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Mental Models
A starter wiki on seven mental models, from first principles to inversion, each traced to Aristotle, Bastiat, Buffett, Munger and other primary sources.
First Principles Thinking
First principles thinking means understanding a subject by tracing it back to its most basic conditions and elements.[1] Aristotle opens his Physics by saying we know a thing only once we have "carried our analysis as far as its simplest elements."[1]
In his logic, Aristotle held that scientific knowledge is demonstrated from premises, which raises the question of where the chain of premises ends.[2] Either the chain runs on forever, or it stops at starting points that are not themselves demonstrated.[2] Aristotle's answer was that first principles are known in another way, through induction and understanding, and they supply the starting points for proof.[2]
Applied to everyday problems, the habit is to separate what is truly foundational in an argument from what has simply been inherited. Analysis is complete, on Aristotle's standard, only when it reaches elements that cannot be broken down further.[1]
Read next: Opportunity Cost, Inversion.
Opportunity Cost
The opportunity cost of using a resource is the value of the best alternative use you give up.[1] Every choice therefore carries a cost, because putting a resource to one use means forgoing its next-best use.[1]
Frédéric Bastiat argued in 1848 that an act, a habit or a law produces a series of effects, and only the first of them is seen.[2] In his broken-window example, the six francs paid to repair the glass are visible, while the shoes or book the owner would otherwise have bought are not.[2] The hidden cost is that the owner "will not be able to spend them for another."[2]
Because the forgone alternative never shows up on a receipt, the discipline lies in naming it before deciding.
Read next: Margin of Safety, Circle of Competence.
Margin of Safety
A margin of safety is a gap between what you estimate something is worth and what you pay for it, so that an error in the estimate does not sink the decision.[1] Warren Buffett wrote that if Berkshire calculates a stock's value as only slightly higher than its price, it is not interested in buying.[1]
Buffett credited the principle to Benjamin Graham and called it "the cornerstone of investment success."[1] Charlie Munger described Graham's approach as buying shares whose real value per share exceeded the price by a wide amount, leaving a large excess of value working for the buyer.[2]
The buffer exists because estimates can be wrong, which makes it a natural companion to knowing where your own understanding runs out.
Read next: Circle of Competence, Inversion.
Circle of Competence
Charlie Munger told USC business students in 1994 that every person has a circle of competence, and that it is very hard to enlarge.[1] His advice was to work out where you have an edge and "play within your own circle of competence."[1]
Buffett made a related point in his 1992 letter: what counts most in investing is not how much you know but how realistically you define what you don't know.[2] He added that an investor needs to do very few things right as long as big mistakes are avoided.[2]
The model is less about the size of what you know than about being honest regarding its edges.[1][2]
Read next: Incentives, Margin of Safety.
Incentives
Charlie Munger opened his catalogue of misjudgment tendencies with incentives, noting that almost everyone thinks they already understand how important rewards and punishments are.[1] His summary was blunt: "Incentives are superpowers."[1] In his USC talk he put it more generally, saying behavior is determined by the incentives of the decision-maker.[3]
His favorite business case was Federal Express, which struggled to get its night shift to move packages quickly between planes.[1][3] The fix was to stop paying by the hour, pay per shift, and let workers go home once all the planes were loaded, and it worked.[1]
Steven Kerr argued in 1975 that many reward systems pay off for exactly the behavior the rewarder is trying to discourage.[2] One of his examples is a society that hopes teachers will not neglect teaching but rewards them almost entirely for research and publications.[2]
Read next: Opportunity Cost, Inversion.
Compound Interest
Compound interest means earning interest both on the money you saved and on the interest already earned.[1] In the CFPB's example, $1,000 at 5% a year grows to $1,050 after one year and $1,102.50 after two, because the second year's interest is figured on the larger balance.[1]
Over long spans, modest rates produce startling totals, and startling totals can hide modest rates.[2] Buffett noted that the Dow rose from 66 to 11,497 during the twentieth century, a gain that "shrinks to 5.3% when compounded annually."[2] Matching that rate in the twenty-first century would require the Dow to close at about 2,000,000 at the end of 2099.[2]
Munger ranked compound interest among the most useful models in his 1994 talk, placing the elementary math of permutations and combinations just after it.[3]
Read next: Margin of Safety, Incentives.
Inversion
Inversion means approaching a problem backwards: instead of asking how to succeed, ask what would guarantee failure, then avoid it.[1] Munger credited the habit to the algebraist Jacobi, whose advice he repeated as "Invert, always invert."[1][2]
In a 1986 commencement speech at the Harvard School, Munger followed Johnny Carson, who had told a graduating class how to guarantee misery rather than how to be happy.[1] Carson's prescriptions included mood-altering chemicals, envy and resentment.[1] Munger summed up the attitude with a joke about wishing he knew where he would die so that he could never go there.[1]
Later he described his own method in the same spirit, saying he sought good judgment mostly by collecting instances of bad judgment and working out how to avoid them.[2]
Read next: First Principles Thinking, Margin of Safety.