per kilowatt hour. Clearly, you need clever ways to take those material and combine them into the shape of a battery cell and you can have batteries much much cheaper than anyone realized.
Essentially, first principles are the origins or the main concepts that cannot be deduced from anything else. They are the fundamental assumptions that we know are true.
Musk used first principles thinking not only for making inexpensive battery packs for his Tesla cars but also for building cheaper rockets for his other space exploration company SpaceX.
Life is mostly about applying the basics, tweet Naval Ravikant, a famous investor and entrepreneur, “and only doing the advanced stuff in the things that you truly love and where you understand the basics inside out.”
John Boyd, a military strategist, explains the idea brilliantly by using a simple thought experiment.
Imagine you have three things:
- A motorboat with a skier behind it
- A military tank
- A bicycle
Now, let’s break these items down into their constituent parts:
- Motorboat: motor, the hull of a boat, and a pair of skis.
- Tank: metal treads, steel armor plates, and a gun.
- Bicycle: handlebars, wheels, gears, and a seat.
What can you create from these individual parts? One option is to make a snowmobile by combining the handlebars and seat from the bike, the metal treads from the tank, and the motor and skis from the boat.
That’s the simplest way to explain this mental model. Even your 7-year old can understand it. First, deconstruct. Second, reconstruct.
Practicing first principles thinking is not as easy as explaining it. As Musk said, it’s mentally taxing. Thinking from first principles is devilishly hard to practice.
The first part, i.e., deconstruction, demands asking intelligent questions and having a deep understanding of the fundamental principles from various fields. And that’s why building a latticework of mental models is so important. These mental models are the fundamental principles, the big ideas, from different fields of human knowledge.
The best way to achieve wisdom, said Charlie Munger, “is to learn the big ideas that underlie reality.”
The second step is the recombination of the pieces which were identified in the first step. This is again a skill which can only be developed by deliberate practice. Any idea as an isolated piece of information doesn’t stay in the human brain for long. To be sticky, it needs to be connected with other ideas. A latticework is essentially a grid of ideas connected to each other. These connections are the glue which holds those ideas together.
If the new knowledge doesn’t find any connection or relevance to the old knowledge, it will soon be forgotten. New ideas can’t just be “stored” like files in a cabinet. They have to connect with what’s already there like pieces of a jigsaw puzzle. As you become better in finding connections between seemingly disconnected ideas, your recombination-muscle becomes stronger. Someone with a strong recombination-muscle will find it easy to practice the second step of first principles thinking.
In his book Succeeding, John Reed wrote:
When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.
Recombination of ideas is a remarkable skill. When you become good at deconstruction and recombination, you become good at identifying the information which is new and which is a reconstruction of fundamentals. This means you process new ideas much faster because of your ability to filter out the stuff that’s just rehashing of basic principles.
So how does this mental model help an investor make better investing decisions?
First of all, if you’re looking for the next Eicher Motors or next Page Industries, then you’re thinking from analogy. Using analogies is the conventional thinking and has its own limitations especially in investing because it can blindsight you.
So, using first principles thinking, we would need to break down the fundamental problem every investor faces – should I invest in a given stock? – into its constituent questions. What are those constituent questions?
As a value investor, here are few that I can think of –
- Do I understand this business? Is it in my circle of competence?
- Does this business have a durable competitive advantage, a moat?
- Is it run by a management which is capable, honest and minority shareholder friendly?
- Can I estimate the value of the business and is there sufficient margin of safety at the current price?
As for the recombination step, in this context, it would mean being clever about giving right weightage to each answer. You would need to interpret the answers in light of few other factors like the type of your investment portfolio and your investment horizon. For example, do you run a concentrated portfolio of fewer than ten stocks or do you have a diversified holding of twenty-five stocks? Are you investing for specific financial goals 5-10 years down the line or you have a longer, say 30 years, investment horizon?
Now, to answer the above questions, an investor may have to sift through a mountain of other data. For example, how the industry works, the competitive landscape, the historical performance of the business, the history of execution by the management, the future potential of the business, etc. Each of these factors, in turn, depends on a dozen other parameters. Fortunately, it’s not very difficult to get answers to most of these questions in these days, thanks to technology and the Internet. But how do you separate the signal from the noise?
So, the second important insight from first principle thinking is this – identifying the right questions. James Clear, in his wonderful post on first principles thinking, writes –
In practice, you don’t have to simplify every problem down to the atomic level to get the benefits of first principles thinking. You just need to go one or two levels deeper than most people. Different solutions present themselves at different layers of abstraction.
So by focusing on the fundamental questions and then while answering them, going 2-3 levels deeper by asking “and then what” at every step, will get you the core of the problem.
One of the primary obstacles to first principles thinking, writes James Clear, “is our tendency to optimize form rather than function.”
In investing, focusing on the form would mean getting seduced with multi-baggers or the latest fads and investing strategies. One could identify ten multi-baggers and still have nothing to show for it if he invested only 0.5% of his portfolio in his multi-bagger picks.
The form of investing – identifying multi-bagger stocks – can take our focus away from the function of investing – compounding money over the long-term.
We recently interviewed Jana Vembunarayanan for our Value Investing Almanack. Jana said:
Any business you look at, there are 2 or 3 important variables that matter the most. It can’t be twenty things. Finding those 2 or 3 things is super important. You can’t do this for every business, but you can do for some. Once you get the key variables right, you should take a decent position when the odds are in your favour.
Those 2-3 important variables that Jana is talking about are like the fundamental principles that determine the quality of that business.
When Jeff Bezos started Amazon.com in 1995, he cleverly identified the first principles that would guide his business philosophy. His first principles were –
- Focusing on the long-term.
- Focusing on the customer rather than the competition. This lead Amazon to focus on things that don’t change rather than things that change, e.g., low prices, fast delivery and wider product selection.
Bezos continues to hammer on these first principles.
Let’s summarize the first principles thinking mental model. In fact, I’ll let Musk do the job. While answering on a Reddit AMA, Musk said:
It is important to view knowledge as sort of a semantic tree — make sure you understand the fundamental principles, i.e. the trunk and big branches, before you get into the leaves/details or there is nothing for them to hang onto.
Well, if you disagree with him, you can always create your own SpaceX and Tesla and prove him wrong.
Thanks for reading.