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Thinking From First Principles

Investing, much like life, is full of uncertainty and learning how to make decisions under uncertainty is one of the most important skills for an investor. Indeed good decision making skills ripple across almost every spectrum of one’s life. One of the key drivers of this skill is the ability to think and reason from first principles.


What is First Principles Thinking?

First Principles thinking involves breaking down any problem into its fundamental facts and datapoints and then thinking them through to their logical conclusions, from the bottom up. You aim to remove opinions of others (especially the faceless crowd), unless they can be justified by these core facts. You focus on hard facts and reason over anecdote and convention. This is actually an extremely intensive process and requires a lot of information gathering as well as correctly thinking about the information once gathered. Thinking is hard so instead we prefer to use conventional wisdom: rules of thumb, historical best practices and the behavior and beliefs of others to drive our decision making. On average, this works, but it can often be suboptimal or even of negative value in specific cases, sometimes even leading to absurd decisions made by seemingly reasonable individuals.


A few examples of reasoning not grounded in First Principles:

  • All those people are making so much money buying Dogecoin. It is up 420%, and Elon Musk is tweeting about it. It is a sure bet

  • Junk bonds are too risky to invest in.

  • You should get married before 35

  • No one has ever closed down airports because of a virus. That would be an overreaction

  • Everyone should own their own house

  • Everyone owns this blue chip stock. The company has never made a loss and you will never lose money buying it


When Conventional Wisdom Fails

I have noticed that most of the biggest mistakes in my life have come from following the prescriptions of conventional wisdom, without exploring the reasoning behind it. In particular I have noticed conventional wisdom often fails for the following reasons:

  1. It fails to account for the fact that individual circumstances are different (what works for the average person may not work for your specific situation). Hence prescribing advice that may be appropriate for the average person but not for you.

  2. It does not account for the fact that the world is always changing. Hence prescribing actions that were appropriate in the past, but no longer relevant as the facts have now changed. This is an especially common reason in our rapidly changing modern world.

  3. It is affected by “external scoreboards” (a topic for another day) and/or values that are not relevant to you.

  4. It prescribes some lofty ambition or goal, without taking into account the negatives of the goal. (For instance Sri Lankans often put great value on getting a foreign citizenship without thinking about any tax implications, the personal cost of being away from loved ones for many years and the opportunities missed in Sri Lanka while one is away)

  5. In reflexive situations, where large crowds are already involved. (For example, the shares of a very good business would be a good investment at a certain price, but as the entire crowd piles into it, and the share price rises, then it stops being an attractive investment and at some time, purely due to the participation of the crowd, stops being an attractive investment).


When you are given advice on something meaningful to your life, it is important to explore if it is grounded in first principles, or if it is conventional wisdom. A lot of damage has been done by bad advice, grounded on conventional wisdom, given with the best of intentions.


Always ask why.

Often a great means of achieving good outcomes in life (and investing) is to find, via first principles reasoning, an action a large majority of people are taking (usually based on conventional wisdom), that is simply not correct in that specific circumstance due to one or more of the factors mentioned above.


One good way to identify if an idea is grounded in first principles is to ask why. If the response is: “That is how everyone does it” or “that is how it has always been” or “Because I am your teacher/parent/boss, so just do it”, then that is probably not based on reasoning from first principles.


As a small country, quite insulated from the rest of the world, where everyone seems to know everyone else, I have found that making decisions based on the “wisdom” of the crowd is especially common and often leads to serious trouble in Sri Lanka. There is no shortage of examples of bad decision making by our politicians, but our disastrous overnight chemical fertilizer ban is a particularly good example of this.


Should you reason everything through all the time?

Reasoning from first principles is hard. It is a cost and time intensive activity to do correctly. If you spent all your time reasoning from first principles, you would probably not be able to get much done and you will find yourself mentally exhausted. Shortcuts are helpful and necessary but the key is to figure out when to use them. In the same way that a lot of people don’t think through their decisions, the opposite can also happen where some overthink low importance decisions and end up with “analysis paralysis”. This is especially true in big corporations and government bureaucracies, where even small decisions get jammed up in a complex decision making apparatus until it is too late. So there is a balance we have to strike, identifying what decisions should be thought through and where we can rely on the shortcuts of conventional wisdom. I find the below framework to be quite helpful in deciding how much effort to put into a decision.




Types of decisions

All decisions are either easy to reverse or not. They also have meaningful consequences or do not. For example:



Reversible (Without Much Consequence)

Not Reversible

Not Important

What brand of soap you use

What you eat for breakfast

Important

Raising prices in your business

Deciding to have children

The only category you must really focus on are the important and non reversible decisions. For all other categories, you should probably just outsource the reasoning to the crowd and save your energy. Don’t overthink the little things, but the key important decisions must be made methodically, with great deliberation and a healthy skepticism of the crowd’s prescriptions. This “barbell” approach to life, of extreme awareness and reasoning for a small subset of decisions, and extreme delegation for reversible or low consequence decisions should lead to the optimal outcomes without too much bureaucracy and fatigue.


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