Upgrade Your Thinking: Risk Models and Mental Tools
Second Level Thinking · Issue 16
Using mental models to navigate market uncertainty. Protecting your creative spirit: why cynicism is a liability, not an asset.
Mental Models
A mental model is a distillation of how something works; an idea, belief, or concept that has been refined down. Like a map, mental models reveal key information while ignoring irrelevant details. Models concentrate the world into understandable and useable chunks.
“To put it simply, mental models are a set of beliefs and ideas that we consciously or unconsciously form based on our experiences. They guide our thoughts and behaviours and help us understand life. They’re basically thinking tools. Shortcuts for reasoning.” Anne-Laure Le Cunff
In order to grow we must identify certain mental models in ourselves and in others and like any behavioural change, this requires introspection. We must start by observing the behaviours of ourselves and others and identify where change is required, if at all.
To get you started and allow you the opportunity to study this more deeply, below is a list of 20 mental models that Le Cunff details. Let’s take a look:
Anchoring: a cognitive bias where an individual relies too heavily on an initial piece of information offered—considered to be the "anchor"—when making decisions.
Commitment and consistency bias: the desire to be and appear consistent with what we have already done.
Common knowledge: knowledge that is known by everyone or nearly everyone, usually with reference to the community in which the term is used. Common knowledge doesn’t necessarily mean truth, but most people will accept it as valid.
Comparative advantage: a principle that holds that under free trade, an agent will produce more and consume less of a good for which they have a comparative advantage, meaning they can produce that good at a lower relative opportunity cost.
Diversification: the process of allocating your resources in a way that reduces the exposure to any one particular risk.
Economies of scale: the cost advantages that enterprises obtain due to their scale of operation. The larger the scale, the smaller the cost per unit.
Game theory: an umbrella term for the science of logical decision making in humans, animals, and computers.
Hyperbolic discounting: a model which states that, given two similar rewards, people show a preference for one that arrives sooner rather than later.
Illusion of control: the tendency for people to overestimate their ability to control events.
Incentive: something that motivates or encourages someone to do something.
Inversion principle: the process of looking at a problem backward. For example, instead of brainstorming forward ideas, imagine everything that could make your project go terribly wrong.
Loss aversion: people's tendency to prefer avoiding losses to acquiring equivalent gains. We are basically more upset about losing $10 than we are happy about finding $10.
Margin of safety: in a business, how much sales level can fall before a company reaches its break-even point.
Mere-exposure effect: a psychological phenomenon by which people tend to develop a preference for things merely because they are familiar with them.
Norm of reciprocity: the expectation that we repay in kind what another has done for us.
Redundancy: the duplication of critical components of a system with the intention of increasing its reliability. For example, a backup or a fail-safe.
Signalling theory: the science of determining whether people with conflicting interests should be expected to provide honest signals rather than cheating.
Status quo bias: a preference for the current state-of-affairs, where the current baseline is taken as a reference point, and any change from that baseline is perceived as a loss.
Survivorship bias: the logical error of concentrating on the people that made it past some selection process and overlooking those that did not, typically because of their lack of visibility. Happens a lot in entrepreneurship.
Tribalism: a way of thinking in which people are loyal to their social group above all else.
It is important to note that in many instances this will include what not to do, ensuring you don’t fall prey to fallacies like “illusion of control” and “status quo bias” as we have discussed previously in this newsletter.
“To break a mental model is harder than splitting the atom.” Albert Einstein.
Finally, don’t be afraid to create your own. We have all been inspired by a leader, a colleague, a friend; seek out how they came to the conclusions you admired and be sure to ask for feedback on your own behaviours. This can be incredibly uncomfortable but equally rewarding to seek out the opinions of those we value most.
“You’ve got to have models in your head and you’ve got to array your experience – both vicarious and direct – onto this latticework of mental models.” Charlie Munger
Another way to think about this is by thinking in first principles. A mental model in and of itself, as Shane Parrish writes; first principles thinking is the art of breaking down complex problems into their most fundamental truths. It's a way of thinking that goes beyond the surface and allows us to see things from a new perspective.
Thinking in terms of first principles allows us to identify the root causes and strip away the layers of complexity and focus on the most effective solutions. Reasoning from first principles allows us to step outside the way things have always been done and instead see what is possible. First principles thinking is not easy. It requires a willingness to challenge the status quo. In a world focused on incremental improvement, first principles thinking offers a competitive advantage because almost no one does it.
Start by identifying the mental models above that resonate with you most and think about why that is. See if you can add an additional five to the list that are unique to yourself or that you have developed through feedback obtained from others. Doing the work on reducing your own blind spots and defining our own mental framework will greatly improve our choices and decision making.
How to Think About Risk
In How to Think About Risk, Howard Marks explores the true meaning of risk and provides us with a brilliant framework that requires deeper thinking. In financial markets risk is the ultimate test of an investor’s skill. When assessing portfolio returns, it’s important to look at how much risk the manager bore in order to achieve their respective results.
Is risk volatility? No. Volatility can be an indicator of the presence of risk, but it’s not risk itself. Risk is the probability of loss and this is what we demand compensation for if we are going to bear it. Investments are not avoided because the potential volatility is too great, it is because of the probability of loss and that is what we demand a risk premium and greater compensation for.
Is risk quantifiable in advance? No. Risk is unquantifiable, even after-the-fact and Marks claims to be fascinated by this, as am I. If you buy something for a dollar and sell it a year later for two dollars, was it risky? You can't tell from the outcome. A profitable investment may or may not have been risky – was it a safe investment that was sure to double, or a risky investment where you got lucky. Essentially, it’s impossible to quantify risk in advance or even in hindsight.
What are other forms of risk? Not just financial loss but other key forms include:
The risk of missing opportunities.
The risk of not taking enough risk.
The chance of being forced out at the bottom.
These are true in our personal lives away from the investment world. On the last bullet point, which is a bigger mistake, buying at the high and seeing it decline, or selling at the low and missing out on the recovery? The latter. Marks believes that selling at the bottom is the cardinal sin of investing.
Where does risk come from?
“Essentially, risk says we don’t know what’s going to happen. We walk every moment into the unknown. There’s a range of outcomes, and we don’t know where the actual outcome is going to fall within that range. Often, we don’t know what the range is.” Peter Bernstein
If we knew what was going to happen there would be no risk. Marks states, “we know what’s likely to happen, we know the other things that probably could happen instead. We have little appreciation for the things that are highly unlikely to happen but could. What we call in modern-day terms, tail events.”
Rick Cain adds that “96% of financial history has occurred within 2 standard deviations but everything interesting has happened outside of 2 standard deviations – that’s the wild part.”
What does it mean to think probabilistically?
Risk means more things can happen than will happen.
The future is not a fixed outcome but a range of possibilities.
Even when you know the probabilities, that doesn’t mean you know what’s going to happen. Knowing the probabilities does not eliminate the uncertainty.
Even though many things could happen, only one will. Sometimes, the expected value isn’t even among the possibilities.
What is the character of risk? Risk is counterintuitive – the risk of an activity doesn’t lie in the activity itself, but in how the participants approach it. The degree of risk present in a market or investment doesn’t come just from the market but how people participate in it. This translates to risk being low when investors behave prudently and high when they don’t, therefore risk is perverse. When an asset declines in price, people say “look how risky it is.” But with the lower price it becomes less risky. Additionally, as an asset appreciates participants claim, “that’s a great asset, look at how much its value has increased.” But with the rising price, it becomes riskier. This perversity is one of the main things that render most people incapable of understanding risk as it is hidden and can be deceptive. As Warren Buffett famously stated, “It’s only when the tide goes out that we find out who’s been swimming naked.”
“An investment can be risky, but if it only exists in salutary environments, it may look like a winner for a long time,” claims Marks. The fact that an investment is susceptible to risk that occurs extremely rarely (an improbable disaster/black swan), results in the infrequency of loss can therefore make the investment appear safer than it really is on the surface.
What is the relationship between risk and asset quality? Risk is not a function of asset quality – there is a belief that high-quality assets are safe and low-quality assets are risky. In fact, Marks believes the opposite; a high-quality asset can be priced so high that it’s risky, and a low-quality asset can be priced so low that it is safer. “It’s not what you buy, it’s what you pay. Investment success doesn’t come from buying good things but from buying things well.” Nothing is excluded from this principle.
What is the relationship between risk and return? Generally, people believe more risk = higher return. Howard challenges this formation and claims: “if it were true that riskier assets produced higher returns, then they wouldn’t be risky.” It is instead that investments that are perceived as being risky must be perceived as generating high returns. This is what induces us to make these investments, but the return is never guaranteed. It’s from the possibility that the projected returns will not be delivered that the risk ensues.
How should risk be managed? Generally superior investors have a better understanding of what proportion of their investments are winners and what proportion are losers. “We’re going to have one outcome, there could be many outcomes.” Elroy Dimson.
How should each of us deal with risk? Risk is best assessed through subjective judgement. Since risk cannot be measured, gauging it must be the province of subject matter experts. Marks believes that “imprecise, qualitative, expert opinion about the probability of loss is far more useful than precise but largely irrelevant numbers concerning volatility.”
“Because of the existence of risk, things are going to be different from what we expect from time to time. How well are we prepared to deal when it’s different.” Peter Bernstein
Essentially, risk just means things are uncertain. Good things can happen as well as bad things. Risk is the possibility that from the range of uncertain outcomes, an unfavourable one will materialise. This may be through permanent loss of capital, in bad times, or missed opportunity in good times.
Regardless, risk is something that should be dealt with constantly, continuously, and not sporadically. We never know when bad things will happen, and risk control will be required. When to be in offence, when to play defence – no one tells you when to play either. It is a continuum that you move back and forth along and the risk is kept under control through a superior portfolio. Skilled investors produce good returns in the event things go as expected and resist declines if they don’t. This asymmetry is the cornerstone of successful investing and constructing portfolios that include risk control along with the potential for gains is a great accomplishment, claims Marks.
The bottom line: Risk is something to be managed and controlled, but not avoided. “Risk is best handled on the basis of accurate, subjective judgements made by experienced investors who emphasise risk consciousness. The great challenge in investing is to limit uncertainty and still maintain substantial potential for gains.” Work on building an improved sense for the probability distribution that governs future events and for whether your potential return compensates for the risks that lurk in the distribution’s unattractive left-hand tail. This enables the asymmetry that characterises superior investors in which we started.
Parting Shot
"You are right to be worried about your growing feelings of cynicism and you need to take action to protect yourself and those around you. Cynicism is not a neutral position (although it asks almost nothing of us), it is highly infectious and unbelievably destructive. In my view, it is the most common and easy of evils.
I know this because much of my early life was spent holding the world and the people in it in contempt. It was a position both seductive and indulgent.
The truth is, I was young and had no idea what was coming down the line. I lacked the knowledge, the foresight, the self-awareness. I just didn't know. It took a devastation to teach me the preciousness of life and the essential goodness of people. It took a devastation to reveal the precariousness of the world, of its very soul, to understand that it was crying out for help. It took a devastation to understand the idea of mortal value, and it took a devastation to find hope.
Unlike cynicism, hopefulness is hard-earned, makes demands upon us, and can often feel like the most indefensible and lonely place on Earth.
Hopefulness is not a neutral position either. It is adversarial. It is the warrior emotion that can lay waste to cynicism. Each redemptive or loving act, as small as you like, keeps the devil down in the hole. It says the world and its inhabitants have value and are worth defending. It says the world is worth believing in. In time, we come to find that it is so."
— Nick Cave
