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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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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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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“We don’t sell saddles here” (The job to be done framework)

[Note: I shared this mental model with my email subscribers on Dec 4, 2016. If you want to receive a new mental model every week, join the club.]

 

At the beach, I saw a guy who sells fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” He said, “Mister, I don’t sell to fish.” – Charlie Munger, Poor Charlie’s Almanack

What it is:

Selling is a huge part of what we do in our lives. Whether convincing our teams to do a particular task, convincing customers to buy our new products, or even convincing our children to do their chores. We’re selling every day.

But all-too-often, we misunderstand the fundamental truth about selling: We’re not selling what we have. The buyer is buying what she needs.

“People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!” – Theodore Levitt, Harvard Business School

Every customer “hires” your product for a “job to be done”. The customer wants a hole in the wall. So she buys a drill. And when you buy a Rolex, it’s not because you want to tell the time.

And why do you think people buy a milkshake every morning en route to work? As McDonald’s found out, it’s not for the taste. It’s to make their boring work commutes more interesting.

Stewart Butterfield (Founder, Slack) captures the essence of this in his 2013 memo to his team – “We don’t sell saddles here”. You’re not selling a feature. You’re delivering a benefit to the customer.

Subtle difference, huge implications.

job to be done

We don’t sell saddles here. We sell a better way to ride. That’s the job to be done.

Examples in business:

  • When selling, we focus too much on talking about our product’s cool features. Instead, listen first. Understand what the customer needs.
  • “Solution looking for a problem”. Another instance of the “hammer looking for a nail” tendency we spoke about last week. We start with a product idea, rather than first seeing what customers need.
  • We define our competitors too narrowly. We see others who offer the same solution as our rivals. But that’s upside down. Our competitors are others who solve the same problem. Even if their solutions are different.

Who does McDonald’s milkshake compete with? Not just Burger King’s milkshakes. Not just other breakfast items. Given the job that customers have hired it to do (make boring commutes interesting), it also competes with FM radio!

Apple is a great example of the power of this framework. The job-to-be-done is quite clear with the iPod, the iPhone, and the iPad. But Apple is struggling to find jobs for the Apple Watch and Apple Pay.

 

Rules to follow:

  1. Start with the customer. Even before you build your product, get out of the building. Talk to customers. Identify what jobs they need done. 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:

 

Filed Under: Sales & Marketing

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Confirmation bias – The bias that supports all your other biases

[Note: I shared this mental model with my email subscribers on Nov 27, 2016. If you want to receive a new mental model every week, join the club.]

 

Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof. – J. K. Galbraith

What it is:

Confirmation bias is our tendency to seek information that confirms our prior beliefs, and to ignore evidence to the contrary. This happens in a few ways:

  • When we see evidence that confirms our beliefs, we accept it with ease. But when we see contrary evidence, the bar suddenly becomes much higher. We look for ways to dismiss the new facts. As this delightfully funny comic shows.
  • We interpret new information in a way that suits our beliefs.

As Sherlock Holmes said, we make “the capital mistake of twisting facts to suit theories”.

Or, in Warren Buffett’s words:

“the human being is best at … interpreting all new information so that their prior conclusions remain intact”.

confirmation bias

The Rorschach Test: What pattern do you see?

Examples in business:

  • We choose performance metrics that suit our conclusion. Call it entrepreneurial optimism. But we always choose the metric that shows most positive performance. “So what if the overall retention numbers are down? At least the <enter ridiculous random metric here> is going up.”
  • We assume our competitors are stupid and evil. In general, we assume the worst characteristics among people we dislike. So, any strategic choice my competitor makes is either (a) a bad idea that is definitely going to fail, or (b) copied from me.
  • We see patterns where they don’t exist. As an investor at OperatorVC, I have to be extra-careful of this. It’s very easy to find examples of failed or successful startups that are similar to the one I’m evaluating now (depending on what I want to find, of course). And analogies are the worst. It’s hard to avoid what Scott Adams calls bumper sticker thinking.
  • “Hammer looking for a nail”. When you have a cool product / concept you’ve come up with, you start looking for an application for it. You start with a solution, and then look for a problem. The issue is, you’ll find problems aplenty. Everything will look like it fits your concept.

At a meta-level, this goes for mental models too. After last week’s issue, I kept seeing situations where people were mistaking “the map for the territory“. They weren’t. That was confirmation bias at work.

Chris Anderson made the same mistake, applying his Long Tail mental model to everything. He also called the Al-Qaeda a “supercharged niche supplier” in “the long tail of national security” (!). Read Tim Wu’s hilarious account of this in The Wrong Tail.

 

Rules to protect yourself:

  1. When you have a hypothesis, look for disproving evidence first. Follow Charles Darwin’s Golden Rule.
  2. Don’t rationalize in hindsight. Make a prediction first, and then see how things match up. In the example of the performance metrics, choose one North Star metric and track that. Don’t choose other, more favorable metrics after the fact.
  3. Don’t use 1-2 mental models for everything. Seriously, the world is not so simple. You need a hammer, but you also need scalpels and spanners. [Moral: Keep checking out my mental models section every week]

 

TL:DR: Be careful what you look for. You’ll find it.

Filed Under: Psychology and Human Behavior

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Eating the Broccoli OR Why the short cut doesn’t always work

[Note: I shared this mental model with my email subscribers on Nov 13, 2016. If you want to receive a new mental model every week, join the club.]

Eating the broccoli

What it is:

We’re always looking for short cuts. Whether the latest fad diet, get-rich-quick schemes, or clever growth hacks, we’re all looking for that easy way out.

But to get what we want, we do have to do the hard part. We have to, as the metaphor goes, eat the broccoli.

This is especially relevant in nutrition / dieting. There’s a new fad diet every week. But nothing works unless you eat the broccoli (or give up sugary foods).

 

Examples in business:

  • Marketing: Growth hacks and Dropbox style incentives to acquire users are fine. But they’re ultimately useless if you don’t build something users want, and would pay for. Similarly, you can have the latest Material Design for your app, but it’s useless if there’s no reason to use the app.
  • Content: You (I) can try all kinds of content marketing SEO tricks to get traffic to your website, but the most important thing is – write to be helpful. To be useful. That’s the hard, but necessary, part.
  • People Management: Many of us hate giving negative feedback. We hope people take a hint, when we are brusque / don’t give positive feedback. We hope they can read our minds. Instead, the simplest way is through. Have the candid conversation. Your team and your relationships will be the better for it.

 

Rules to follow:

  1. All things that are worth doing have some broccoli to be eaten. Identify the broccoli – the painful, necessary, non-scalable first step – and you’re already ahead of the others.
  2. Instead of ways around the broccoli, identify ways to make it easier to eat it. If it’s a feedback chat, prepare a script for it if required. If it’s understanding what customers want, do structured interviews.

Now, an analogy can only go so far. But in summary, as Seth Godin says, when you’re looking for the trick, remember: it often turns out that the trick-free approach is the best trick of all.

Simple. But not easy.

Further reading:

 

Filed Under: Decision-making

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The Fogg Behavior Model

[Note: I shared this mental model with my email subscribers on Nov 6, 2016. If you want to receive a new mental model every week, join the club.]

What it is:

The Fogg Behavior Model (FBM) is a way to understand what drives behavior.

We normally assume that every decision / action is based on a solid rationale. That’s usually true, but that’s not enough. To overcome the inertia of inaction, you need something more. Enter the FBM.

At the heart of FBM is an equation:

Behavior = Motivation * Ability * Trigger

Thus, driving a behavior is not about just providing Motivation. You also need Ability (e.g., ease in terms of time, money, effort, routine vs. non-routine). And you need to Trigger the behavior – with a cue, prompt, or call-to-action.

Fogg Behavior Model

[Source: BJ Fogg’s Behavior Model website]

Examples in business:

  • Marketing: Your customer value proposition (motivation) is not enough to drive a sale. You also need to make it super-simple to say Yes, as I found when trying to sell toilets in rural Bihar (see point 3 in article).
  • Design: Having the most important features in your app isn’t enough. You need to make them easy to access (Hick’s Law – anything more than 2 clicks away won’t get done), with a clear call-to-action (Fitt’s Law – the big red button always wins).
  • Productivity: The reverse also works. If you want to stop checking FB on your phone at work, make it difficult to access – log out so you’ll need to enter the password next time. And remove visual cues – take it off your home screen.

 

Rules to follow:

  1. When you’re persuading a buyer, don’t just focus on why they should buy. Make it easy for them to say yes (e.g., easy, low-risk payment terms), and then trigger the sale (e.g., social proof, limited time offers).
  2. If you want to break a habit, just make it hard to do. And remove all cues from the environment.

Further reading:

 

Filed Under: Psychology and Human Behavior

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The Red Queen Effect

[Note: I shared this mental model with my email subscribers on Oct 30, 2016. If you want to receive a new mental model every week, join the club.]

 

In Lewis Carroll’s Through the Looking Glass, the Red Queen tells Alice:

Here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast!

The Red Queen Effect

What it is:

The Red Queen mental model comes from biological evolution. Trees in a forest grow taller and taller, to better capture sunlight. Soon, all the trees have expended enormous energy to get much taller. Yet, they get the same amount of sunlight as before.

This evolutionary arms race happens among animals too. Prey evolve to better ward off predators (e.g., rabbits running faster). But predators, in turn, evolve to better capture prey (e.g., foxes run faster too).

Everyone runs much faster, to stay in the same place.

 

Examples in business:

  • A business differentiated only on price will likely never make money. If what you’re selling is a commodity, then someone will always come along to offer it at a lower price. And good luck if someone = Amazon. Your margin is Jeff Bezos’ opportunity.
  • And just incremental differentiation won’t do. So your new cab service is the only one with wifi. Well, guess what? Uber will have it in 24 hours!

 

Rules to protect yourself:

  1. Don’t assume your competitors are stupid. They’re as interested in survival and growth as you are. And yes, they are as smart as you.
  2. If you’re launching a business in a crowded market, you can’t be differentiated only incrementally. Or worse, only on price. Remember: 10x, not 10% (and cheaper too). Like Uber.

Further reading:

 

Linked to: Value Capture

Filed Under: Biology (Mathematics & the Sciences)

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The Availability Heuristic OR “What you see is all there is”

[Note: I shared this mental model with my email subscribers on Oct 23, 2016. If you want to receive a new mental model every week, join the club.]

What you see is all there is.

What it is:

It’s a shortcut that our minds take, when evaluating the consequences of a decision. We ascribe more importance to the first examples that come to mind. But here’s the thing – they’re not necessarily more important or probable. They’re just easier to recall / visualize.

 

Examples in business:

  • What you see is all there is – When we get into a strategic business partnership, we get complacent, thinking “we’ve made it”. But we haven’t. It’s just that success is easy to visualize, but the thousand ways it can fail are not.
  • Tyranny of the quantifiable – what gets measured gets managed. Your teams chase specific performance targets, and not your overall business goals. What doesn’t get measured might as well not exist!
  • Attribute substitution – when we hear a hard question, we substitute it with a simple one. “How happy are you?” becomes “How much money do you have?”. “Will this strategy work?” becomes “Do I remember an instance of this working?” Never mind that you’ve only heard of instances where it worked (if it didn’t work, you probably wouldn’t have even heard about it).

What gets measured gets managed - Peter Drucker

Rules to protect yourself:

  1. Remind yourself that just because you can recall or visualize something easily, it doesn’t become more probable or valuable.
  2. Use checklists for decisions that are influenced by a number of factors. [Note: checklists are very useful when evaluating startups at OperatorVC. It’s surprisingly easy to get swayed by a good looking product].

Further reading:

 

Linked to: Mere Exposure / Association Theory

Filed Under: Psychology and Human Behavior

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