Margin of Safety, or why you should always save for a rainy day

[Note: I shared this mental model with my email subscribers on Feb 12, 2017. If you want to receive a new mental model every week, join the club.]

Margin of Safety: You build a bridge that 30,000-pound trucks can go across, and then you drive 10,000-pound trucks across it.

What it is:

Margin of safety is a critical principle in engineering.

Let’s say we’re building a bridge, and the maximum weight of vehicles we expect on the bridge is 5,000 tons. So do we build it to withstand 5,000 tons? 6,000 tons?

No. We build it to withstand 20,000 tons. That’s the margin of safety.

When you save “for a rainy day”, that’s what you’re doing. Building a contingency fund. A margin of safety for your lifestyle, should you lose your job.

As Seth Godin explains in Breakpoints: when laying a sidewalk, workmen don’t put long slabs of concrete in place. Instead, they keep small gaps every few feet. That’s a margin of safety too – in case the concrete breaks or expands in unpredictable ways.

Examples from business:

  • Investing: Margin of safety is a core tenet of value investing, popularized by Benjamin Graham and David Dodd. As Warren Buffett, a long-time protege of Ben Graham, says: “If we calculate the value of a stock to be only slightly higher than the price, we’re not interested.”
  • Startup fundraising: You don’t raise just enough capital to get to your next round of funding. If you want to raise your next round at $1Mn in revenue, raise enough now to get to $2Mn. Better still, raise enough to become profitable. Similarly, don’t start looking for investors when you have one month of cash in the bank. Start when you have six.
  • Capacity planning: Most services organizations keep a bench (idle employees) of up to 20% of their total headcount. So that they can service any sudden requirements. Same goes for manufacturing – as they say, if you have 20% spare capacity, you have no spare capacity.
  • Project planning: When drawing out a project plan, always put in a few buffer days / weeks.
[Aside: we almost never do this. There’s even a name for it. The planning fallacy – how we believe that this time, unlike all previous times, we’ll finish the project on time.]

Rules to follow:

  1. Always build a margin of safety. Whatever you’re doing, estimate how long, how much money, etc. it’ll take. Then add a buffer.
  2. Expect your plans to go awry. Do a premortem. And then build redundancy / backups.

As Seth Godin says in the article above, there’s no doubt the ground will shift. The question is: when it does, will you be ready?

Further Reading:

 

Linked to: Redundancy, Premortem

Filed Under: Engineering

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Cognitive Dissonance, or why it’s so hard to persuade people with facts

[Note: I shared this mental model with my email subscribers on Feb 5, 2017. If you want to receive a new mental model every week, join the club.]

Charlie Munger Quote on Cognitive Dissonance

Why is it so hard to persuade people with facts?

You feel like their argument stands on three key pillars, and you’ve destroyed all of them with hard data. Still, it remains standing. In fact, they’ve dug their heels in even more!

Why does being corrected trigger feelings of anger and dismay?
Short answer: Cognitive dissonance.

 

What it is:

Why does cognitive dissonance happen? As this article says, there are two main reasons:

  • Our brains don’t store facts as standalone pieces of information. We remember data points as a network of interrelated “facts”. So, when one of them is called into question, it feels like the entire network of beliefs is threatened. Loss aversion kicks in.
  • When an argument threatens your world view, self concept, or your very identity, facts can even backfire. You become more convinced of your erroneous stand, when you hear you’re wrong.

Strange things happen when you think your identity is attacked.

See the GMO study in the article above, or this interesting example of cognitive dissonance from the ever-provocative Scott Adams.

And cognitive dissonance isn’t triggered only in an argument. In any setback, you choose the interpretation most favorable to your self esteem. Just ask Aesop:

The Fox & the Grapes - Cognitive Dissonance

Rules to follow:

So, what do you do? Or, as the title of this section says, how do you convince someone when facts fail?

  1. First, articulate the opposite position accurately. Acknowledge that you understand why someone could hold that opinion.
  2. Stick to the facts, and layer them up gradually. First, the raw information. Then, a second order inference. Agree on both. Only then, bring up your controversial conclusion.
  3. Keep emotions out. Discuss, don’t attack. No absurd absolutes. No ad hominem. And definitely no ad Hitlerum.
  4. Don’t activate identity when arguing a point. Show how changing facts doesn’t necessarily mean changing world-views.

If you and your stubborn interlocutor are a little geeky, try the Double Crux method. [I’m still trying to find a fellow geek I disagree with, to try this.]

Further Reading:

 

Linked to: Confirmation Bias

Filed Under: Psychology & Human Behavior

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The Premortem, or how foresight can also be 20:20

[Note: I shared this mental model with my email subscribers on Feb 5, 2017. If you want to receive a new mental model every week, join the club.]

Premortem

Or as more ancient stoics said, “Premeditatio malorum”. Or “premeditation of evils”.

 

What it is:

We’ve all heard of the postmortem in business. When something goes wrong, all the decision-makers get together to diagnose what happened. And learn how to prevent it from happening again.

In theory, at least.

What really happens though, is an advertisement for hindsight bias. Everyone suddenly remembers how they “always knew it wouldn’t work”.

As Amos Tversky said, “The writing may have been on the wall all along. The question is: was the ink invisible?”

A premortem asks the same question as a postmortem, but before you embark on your endeavor. “It’s two years from today, and our plan has been implemented. But it’s been a disaster. What went wrong?”

Explicitly going through such a thought experiment can help avoid the overconfidence and groupthink that team decisions can suffer from. We all love “playing the devil’s advocate” – here’s an executive license (and order) to do so!

Examples of premortems / thought experiments:

Here are a few examples of thought experiments to try.

1 Year from Now:

  • We haven’t hit product-market fit yet. We took too long to launch our initial product. What features could we have left out?
  • Half our customers didn’t renew their contracts. Why? What went wrong?

 

3 Years from Now:

  • Our startup has just shut down. We just couldn’t hit a growth trajectory. What are the reasons for this failure?

 

Rules to follow:

  1. When you’re making a big decision, make sure you think about what could go wrong. And protect against it. Don’t only think about what happens when the plan works – you’ll fall prey to the focusing illusion.
  2. Every few months, revisit and repeat the premortem. Have you covered for the main risks? Have any new risks opened up?

Further Reading:

 

Linked to: Focusing Illusion, Hindsight Bias

Filed Under: Decision-making

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The focusing illusion, or why “it’s not really as important as you think it is”

[Note: I shared this mental model with my email subscribers on Jan 29, 2017. If you want to receive a new mental model every week, join the club.]

Focusing Illusion Quote

What it is:

Have you been subjected to this nifty party trick? A person at the party claims to be able to read your psychology from manipulating your hand.

He presses your thumb backward, and says, “Hmm, you look like you’re often stubborn.” You’re surprised – it is true!

Later, you cross paths again. This time, he presses the thumb back and says, “You’re a surprisingly flexible person.” And that seems true too. You can think of several instances when you demonstrated surprising flexibility.

 

So which is it? Probably neither. You, my friend, have been subjected to the focusing illusion.

Just like the respondents to a question, “Are you adventurous?” in a research study. 97% said “yes”.

When you think of or focus on something, your subconscious assumes it’s important. After all, why would you think about it otherwise?

It’s recursive logic, with a healthy dollop of confirmation bias.

You focus on it, therefore it’s worth focusing on.

 

Examples in business (and elsewhere):

What you focus on seems important.

  • When you’re fundraising, it seems like make-or-break for your startup. But it isn’t. Money from customers, not investors, will drive success for you. If you’re building something useful, you’ll find a way.
  • You commit a silly mistake at work on Friday evening, and then you’re in torment all weekend. But your boss – he barely notices it on Monday morning. It wasn’t that important after all.
  • “There’s no such thing as bad publicity.” Fading movie stars crave it – at least it gives them presumed importance in the public’s eyes.

What you focus on seems true.

  • The positive test: In deciding whether a possibility is correct, we look for hits rather than misses. Just like the adventurous respondents in the survey above, we can be flexible or stubborn. It depends on the question. This kind of one-sided question (e.g., asking only whether you’re dissatisfied about a situation), is called a positive test. Beware when you hear such a question – maybe your counterpart wants to send you down a specific line of thought.
  • Medical students and their diseases: It’s common for medical students to feel they’ve contracted the latest disease they’ve heard about. They read that pneumonia produces pain in a particular place, concentrate attention on it, and get alarmed at the slightest sensation. This is so common, there’s an aphorism for it in medicine:

“When you hear hoofbeats, think of horses, not zebras.”

  • If 2016’s Brexit and US presidential campaigns have taught us anything, it’s this: Say anything often enough, and people will think it’s true.

What you focus on seems causal.

  • Offer people a lot of money to do something, and they’ll do it for free. The listener automatically assumes the task is very important to you. (That’s why you’re willing to pay so much!). Try this the next time you’re trying to jump ahead in line.
  • The most visible action is assumed to be causal: When a company misses its projections, newspapers attribute it to a recent government announcement. Or a tepid product launch to a bad ad campaign.

 

Rules to follow:

How do we save ourselves from the focusing illusion?

  1. Don’t make big decisions in the heat of the moment. It’s quite likely you’re overestimating the importance of a couple of factors. Calm down, sleep on it, and make the decision later.
  2. Beware of one-sided questions. It’s quite likely that your counterpart is priming you towards an answer they prefer.
  3. Whenever you’re making a big decision, do a premortemMake sure to think about what could go wrong, and protect against it.
  4. In summary, remember Kahneman’s adage: Nothing is as important as you think it is when you’re thinking about it.

Further Reading:

 

Linked to: Confirmation Bias, Availability Heuristic

Filed Under: Psychology & Human Behavior

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Occam’s Broom OR “You don’t know what you don’t know”

[Note: I shared this mental model with my email subscribers on Jan 22, 2017. If you want to receive a new mental model every week, join the club.]

Occam's Broom: "You don't know what you don't know"

My wife berated me the other day for forming a strong opinion about something (I forget what) without knowing all the facts. To which I responded with a question: Is it even possible to know all the facts?

Pride at being a smart alec notwithstanding, the conversation reminded me of this mental model. So, thanks hon!

What it is:

Philosopher Daniel Dennett talks about Occam’s Broom, a play on Occam’s Razor (a mental model for another day).

He uses the term to describe how, when we’re making an argument, we have a tendency to whisk inconvenient facts under the carpet.

And this tendency, already questionable, becomes downright insidious when experts present their arguments to the layperson. And completely leave out pertinent (but contrary) evidence.

Or when journalists present only half the story in the garb of “news”. Move over fake news – at least those guys aren’t pretending to themselves that they’re telling the truth!

And the worst thing is – you cannot do anything about Occam’s Broom. You’re helpless. After all, you don’t know what you don’t know!

Examples in business:

  • Evaluating partnerships / acquisitions: When you’re assessing a company to acquire / partner with it, you can only ask so many “right questions”. You never know where a black swan may be lurking. That’s probably why half of M&A deals fail.
  • Deciding on potential product features / business choices: If your team presents a new business opportunity / product feature, you can expect to mainly hear the pros of the choice. Sure there’ll be cons, but most of them will be strawmen.
  • Listening to a sales pitch: Let’s say a salesman presents you the latest software to revolutionize your business, or a “sure” stock pick. You have no way to know what he’s not telling you.
  • To assess whether a hypothesis is true, you need to test it. You can talk to all the experts you want. But you won’t get decisive answers unless you ask the right questions. And you don’t know the right questions!

 

Rules to follow:

OK, we get it. You don’t know what you don’t know. What do you do then?

  1. Whenever you’re making up your mind about something, recognize that you may not know all the relevant factors.
  2. Avoid forming opinions in areas where you’re not an expert. Keep your identity small.
  3. Sometimes, you do have to form opinions based on incomplete facts. In such cases, remember the adage “strong opinions, weakly held”. Form decisive opinions, but change them when the known facts change.
  4. Whenever someone offers you a strong / extreme opinion, get your guard up. Reality is not as stark as Occam’s Razor would argue.
  5. Tread carefully in a new area. Do a “pilot”.  No matter how much you’ve analyzed it. It’s a hypothesis till it proves itself in action.

Further Reading:

  • Occam’s Broom
  • Intuition Pumps: Daniel Dennett’s book, which introduces this model. [Warning: it’s not an easy read]. Also check out this article for a collection of his critical thinking tools – mental models in their own right.

 

Linked to: Occam’s Razor

Filed Under: Psychology & Human Behavior

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The Power of Exponential Growth OR Why you are not late

[Note: I shared this mental model with my email subscribers on Jan 15, 2017. If you want to receive a new mental model every week, join the club.]

Exponential Growth

I complain about this often. And I’ve heard others grumble in a similar vein. Whether entrepreneurs, technologists, scientists, economists, you name it – “I wish I was born when all the action was happening.”

But here’s the thing – as Kevin Kelly says in You are not late, you can bet that in 2045, someone will say the same thing about 2015.

The last 30 years have created a platform, from which ever new exciting things can result. Whether it’s AI, virtual reality, nanobots, etc. – it’s likely that the key technologies of 2045 will be very different from the ones today.

So, next time you complain about being too late to create Microsoft or Google or Facebook or string theory, read this. You are not late.

But the article also illustrates a larger point – the power of exponential growth.

What it is:

Exponential Growth - Bill Gates Quote

That’s the best summary of exponential growth I’ve seen. Our brains can think only incrementally. But technology improves exponentially. Advancements pile on each other.

For a long time, nothing seems to be happening. Then all of a sudden, hypergrowth.

Credit: Mother Jones [http://www.motherjones.com/media/2013/05/robots-artificial-intelligence-jobs-automation]

I bet you’ll see the above graphic again and again. The last bit of shooting growth always astounds us. Despite it often being a mathematical certainty.

It’s not for nothing that Einstein (is rumored to have) said, “Compound interest is the 8th wonder of the world.”

 

Examples:

  • Moore’s Law: Gordon Moore’s prediction in 1975 that computing power would double every 18-24 months [I paraphrase] has held remarkably true. This regular doubling has given us PCs, mobiles, smartphones, and now AI.
  • Adoption rates of consumer technologies: As this graph shows, adoption rates of consumer technologies are ever-accelerating.
  • Look at any of the major growth stories of the last few years – Uber, Airbnb, etc. In each new market, they started small. No one noticed them, or worse, they dismissed them as irrelevant, non-scalable, or playthings of the rich. Till, suddenly, their dad started using them.

 

Rules to follow:

  1. When planning your career, try to work in sectors that are growing exponentially. Growth creates options.
  2. Don’t skate to where the puck is. Skate to where it will be. To requisition Wayne Gretzky’s memorable words, go where the future will be. Build skills that will be useful tomorrow.

Bottomline: The future will always be more different from today than today is from the past. The future adds a zero.

Ergo, the best time to start something new is NOW.

Further Reading:

 

Linked to: Power Law

Filed Under: Mathematics & the Sciences

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Same Side Selling, or Sales as a Jigsaw Puzzle

[Note: I shared this mental model with my email subscribers on Jan 15, 2017. If you want to receive a new mental model every week, join the club.]

What it is:

For a long time, we’ve had this notion of great salesmen as master persuaders. Skilled negotiators who can seal the deal. Who use anchoring, pricing hacks, false urgency, etc. to close the sale. And if that doesn’t work, they use bull-headed tenacity to wear down the customer into a tired “YES”.

But as Same Side Selling (an excellent, short book) says, nothing could be further from the truth. 

Our mental model of selling is wrong. Sales is not an adversarial game, where you “close a sale” or “hit up your targets”.

Instead, look at sales as a jigsaw puzzle.

Sales is not:

Chess

How can I bamboozle you?

Sales is:

Jigsaw puzzle

Let’s solve this together.

The moment you change the metaphor, your frame of reference changes. Completely.

 

Examples in business:

  • You are not on opposite sides of the table. This is not like chess or checkers. Like when you’re solving a jigsaw puzzle with your friends, you and your customer are on the same side!
  • Do you have the right piece for the puzzle? Are you solving the customer’s problem? Or are you selling the solution you have, with scant regard for whatever the customer’s problem may be? Focus on benefits, not features. Focus on the “job to be done”.
  • Sometimes, the pieces don’t fit together. Maybe the client needs something else. Can you help him find it, even if it’s from another vendor?

If your job / business / life involves selling (and trust me, it does), this subtle change in the game metaphor will change your approach forever.

 

Rules to follow:

  1. Start with what the customer wants. How you can help?
  2. When selling, focus on benefits, not on features. Remember – you’re not selling saddles. Your customer is buying a better way to ride.
  3. Always think from your customer’s point of view. You’re not selling to her. You’re working with her. Helping her solve a problem. You’re on the same team.

Further Reading:

 

Linked to: Job to be done

Filed Under: Sales & Marketing

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The Procrastination Equation OR How to never be late again

[Note: I shared this mental model with my email subscribers on Jan 15, 2017. If you want to receive a new mental model every week, join the club.]
Procrastination

Should I procrastinate now? Or can I do it later?

What it is:

Piers Steel, in his book, outlines the Procrastination Equation:

Motivation = [Expectancy * Value] / [Impulsiveness * Delay]

That is the sum total of why we procrastinate. As Steel says:

Decrease the certainty or the size of a task’s reward – its expectancy or its value – and you are unlikely to pursue its completion with any vigor. Increase the delay for the task’s reward and our susceptibility to delay – impulsiveness – and motivation also dips.

 

Examples / how to use it:

How can we use this equation to beat procrastination?

  • Increase expectancy of success: In essence, we need to increase our optimism regarding success in the task in question. How do we do that? By creating a spiral of success – break the task into sub-tasks, and start completing and ticking them off.
  • Increase the task’s value: The more valuable something is to us, the more likely we are to do it. So, how can we increase the reward for completing something? Maybe we reward ourselves (with chocolate?) for doing something we’ve been putting off (filing taxes?). Or, we can “mix bitter medicine with sweet honey” – try to make the task more enjoyable (e.g., by having premium coffee while doing it.).
  • Decrease impulsiveness: According to the book, this is often the biggest factor. How do we fix this? The only solution – set clear, measurable goals in advance. Commit now, to do later.
  • Decrease delay: Usually, this is not in our hands. But if you can, artificially constrain the deadline for a task. Use Parkinson’s Law to get things done.

 

Rules to follow:

  1. Notice when you’re procrastinating.
  2. Guess which part of the equation is causing the problem. Fix it.
  3. If that doesn’t help, look at the other factors again. Repeat. 

Further Reading:

 

Linked to: Parkinson’s Law

Filed Under: Productivity

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Goals vs. Systems OR The right way to make New Year’s resolutions

[Note: I shared this mental model with my email subscribers on Dec 18, 2016. If you want to receive a new mental model every week, join the club.]

Goals vs. Systems

What it is:

It’s that time of the year. We’re all thinking about past resolutions we couldn’t keep, and resolving to be more faithful to our resolutions for the coming year.

Most of our resolutions are of the form: “Next year, I will do X”. Where X could be: “lose 10 pounds”, “run a marathon”, “get up at 5 am everyday”, “hit a million dollars in revenue”.

But point goals such as these have a number of disadvantages:

  • The focusing illusion: When you focus on your goal, it becomes more important in your head than your primary objective (e.g., “to be happy”). Till you realize one day – it’s not making you happy at all.
  • Dependence on outcomes extrinsic to you: Extrinsic goals tie your self-worth to factors that you don’t have complete control on. This (a) reduces intrinsic motivation, and (b) increases irrational risk-taking, as a Harvard study shows.
    Think running a marathon despite a niggle, only because you’d resolved to 9 months ago.
  • Goals can seem overwhelming and amorphous: Sure, you want to get to a million dollars in revenue, but where do you start?

And, as Scott Adams says:

OK, so what should we do instead?

Focus on process. On systems.

 

What does that mean? Break down your goal into its constituent parts – the specific actions you’d take to achieve that goal. Focus on those instead.

Such an approach gives more opportunities for daily victories (“I exercised today”), and sustains motivation.

But more importantly, it also prevents tunnel vision. If something else comes along that’s better than your previous goal, your mind is free to notice it.

Thus, a systems approach takes you from low odds of success to much higher odds.

From “I need to achieve this specific goal, else I fail” to “I’m building skills and creating options, and I’ll take advantage of whatever comes”.

 

Examples in business:

  • Career Planning: Don’t “plan” your career, as Marc Andreessen says in his career guide. Instead, make choices that maximize your future options / upside. Go where the action is.
  • Starting a company: Don’t over-invest in the solution you’re building. Instead, start with the customer. Identify the problem, and experiment with different solutions till one “catches fire”.
    Hypothesize > Test > Rinse and Repeat till you succeed. This is not novel – it’s the Lean Startup approach.
  • Marketing: Don’t try every single new marketing channel to get to 1 Mn users. Instead, use the Bullseye approach – prioritize 3 marketing channels, and experiment with them. Once you saturate them, unlock the next ones.
  • Any risky endeavour: Preserve and generate optionality. Understand how you can maximize potential upside and minimize downside risk.

Stack the cards so that you come out ahead even if you fail (e.g. learn unique / hard-to-replicate skills, build a strong network of influencers, etc.). Plus if Lady Luck smiles, you rake in a windfall.

 

Rules to follow:

  1. Focus on inputs (which you can control), not on outcomes (which you can’t). Create a process for success. Follow the process.
  2. Ask the question: How can you take key extrinsic risks out of the equation? How can you increase the odds of your actions having the desired result?
  3. In any decision, choose the path that creates the most options.

TL:DR: Success is a system (take several high reward / low risk bets), rather than a goal (I want to get rich).

Further Reading:

 

Linked to: Focusing illusion, Antifragility

Filed Under: Decision-making

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The Pareto Principle and the Minimum Effective Dose

[Note: I shared this mental model with my email subscribers on Dec 11, 2016. If you want to receive a new mental model every week, join the club.]

 

Out of more than 120 wholesale customers, a mere 5 were bringing in 95% of the revenue. I was spending 98% of my time chasing the remainder. – Tim Ferriss, Four Hour Work Week

What it is:

Most of us are familiar with the Pareto Principle. 80% of your sales come from 20% of your clients. 20% of people produce 80% of your enjoyment and propel you forward. But 20% produce 80% of your anger too.

A few factors have disproportionate influence.

Some of us are also familiar with Pareto’s more extreme cousin – the power law.

But fewer of us make the jump to its immediate corollary – the Minimum Effective Dose (MED). 

 

I first came across this in Tim Ferriss’ books. He defines it as “the smallest dose that will produce the desired outcome”.

The logic goes – if 20% of tasks produce 80% of the results, then you need to focus only on this 20%. In most avenues of life, where perfection is not the goal, this 20% is all you need to be effective.

This was one of the big ideas of 2015 for me. It transformed how I think. See more here.

Minimum Effective Dose

The Minimum Effective Dose (MED)

Examples:

  • MED in business: Whether your customers, your vendors, or your advertising – choose the few that give you the most value, and forget about the rest.
  • MED in daily productivity: What’s the no. 1 most important task of your day. Do that first. (“Minimum Viable Day”, anyone?).
  • MED in health: Stop eating white carbs. See Tim Ferriss’ slow carb diet, or Gary Taubes’ Why we get fat. (But maybe I’m oversimplifying – I’m not a health expert).

Rules to follow:

  1. Identify which tasks have the most impact on your objective.
  2. Focus on them. Forget about the rest.

This suddenly reminded me of Warren Buffett’s Two List strategy.

Further Reading:

 

Linked to: Power Law, Parkinson’s Law

Filed Under: Economics, Business & Investing, Productivity

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