Mental Models

Understanding the World With Mental Models

339 models explained to carry around in your head.

All we want to do is make sense. Make sense of things around us, why we exist, our actions, and the outcomes we face.

Through evolution, the human mind has responded to this need by establishing a quick ability to view things in terms of cause and effect.

And that is pretty much how we all start out learning about the world from childhood.

Everything children know comes from what they’ve observed and experienced firsthand. How toys and candies are nice. How a hot stove isn’t. Their entire understanding of the world is based on these experiences. And therefore, they have no idea how most things work. They don’t know what they don’t know. You couldn’t walk a child through a class on biology, politics, or teach how to tear apart a balance sheet (that is, not literally). Children have pretty much no concept of giant chunks of the world.

Well, that changes when growing up. That is when we realize how little of the world we understand. And when humans don’t understand something, it’s frustrating. Depressing. It's interesting because you rarely see a depressed child.

"I want to live happily in a world I don't understand.

- Nassim Taleb

Faced with how little we know, we cling to the initial method of cause and effect. Mental scars from bad experiences cause us to either stay completely away from certain endeavors because the past effect makes us not want to cause it again. Inversely, overconfidence from prior good experiences tends to cause us to turn overconfident in other endeavors.

“Your own thoughts are not really your own thoughts. Everything you think is a product of the people you meet and the experiences you’ve had, both of which are largely outside of your control.”

- Robert Shiller

The result is intuitions and hunches - or what Daniel Kahneman terms our system 1. And sometimes that is useful for certain decisions. But the result is also that we have a tendency to dismiss the impact of the millions of variables that lead to an outcome and we thus tend to focus on surface-level results - or single outcomes. It meanwhile leads to only thinking or caring about the first-order effects of a decision, and because it's a shortcut, it occasionally results in decision-making errors - at times fatal. One would be a bit skeptical of the engineer who bragged about his ability to construct a bridge based solely on intuition and first-order thinking.

Therefore, the most important things usually require one to slow down and think. But learning how to think critically is not easy. Otherwise, everyone would do it. A world filled with huge complexity makes it impossible to carry every detail of it, and how it works, around in our heads. So we can’t know everything. But we can know the big ideas from multiple disciplines in order to face whatever we're facing with rationality and a non-clobbered mind.

Enter mental models.

Mental Models - What of It?

Why they're important.

“I think it is undeniably true that the human brain must work in models. The trick is to have your brain work better than the other person’s brain because it understands the most fundamental models - ones that will do most work per unit.”

- Charlie Munger

Think about Munger’s quote. Every person routinely uses mental models, because essentially, they're tools we use for explaining things. For example, when we cross a road, we mentally assess how matter moves in a particulate manner, the relationship between apparent size and distance, change in size with time and velocity, and so forth. We use these models to cross the road. But because mental models are so basic to understanding the world, people are hardly conscious of them. And so they don’t think about how to use them optimally.

However, the first part of making rational decisions is knowing the right models. Looking at a situation using the wrong models, or no model at all, is dangerous in decision making. Inversely, using the right models is a great source of competitive advantage in any endeavor.

“Man acts at all times on the models he has available […] Anyone who proposes a policy, law, or course of action is doing so on the basis of the model in which he, at the time, has the greatest confidence.”

- Jay Wright Forrester from the book, World Dynamics.

People's views of the world, of themselves, of their own capabilities, and of the tasks that they are asked to perform, or topics they are asked to learn, depend heavily on the conceptualizations that they bring to the task. And so, every discipline of thought has its own set of models learned through coursework, mentorship, or first-hand experience.

Combining these models - or ideas - produces a cohesive understanding. Not combining them produces dangerous results.

Here's Richard Feynman describing why that is:

Those who cultivate the broad view of ideas are well on their way to achieving worldly wisdom. But we can only get there by doing worldly studies over a long period of time, slowly building on top of the models already existing in our heads.

The following list is a rather comprehensive collection of useful mental models to understand the world, filter signal from noise, and shape connections.

That’s all well and good, but here’s the problem: Memorizing them is the easy part. Thoroughly understanding their flexibilities and limitations is the real task at hand.

As Richard Feynman once said:

“No idea is true just because someone says so. Test ideas by the evidence gained from observation and experiment! If a favorite idea fails a well-designed test, it’s wrong!”

The goal of thinking in terms of mental models is to continually refine our personal vision, to seek broadening of thought, to develop patience, and to seek objective reality.

It’s a lifelong, and very virtuous, project.

The List of Mental Models

Some models carry the most freight. The heaviest apply broadly to life and are useful in most circumstances. But the task to dig those out is up to each individual and what circumstances that individual is facing.

Before you continue with the list, we have a confession to make: these are not all mental models per se. Essentially, this is a list of models, frameworks, thinking tools, and mental representations. Then why do we use the term mental models? Because it's just a beautiful catch-all phrase for ideas designed to rapidly navigate worldly problems.

Models in Economics and Strategy

Opportunity Cost

The value of what you have to give up in order to choose something else. As with any other cost, the goal is to minimize it. Opportunity costs are very real.

A central component of economics is the time value of money which means that money today is worth more than money in the future. Economically, this relationship is entirely based on opportunity costs.

Creative Destruction

Sometimes called Schumpeter's gale and formulated after Austrian economist Joseph Schumpeter, creative destruction is a theory of economic innovation and the business cycle in a free-market economy. It refers to the incessant product and process innovation mechanism by which new production units replace outdated ones - or ones stuck without innovation.

In capitalistic competition, the absence of innovation does not result in stasis. It results in decay.

Primary source: Joseph Schumpeter

Double-Entry Bookkeeping

The invention of the double-entry bookkeeping system traces all the way to Genoa in 1494 when the first book on the subject was published by Luca Pacioli. Ever since then, the system of balancing the books by using two accounts for every entry has hardly changed.

The duality that is an essential part of an accountant's view of the world is a remarkably powerful model for understanding economic and other events.

Primary source: Luca Pacioli

Comparative Advantage

As a foundational model in the theory of international trade, Scottish economist David Ricardo found that all actors, at all times, can mutually benefit from cooperation and voluntary trade if those actors focus on what they are comparatively best at in terms of opportunity cost.

The party with the lower opportunity cost of producing a good or service, and thus the smallest potential lost benefit, holds the comparative advantage of that good or service.

Primary source: David Ricardo

Rent-Seeking

An attempt to make a profit (economic rent) at the expense of others rather than by creating new value. An example is using resources on political lobbying to promote specific legislation that serves one's own interests.

Primary source: David Ricardo

Switching Costs

The transaction costs or disadvantages a buyer incurs from switching to another seller.

Nash Equilibrium

When two or more participants in a non-cooperative game have no incentive to deviate from their respective equilibrium strategies after considering their opponent's choices and strategies on a rational basis.

Named after mathematician John Nash, the model proves that decisions that are good for individuals can sometimes be terrible for groups.

Primary source: John Nash

AD-AS Model

Based on John Maynard Keynes's general theory, the AD-AS model explains the level of prices and national income through the relationship of aggregate demand and aggregate supply. Being a fundamental tool in economics, it's an incredibly powerful model when thinking about macroeconomic effects in the short, medium, and long term.

The model is flexible enough to accommodate both the Keynes’ law approach, which focuses on aggregate demand and the short run, while also including the Say’s law approach, which focuses on aggregate supply and the long run.

Controlling the Center

Controlling the center of something provides greater flexibility and mobility of choices compared to one's competitor. In chess, if you don't control the center squares and let your opponent control them, they will have an easier game than if they have to fight for their control. A piece does not have to physically be on a central square to control the center. For example, the bishop can control the center from afar.

In business, controlling the center of a value chain can prove mightily profitable. Examples include the business model of brokerage firms or indispensable internet marketplaces such as Alibaba.

Specialization

Sometimes termed division of labor, specialization refers to the process by which participants in a free-market system divides into different sets of skills to increase efficiency. By increasing productivity within each field of specialization, the whole system benefits.

Primary source: Adam Smith

Intellectual Property

The introduction of intellectual property rights into society has been a huge accelerator of societal creativity. Such rights include intangible creations of the human intellect. There are many types of them, and some countries recognize more than others. The most well-known are copyrights, patents, trademarks, and trade secrets. If individuals and corporations get these right, they can create defensible economic moats against the competition. And as long as on-going research and development and capital expenditures can be managed, there is tremendous leverage in this model.

However, very few, if any, economic moats originating from intellectual property seem to be able to stand the test of time. Either they’re expiring or becoming obsolete due to societal progress and creative destruction. But they can last for very long.

Utility

The concept used to assess how satisfaction levels affect consumer decisions. The law of diminishing marginal utility describes how the initial units of a good or service carry more utility than each additional unit.

The concept has its roots from the 19th century as economists worked on explaining price discovery. This mechanism was originally thought to be solely driven by a product's utility. Adam Smith then proposed the problem known as "the paradox of water and diamonds" which made it very difficult to explain why diamonds should be valued more highly than an essential good such as water.

That was until the discovery was made to explain that economic decisions are made based on marginal benefit rather than total benefit. In other words, consumers are not choosing between all the diamonds in the world vs. all the water in the world. Clearly, water is more valuable. Instead, they are choosing between one additional diamond versus one additional unit of water.

Primary source: John Stuart Mill

Elasticity

The economic measure of how responsive an economic variable, such as demand, is to a change in another, such as price. An elastic variable has an absolute elasticity value greater than 1 and responds more than proportionally to changes in the dependent variable. An inelastic variable has an absolute elasticity value less than 1 and changes less than proportionally to changes in the dependent variable.

Supply and Demand

Being the main model of price determination used in economic theory, the supply and demand relationship explains a lot of things in the world. The basic premise is that prices settle at equilibrium when demand equals supply.

While it's easy to take the model of supply and demand for what it is, it's important to know that there are blind spots. In some situations, the model is not as rigid as economics presumes when seen in the context of behavioral psychology, incentives, contrast, etc. As Charlie Munger puts it: Suppose that you raise the price and use the extra money to bribe the other guy’s purchasing agent.

Deadweight Loss

A loss of economic efficiency that is caused by supply and demand being out of equilibrium. Such causes may include price and rent controls, minimum wages, taxation, and monopolies.

Moral Hazard

A situation where either party to an entered agreement changes its behavior after the contract is completed so that the probabilities attributed to either party's way of acting no longer apply. It's called moral hazard because the party is no longer fully affected by the negative effects of its own actions. Thus, it might be incentivized to act less cautiously than otherwise.

Bottlenecks

Matter, either tangible or intangible, can get clogged if pushed too quickly through a system than what that system can handle. Every system is limited by various constraints with some critical and some less critical. No change to the system will result in overall improvement unless that change addresses the bottleneck. The term is named after the narrow point of a typical bottle.

Bribery

Bribery is a form of a moral-breaking bottleneck in human systems which is hard to eliminate. The concept can in some circumstances significantly affect other models such as price discovery, incentive-induced bias, and so on.

Arbitrage

The attempt to profit by exploiting price differences in identical or similar financial instruments, capitalizing on the imbalance. As more and more arbitrageurs participate, such opportunities diminish and eventually vanish. The traditional definition of arbitrage concerns a 100% risk-free activity after transaction costs. But in practice, that is rarely certain.

Scarcity

Limited availability of something gives rise to trade-off. Rarely is something of limitless supply, except maybe the need for it. Scarcity involves making a sacrifice by giving something up - or making a trade-off - in order to obtain more of the scarce resource that is wanted.

Mr. Market

Benjamin Graham proposed imagining the stock market as a somewhat manic and not too intelligent profile who would stop by every day to call out prices. Mr. Market will not care if you are interested but will show up every day. However, his mood is subject to extreme changes. There will be times when he is optimistic about the future and so his prices will be high. There will be times when he is pessimistic about the future and so his prices will be low. For the most part, it's best to ignore his shouting. But when Mr. Market becomes extremely worked up – either excited or depressed – you can exploit his out-of-boundary prices.

The model of Mr. Market is simple, but here’s the problem: it sounds easy to put into practice. But the truth of the matter is that there's a collective mass of real people on the other side of every transaction. This group might be better educated, have more capital, have more power, and have more experience. So after a while, one might feel that Mr. Market and these people are all superior.

But even then, the model of Mr. Market is paramount.

Primary source: Benjamin Graham

Fisher Effect

A direct relation to the concept of money neutrality, named after economist Irving Fisher. The Fisher effect states that the real rate of interest in an economy is stable over time so that changes in nominal interest rates are the result of changes in expected inflation. Therefore, the nominal interest rate in an economy is the sum of the required real rate of interest and the expected rate of inflation over any given time horizon.

Primary source: Irving Fisher

Cancer Surgery Formula

Charlie Munger explains: I've had many friends in the sick-business-fix-up-game over a long lifetime. And they practically all use the following formula — I call it the cancer surgery formula: They look at this mess and they figure out if there’s anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn’t work, they liquidate the business. But It frequently does work.

Primary source: Charlie Munger

Surfing

You won't be able to surf if you don't catch the wave. And if you do catch it, you can stay on it for long. The trick is catching the one that lasts the longest as early as possible and not to get off. Microsoft was a result of a 16-year-old catching a wave of software revolution right on the edge.

Primary source: Charlie Munger

Porter's Five Forces

Developed by Michael Porter in 1979, Porter's Five Forces is a framework to look at competitive forces in an industry. The five undeniable forces are: 1) threat of new entrants, 2) threat of substitutes, 3) bargaining power of customers, 4) bargaining power of suppliers, and 5) competitive rivalry.

Primary source: Michael Porter

Phillips Curve

A historical inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy.

Primary source: Williams Phillips

Parity Conditions

Where two (or more) things are equal to each other. In economics, this might include equality in price, rate of exchange, purchasing power, or wages. Parity conditions typically make simplifying assumptions, such as zero transaction costs, perfect information that is available to all market participants, risk neutrality, and freely adjustable market prices.

International exchange rate parity conditions:

  1. Covered interest rate parity
  2. Uncovered interest rate parity
  3. Forward rate parity
  4. Purchasing power parity
  5. International Fisher effect.

Covered interest rate parity is the only parity condition that is enforced by arbitrage.

Transaction Costs

Transaction costs can essentially be divided into three broad categories:

  1. Search and information costs are costs associated with determining whether the desired good is available in the market, where the lowest price exists, and so on.
  2. Bargaining and decisions costs are costs used to reach an acceptable agreement with the counterparty in the transaction, write an appropriate contract, and so on. In asset markets and in market microstructure, the transaction cost is some function of the distance between the bid and ask.
  3. Policing and enforcement costs are costs incurred to ensure that the counterparty complies with the agreement or to respond appropriately (often through the judicial system) if it proves that the counterparty doesn't.

Founder's Syndrome

The situation where leaders of companies are so emotionally invested in them that they can’t effectively delegate decisions, leading to micromanagement and stasis.

Luxury Paradox

More expensive goods are less likely to be used regularly than cheaper alternatives even though the higher price might indicate higher quality. The relationship between price and utility is an inverted U.

Winner's Curse

In open cry auctions and bidding wars, the winning bid has a tendency to exceed the intrinsic value of the item won. The smartest side to take in a bidding war is the losing side.

Ratchet Effect

During times of crisis, government spending increases but has a tendency to not fall back to pre-crisis levels when the crisis is over.

Primary source: Alan Peacock; Jack Wiseman

Iron Law of Civilization 3.0

A freely competitive market is a mechanism that is constantly self-evolving, self-advancing, and self-perfecting. When there is more than one market, the largest will eventually become the only one, since if any individual, society, enterprise, or nation is removed from this single market, it will start to steadily fall behind and will ultimately be forced to join in.

So, the best way for any nation to build its own strength is to abandon all trade barriers and join the largest international free market system in the world. The best way to fall behind is to close itself off from other countries.

Primary source: Li Lu

Say's Law

According to Say's law, supply creates demand because the income generated by past production and sale of goods is the source of spending that creates the demand to purchase current production. The reasoning is that to have the means to buy, a buyer must first have produced something to sell. And thus, the source of demand is production itself. As actor Kevin Costner says in the movie, Field of Dreams: If you build it, he will come.

Primary source: Jean-Baptiste Say

Paradox of Choice

The effect of how eliminating consumer choices can greatly reduce anxiety for users. There are, however, certain limitations about this paradox. Should there then be no choice at all? And if that be the case, how would business look like? If so, would all industries operating in an oligopoly switch to a monopoly leading to higher prices?

Primary source: Barry Schwartz

Hick's Law

Related to the paradox of choice, Hick's law poses that increasing the number of choices will increase decision time logarithmically. The more choices presented to users, the longer it will take them to reach a decision but the marginal decision time per extra choice decreases.

Primary source: William Edmund Hick

Free Rider Problem

A form of market failure where those who benefit from resources, goods, or services do not pay for them, which results in an under-provision of those goods or services. If someone builds a lighthouse, all sailors will benefit from its illumination.

When people are asked how much they value a particular public good, with that value measured in terms of how much money they would be willing to pay, their tendency is to under-report their valuations.

Cockroach Theory

When bad news are revealed, there may be many more related negative events yet to be revealed. There's never just one cockroach in the kitchen.

Evolutionary Stable Strategy

A subject in game theory indicating a strategy that is impenetrable by competitors once initiated. The evolutionary stable strategy creates a form of Nash equilibrium that is "evolutionarily" stable: once it is fixed in a population, natural selection alone is sufficient to prevent alternative strategies from successfully invading.

Two conditions must be present for such a circumstance:

  1. The entity employing the strategy must be better than any other entity that employs the same strategy or any other strategy
  2. Should a new strategy evolve that is equally as good, the entity employing the original strategy must do better than any entity employing both strategies.

Primary source: John Maynard Smith

Unknown Unknowns

Known unknowns are risks one is aware of, such as canceled flights or worker injuries. Unknown unknowns are risks coming from situations that are so out of this world that they are not imagined in advance.

Critical Mass

A term borrowed from physics, critical mass is the minimum amount of something required to sustain itself going forward. In the scene of social networks, critical mass refers to the number of adopters for a system that is required for the further adoption rate to be self-sustaining. In nuclear physics, it's the smallest amount of fissile material needed for a sustained nuclear chain reaction.

Freemium

A pricing strategy by which a good or service is offered for free to spur the growth of adoption but with a price charged for proprietary features or functionality. The business strategy has been used in the software industry since the 1980s.

Crowdsourcing

A sourcing model for soliciting ideas or finances from a large group of participants rather than from employees or suppliers. It's a method of "outsourcing work to the crowd".

Diversification

When multiple uncorrelated subjects move with certain volatilities, splitting the interest between them produces collective volatility which is lower than either of those subjects' volatilities. The strategy of diversification is commonly used in portfolio management by allocating capital to a mix of different investments with the ultimate goal of reducing volatility.

3-6-3 Rule

The value of a bank is easier to value based on how efficiently it utilizes the 3-6-3 rule which goes like this: a bank pays 3% on savings accounts, loans out money to businesses with solid financials at 6%, and then the banker leaves the office at 3 p.m. to play golf.

Excessive presence of derivates on a bank's books undermines the 3-6-3 rule.

First-Mover and Last-Mover Advantage

The advantage gained by the initial significant occupant of a market. First-mover advantage may be gained by technological leadership or early purchase of resources. However, in certain growth markets, the last-mover might be better positioned competitively if it's able to introduce the last great development in that market to gain years of monopoly profits.

Related to inversion, Grandmaster chess player José Raúl Capablanca said: You must study the endgame before everything else.

Principal-Agent Problem

The theory of delegation and accountability between individuals used in many areas of social sciences, but primarily political science and economics.

The theory deals with relationships where one party (the principal) delegates the performance of a given task to another party (the agent). The principal wants the agent to perform the task satisfactorily, but the principal has a problem that consists in establishing a payment structure - a reward - that gives the agent sufficient incentive to perform the task in accordance with the principal's wishes.

Principal-agent problems are a frequent cause of market failure.

Market for Lemons Problem

The quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind - e.g. a car that is found to be defective after purchase.

Primary source: George Akerlof

Minsky Moment

A sudden collapse of asset values marking the end of a credit cycle or an economic cycle.

Primary source: Hyman Minsky

Zero to One Theory

A thought experiment by Peter Thiel stating that technology and globalization are different modes of progress. Globalization is horizontal progress that goes from 0 to n while technology is vertical and goes from 0 to 1.

Primary source: Peter Thiel

Models in Human Nature and Judgment

Trust

Trust is a fundamental part of human nature and is pretty much all-encompassing in all we do. Trust produces increased speed, efficiency, empower ethical decision making, and hence, decreases costs.

Availability Heuristic

The tendency to judge the frequency of events in the world by the ease with which examples come to mind. We tend to most easily recall what is salient, important, frequent, and recent. So, we make decisions based on what we most easily recall but this undermines our ability to accurately judge frequency and magnitude.

Primary source: Daniel Kahneman; Amos Tversky

Anchoring

The tendency to rely too much on an initial piece of information when making subsequent judgments. The cognitive bias of anchoring is closely related to availability heuristic since the mind anchors to what information is familiar.

Primary source: Daniel Kahneman; Amos Tversky

Reciprocity

A social norm of responding to a positive action with another positive action, even if the action received has been unwanted. The interesting thing is that the positive action returned is often-times bigger than the initial action received.

Primary source: Robert Cialdini

Envy and Jealousy

Trying to avoid envy in an interconnected world is very difficult. It's a phenomenon that lies deep in human nature going back to ancient times. The Stoics warned against the consequences of envy, but yet it's still ingrained in human nature as ever. Warren Buffett says: It is not greed that drives the world, but envy.

Denial

Denial is a powerful psychological effect. When reality is too painful to bear, denial just distorts it until it's bearable. The refusal to accept reality or fact is a primitive defense or survival mechanism.

Stress

A situation that triggers a particular biological response when perceiving threat or standing in front of a major challenge. Stress triggers your fight-or-flight response and traces all the way back to assisting hunter-gatherer ancestors to survive.

Yerkes-Dodson law states that performance increases with anxiety and excitement, but only to a point.

Social Proof

In a study, researchers arranged for a man to violate the law by crossing the street against red light right into traffic. In half the instances, he was dressed in a business suit and tie. In the other half, he wore a work shirt and trousers. The study showed that three times as many pedestrians were swept along behind the man into traffic, against the light, and against the law, when he wore a suit.

Social proof, coined by Robert Cialdini, is a powerful psychological phenomenon of assuming the actions of others in an attempt to reflect correct behavior for a given situation.

Primary source: Robert Cialdini

Framing

The way a question or situation is framed can determine your response and lead to an action decided based on whether the options are presented with positive or negative connotations. Mixed with the narrative fallacy, framing can turn out dangerous for errors in decision making and might be used as power over other's behavior.

Primary source: Daniel Kahneman; Amos Tversky

Mental Accounting

A tendency to divide money into different pots and then treat them all separately based on subjective criteria. According to Richard Thaler, people think of value in relative rather than absolute terms. They derive pleasure not just from an object’s value, but also the quality of the deal - its transaction utility. The phenomenon helps explain why people are willing to spend more when they pay with a credit card than cash.

Primary source: Richard Thaler

Pavlovian Association

Ivan Pavlov's learning procedure of pairing a stimulus with a conditioned response. The idea emerged from an experiment on Pavlov's dogs demonstrating how the ring of a bell and the presence of a bowl of dog food (stimulus) would trigger an unconditioned response (salivation). Pavlov also came to notice that his dogs started to associate his lab assistant with food, creating a learned and conditioned response.

Primary source: Ivan Pavlov

Operant Conditioning

A method of learning through rewards and punishment. Such methods take place in many natural settings as well as in more structured settings such as the classroom or therapy sessions.

Primary source: B. F. Skinner

Commitment and Consistency Bias

A tendency to want to be consistent with one's prior actions. Because human actions, beliefs, and commitments help form self-perception, the commitment and consistency bias creates a reluctance to change a course of action once it's chosen even though that action may be forced by someone else.

Primary source: Robert Cialdini

Sunk Cost Fallacy

Linked to anchoring bias and commitment bias, the sunk cost fallacy is the tendency to continue an endeavor due to resources and effort invested in that endeavor even though cutting it loose seems to be a wise choice. Research suggests that rats, mice, and humans are all sensitive to sunk costs after they have made the decision to pursue a specific reward.

Liking Tendency

As Robert Cialdini puts it: It's no surprise that people prefer to say yes to a request to the degree that they know and like the requester. A simple way to make things happen in your direction is to uncover genuine similarities or parallels that exist between you and the person you want to influence, and then raise them to the surface. That increases rapport.

Primary source: Robert Cialdini

Stereotyping

A tendency to over-generalize a population or class of people. The concept is closely related to the availability heuristic.

Groupthink

The strive and desire for harmony, conformity, and compromise in a group can result in an irrational or dysfunctional decision-making outcome, although the opposite might be the purpose of creating the group.

Primary source: William H. Whyte Jr.

Authority Bias

The behavioral tendency to attribute greater weight and accuracy to the opinion of someone with an authority. This sometimes happens even when an individual believes that there’s something wrong with following the authority, and even when there wouldn’t be a penalty for defying them.

In 1961, the now-famous Milgram experiment was conducted by Stanley Milgram, a professor of psychology at Yale University. In it, participants were ordered to administer painful and potentially harmful electric shocks to another person they could not see. Many of them did so, even when they felt that it was wrong, and even when they wanted to stop because they felt pressured by the perceived authority of the person leading the experiment.

Primary source: Stanley Milgram

First-Conclusion Bias

A tendency to settle on the first information or conclusion adopted for a given problem, thus remaining resistant to the search for any more alternatives.

Confirmation Bias

The tendency to interpret a situation or seek out reinforcing evidence according to pre-existing beliefs. Charles Darwin is said to not have been able to come up with the theory of evolution without applying a constant process of destroying confirmation bias in his studies. He constantly sought out and noted observations that were opposed to what he thought and made an intense effort to investigate them.

Hindsight Bias

Also called creeping determinism, it's the tendency of overestimating one's ability to have predicted an outcome that could not possibly have been predicted. Hindsight bias is dangerous because it hinders one from learning from past mistakes. If we feel like we knew it all along, it means we won’t stop to examine why something really happened.

Recommended reading: Looking Back at 2020 (in Hindsight)

Survivorship Bias

A form of selection bias where the survivors - or the illuminated data - of a particular subject are disproportionately evaluated.

A commonly held belief is that machinery, equipment, and goods manufactured in previous generations often is better built and lasts longer than comparable items built during present times. You usually hear someone say: They don't make 'em like they used to. But because of the selective pressures of time and usage, it is inevitable that only those items which were built to last will have survived into the present day.

Curse of Knowledge

Once we learn something, we find it hard to imagine what it was like not to know it and thus find it difficult to think about problems from the perspective of lesser-informed people. The more knowledgeable you became on a subject, the more unnatural it becomes to communicate that idea in a simple and clear way. In short, knowledge itself becomes a barrier to its own propagation.

Primary source: Colin Camerer; George Loewenstein; Martin Weber

Reductive Bias

The need to treat non-linear complex systems as if they are linear. Mistakes generally arise from the mismatch between the complex reality one faces and the simplifying mental routines one uses to cope with that complexity.

Incentive-Caused Bias

People do what they’re incentivized to do. If someone is paying someone to be irresponsible, that someone is likely to be irresponsible. You generally get the outcome that you reward for. So you need to be very careful about how you design those rewards.

Representativeness Heuristic

Consider the following: Linda is 31, bright, single, and outspoken. She majored in philosophy at the university. As a student, she was deeply concerned with issues of discrimination and social injustice, and also participated in antinuclear demonstrations.

Is it more likely that Laura works at a bank? Or, is it more likely that she works at a bank and is active in the feminist movement?

Opting for the last option is prone to representative heuristic - the tendency to let the similarity of objects or events confuse one's thinking the probability of an outcome. Because the possibility that Linda is active in the feminist movement is a subset of a more inclusive category, the probability of her just working at a bank is simply higher.

Primary source: Daniel Kahneman; Amos Tversky

Narrative Instinct

Because we have a strong tendency to make sense from cause-and-effect, stories help us make sense of the world and is therefore remarkably powerful. But you could imagine the kinds of tripwires of errors this might cause. Just think back to the story of Linda in the prior model of representativeness heuristics.

Bizarreness Effect

Bizarre or controversial information is easier to recall than what is common.

Baader-Meinhof Phenomenon

Also known as a frequency illusion, this phenomenon is an illusion where once something has recently come to one's attention, it suddenly seems to appear with improbable frequency shortly afterward, making one overestimate its prevalence. Closely related to selection and recency bias.

Cobra Effect

At the time of British rule of colonial India, the British government was concerned about the number of venomous cobra snakes in Delhi and so it offered a bounty for every dead cobra. The policy initially appeared successful. Eventually, however, the number of dead cobras being presented for bounty payment began to increase over time and it was discovered that people began to breed cobras for the income. When the government became aware of this, the reward program was scrapped, causing the cobra breeders to set the now-worthless snakes free. As a result, the wild cobra population further increased. The apparent solution to the problem made the situation even worse.

Hence, the Cobra effect is when an attempted solution to a problem makes the very problem worse. The root of the cause is often applying too linear thinking to the problem while neglecting the effect of feedback loops. The model shows that simplistic policies can come back to bite you.

Boomerang Effect

An unintended consequence of people being persuaded to do one thing but then turns around to the opposite. Sometimes referred to as the theory of psychological reactance, the boomerang effect basically occurs when individuals perceive that someone attempts to restrict their freedom.

Curiosity Instinct

Curiosity opens up for exploration, investigation, and learning. Without the human curiosity instinct, science and technology would not be present. Companies do not survive without curiosity.

Language Instinct

Humans are born with an innate capacity for language and this capacity shows a lot about our cognitive organization. Steven Pinker sees language as an ability unique to humans, produced by evolution to solve the specific problem of communication among social hunter-gatherers.

Primary source: Steven Pinker

Hasty Generalization

Closely related to stereotyping, the human mind tends to generalize based on general rules from a sample set of data. But sometimes when the data does not fit the population, it leads to overgeneralization. As Daniel Kahneman puts it: Extreme outcomes (both high and low) are more likely to be found in small than in large samples. This explanation is not causal.

Relative Satisfaction

The tendency to determine own level of satisfaction by comparing circumstances to other's circumstances. Envy and jealousy are strongly caused by relative satisfaction. As Charlie Munger said: Envy is a really stupid sin because it's the only one you could never possibly have any fun at.

Kantian Fairness Tendency

Emmanual Kant's ethical theory of fairness requires that, for an action to be permissible, it must be possible to apply it to all people without a contradiction occurring.

The human psyche is strongly tended towards the idea of fairness. But life isn’t fair and many can’t accept this. Tolerating a little unfairness should be okay if it means greater fairness for all. We want things to balance but balance is not the order of life.

Fundamental Attribution Error

The tendency to overemphasize personal characteristics and ignore situational factors when judging others' actions and behavior. It results in believing that what people do reflects who they are.

Consider the case where Alice, a driver, is cut off in traffic by Bob. Alice instantly attributes Bob's behavior to his fundamental personality, e.g. that he's selfish and an unskilled driver. She does not immediately consider that Bob might be late for a flight, his son's birth, or an accident. Inversely, Alice might well make the opposite mistake and excuse herself by saying she herself was influenced by situational causes. Also termed the actor-observer symmetry.

Primary source: Lee Ross

Action Bias

Waiting and watching is torture, so humans have a tendency to act even when no action is needed. The best decision is sometimes to watch the grass grow.

Principle of Least Effort

A theory postulating that animals, humans, and well-designed machines will naturally seek the path of least resistance, and that effort declines as the minimum acceptable result is attained.

Primary source: Guillaume Ferrero

Cognitive Dissonance

The effect of simultaneously trying to believe two incompatible things at the same time. When people smoke even though they know it's pretty bad for them, they experience cognitive dissonance.

Primary source: Leon Festinger

Hard-Easy Effect

We tend to overestimate our ability to do something hard and underestimate our ability to do something easy. And so we attempt to focus on what's hard even though the thing that's easy might bring the same, or larger, rewards. Related to the Dunning-Kruger effect.

Primary source: Leon Festinger

Focusing Effect

The tendency to put too much emphasis on limited factors that do not matter much as part of a larger system. In other words, it's when someone doesn't see the forest for the trees. Daniel Kahneman once said: Nothing in life is as important as you think it is, while you are thinking about it.

Recency

The tendency to weigh recent information more heavily because that information seems more vivid even though it might be less important than past information. It's closely related to the availability heuristic.

Planning Fallacy

Tasks often take longer than expected. First proposed by Daniel Kahneman and Amos Tversky in 1979, the planning fallacy is an effect of optimism bias and is describing not only the underestimation of time but also of costs and risks.

Primary source: Daniel Kahneman; Amos Tversky

Reputation Fragility

As Warren Buffett says: It takes 20 years to build a reputation and 5 minutes to ruin it.

Noise Bottleneck

Coined by Nassim Taleb, a noise bottleneck is when more sampling of something decreases the signal to noise relationship, increasing the amount of randomness, and decreasing the probability of sound conclusions. We tend to think that consuming more information is better except when that causes us to place too much emphasis on irrelevant data.

Primary source: Nassim Taleb

Keynesian Beauty Contest

Closely related to the pari-mutuel system, a Keynesian beauty contest is a concept used to describe an action that is based not on one's own perception but an inference of what one thinks the public perception will be of a subject. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus, the strategy can be extended to the next order and the next, and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.

To demonstrate this, John Maynard Keynes used an analogy based on a fictional newspaper contest in which contestants were asked to choose the six most attractive faces from a hundred photographs. Those who picked the most popular faces would win a prize.

Keynes then argued: It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

Primary source: John Maynard Keynes

Serpico Effect

Named after Frank Serpico, who became known for whistleblowing on police corruption in the late 1960s and early 1970s, the Serpico effect is the tendency to rationalize an action because everyone else is doing it.

Depressive Realism

A hypothesis stating that depressed people make more realistic inferences than non-depressed people. It's the opposite of being blissfully unaware. While a useful mental model, the evidence for depressive realism is largely debated and remains a hypothesis.

Primary source: Lauren Alloy; Lyn Yvonne Abramson

Skill Compensation

People who are relatively good at one thing might tend to be relatively poor at another. An effect of trade-offs in deciding the time spent developing one skill over another.

Compassion Fade

The tendency to have more compassion for victims within small groups than larger groups, because the smaller the group the easier it is to identify individual victims. One victim can break our hearts while larger groups seem more distanced.

Three Men Make a Tiger

A Chinese proverb that underlines the tendency to accept absurd information as long as it is repeated enough times by enough people. If one person tells you there’s a tiger roaming around town, you might assume they’re lying. If two people tell you, you begin to wonder. If three say it’s true, you're getting closer to believing it.

Primary source: Pang Cong

Buridan's Ass

Coined after French philosopher Jean Buridan, Buridan's ass is a type of decision paralysis where two equally good options lead to no decision.

The paradox is explained by the story of a donkey that is equally hungry and thirsty and placed precisely midway between a stack of hay and a pail of water. Since the paradox assumes the donkey will always go to whichever option is closer, it dies of both hunger and thirst since it cannot make any rational decision between its two options.

Primary source: Jean Buridan

Imposter Syndrome

The fear of being exposed as less talented than one's surroundings think about one. Also termed impostorism, the phenomenon occurs when individuals feel they do not deserve all they have achieved.

Primary source: Pauline R. Clance; Suzanne A. Imes

Semmelweis Reflex

Related to first-conclusion bias, the Semmelweis reflex is the tendency to reject new evidence or new information because it contradicts established norms, beliefs, or paradigms. It's named after a Hungarian doctor named Ignaz Semmelweis who discovered that patients treated by doctors who wash their hands get fewer infections but struggled to convince others that his finding was true.

Primary source: Ignaz Semmelweis

False-Consensus Effect

The tendency to erroneously believe that your views or beliefs are more widely held within a population than they are. This false consensus increases or decreases self-esteem, overconfidence effect, or a belief that everyone knows one's own knowledge. Relation to the curse of knowledge.

McNamara Fallacy

Named after Robert McNamara, the US Secretary of Defense during the Vietnam War, it's the belief that rational decisions are made solely on the basis of quantitative evidence, ignoring all other factors. McNamara measured success during the war solely on the measure of enemy body counts, causing the US army to lose track of the war’s strategic objectives. Don’t presume that what can’t be measured isn’t really important.

Courtesy Bias

The resistance to giving an honest opinion due to a desire not to offend the person or organization responding to. A frequent example is of employees hesitant to giving an honest opinion to their superiors, clogging information flow for rational decision making in the company.

Ludic Fallacy

Identified by Nassim Taleb and described in The Black Swan, the ludic fallacy is the tendency to falsely associate simulations with real life. Because simulations are designed as "narrow worlds of game and dice", they fail to account for chaos regarding future events in the real world.

Primary source: Nassim Taleb

Dunning-Kruger Effect

The cognitive bias that can be observed when people with beginning-level competencies tend to overestimate their own abilities. The effect, documented by and named after psychologists David Dunning and Justin Kruger, is explained by the fact that at this level of understanding and competence, one has not yet learned to recognize the limits of one's own competences. Knowing the limits of one's intelligence requires a certain level of intelligence.

Primary source: David Dunning; Justin Kruger

Abilene Paradox

The situation where a group decides to make a decision that is counter to the thoughts and feelings of its individual members in the group. It happens because the members fail to communicate their individual beliefs.

Primary source: Jerry B. Harvey

In-Group Favoritism

Related to the liking tendency, in-group favoritism is the inclination to give preference to people within your own social group. Nepotism is an example.

Primary source: William Sumner

Collective Narcissism

The tendency to exaggerate the positive image and importance of a group that one belongs to.

Primary source: Sigmund Freud

Normalcy Bias

The tendency to believe threats and disasters are not at all probable due to a belief that things will remain as they always have.

Texas Sharpshooter Fallacy

The action of picking the target to go for after making the shot, making it impossible to miss. When the same data is used both to construct and test a hypothesis, conclusions are misguided.

Plain Folks Fallacy

A logical fallacy involving speakers attempting to convince an audience that they, and their ideas, are “of the people" and that they themselves are Average Joes.

Poisoning the Well

Also called a smear tactic, it's the act of presenting negative information that is irrelevant before presenting an argument, which makes that argument, or person, seem untrustworthy. Before you listen to what he has to say, may I remind you that he has been in jail.

Primary source: John Henry Newman

Appeal to Consequences

An argument that attempts to prove a hypothesis true or false because the consequences of it being true or false are desirable or undesirable. It's a logical fallacy.

Behavioral Inevitability

The notion that human behavior, and its inherent biases, will always remain. As Voltaire said: History never repeats itself; man always does.

Self-Handicapping

The tendency to resist putting in an effort to do something because of a worry that failing might put a dent to one's self-esteem.

Primary source: Edward E. Jones; Steven Berglas

False Uniqueness Effect

An attributional cognitive error of assuming that one's qualities, traits, and personal attributes are unique when in reality they are not. In essence, it's the opposite of imposter syndrome.

Backfiring Effect

The tendency to enforce one's existing beliefs about something when presented with disconfirming evidence. A study that looked at political voting showed that introducing people to negative information about their favored political candidate would often cause them to increase their support for that candidate.

Positive Illusions

A form of self-deception that causes individuals to think inflatedly about themselves, their decisions, and abilities to avoid short-term discomfort or raise self-esteem. A positive illusion might cause a negative spiral of justifications about worse and worse decisions.

Primary source: Shelley Taylor; Jonathon Brown

Ironic Process Theory

The psychological process of attempting to suppress certain thoughts, making those thoughts more likely to resurface in one's mind.

Primary source: Daniel Wegner

Aumann’s Agreement Theorem

Named after Israeli-American mathematician Robert Aumann, it's the notion that two rationally people in an opposing argument can't and shouldn't come to the conclusion of agreeing to disagree if they have common knowledge of each other's beliefs.

Primary source: Robert Aumann

Ostrich Effect

As ostriches bury their heads in the sand to avoid danger, the ostrich effect is the tendency to avoid opposing information to what one desperately wants to be right.

Primary source: Dan Galai; Orly Sade

Bounded Rationality

Limits to the capacity of the human mind make it impossible to contain and recall all information obtained, and therefore, rationality is also limited.

Primary source: Herbert Simon

Fluency Heuristic

Related to the narrative fallacy, fluency heuristic is the tendency to believe more in ideas that are easy to explain rather than those that are hard to comprehend.

Persian Messenger Syndrome

The act of blaming the bearer of negative news.

As Charlie Munger has said: The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.

Okrent's Law

A law stated by writer Daniel Okrent referring to the phenomenon of the press providing legitimacy to unsupported fringe viewpoints in an effort to appear even-handed.

He once said: The pursuit of balance can create imbalance because sometimes something is true.

Primary source: Daniel Okrent

Vierordt’s Law

In 1868, German physiologist Karl von Vierordt created this law stating that humans perceive time at different magnitudes over different durations. We underestimate long periods of time and overestimate short periods of time.

Primary source: Karl von Vierordt

Cunningham's Law

Ward Cunningham, the creator of the first wiki, said: The best way to get the right answer on the Internet is not to ask a question. It’s to post the wrong answer.

If you constantly express anger in your private conversations, your friends will likely find you tiresome, but when there’s an audience, the payoffs are different; outrage can boost status.

The internet promotes the same dynamic as road rage: once you’re arguing with a computer (or vehicle) rather than a person, social norms tend to vanish.

Primary source: Ward Cunningham

Tyranny of Small Decisions

A situation where a series of small, individually rational decisions creates a path dependence that might negatively alter the context of decisions made subsequently to the point where the original desire is irreversibly destroyed.

Primary source: Alfred Kahn

Hyperbolic Discounting

The tendency to show a higher preference for the reward that comes sooner rather than later. Humans discount future events. This is why we have interest rates.

Primary source: Richard Herrnstein

Delayed Gratification

The process an individual undergoes when resisting the temptation of an immediate reward in preference for a later reward.

Observer Effect

A situation where an individual is being observed, but the very observation alters that individual's actions. Merely observing a phenomenon inevitably changes the same phenomenon.

Golem Effect

Related to the observer effect, performance tends to decline when supervisors, teachers, or bosses have low expectations of one's abilities.

Maslow's Hierarchy of Needs

A motivational theory created by psychologist Abraham Maslow in a 1943 paper stating that humans have five categories of needs in order: physiological, safety, love, esteem, and self-actualization. Higher needs in the hierarchy emerge when the previous need is appropriately satisfied.

Primary source: Abraham Maslow

Bystander Effect

A social observation that people are less likely to help a victim when others are present as an audience. The greater the number of bystanders, the less likely is it that one of them will help.

Primary source: John M. Darley; Bibb Latané

Hot Hand Fallacy

Describes the positive expectation that an event will occur that has already been preceded by a consequence of the same event. Sports fans have a tendency to assume that a particular player having a streak of successful shots has an increased probability of making the next shot, irrespective of the player's historical shooting record.

Primary source: Amos Tversky; Thomas Gilovich; Robert Vallone

Gambler's Fallacy

Also known as the Monte Carlo fallacy, it's the mistaken belief that a run of specific results in a random process makes it less or more likely to occur the next time.

For example, a series of 10 coin flips might all land on heads. Under the gambler's fallacy, a person might expect that the next coin flip is more likely to land on tails the next time.

Primary source: Daniel Kahneman; Amos Tversky

Models in Numeracy and Interpretation

Power Laws

When a relative change in one quantity results in a proportional relative change in the other quantity. Few empirical distributions fit a power law for all their values but rather follow a power law in the tail. For example, the distribution of income in a market economy is following a power law because inequality is built into the process of wealth accumulation itself. Big cities people draw more people. Capital in corporations attracts more capital. Profits generate greater profit. The Pareto principle is a type of power law.

Permutations and Combinations

With permutations, we care about the order of the elements, whereas with combinations we don’t. The mathematics of permutations and combinations leads us to understand the practical probabilities of the world around us and are enormously important.

Primary source: Blaise Pascal; Pierre de Fermat

Algebra

The study and manipulation of mathematical symbols or letters to demonstrate equivalence or inequivalence of subjects. Algebra is considered an essential part of any study within mathematics, science, or engineering, as well as such applications as medicine and economics.

Multiplying by Zero

Any number multiplied by zero, no matter how large, becomes zero. And yet, this is often learned the hard way. When trying to compound returns it's fatal to multiply your capital by zero.

Randomness

Randomness is present everywhere in the real world but it often doesn't fit how we think about the world. An erroneous strive for pattern-seeking sometimes makes us see patterns that are not there. As Nassim Taleb puts it, we are "fooled by randomness".

Stochastic Processes

A family of random variables on the same probability space. Brownian motion and the random walk theory are stochastic processes.

Gambler's Ruin

Playing a negative-probability game persistently enough guarantees to go broke. Gambler's ruin might also explain the case where a gambler goes broke even if he might have a positive expected value on each bet. This happens if the gambler raises the bet to a fixed fraction of bankroll when winning, but doesn't reduce it when losing.

Primary source: Blaise Pascal; Pierre de Fermat

Compounding

A powerful force that happens when interest is regularly added to the sum which earned interest on the previous sum. Said to be called the "8th wonder of the world" by Albert Einstein, it’s a mathematical concept that lays the foundation for the field of finance but is clearly not bounded by the realm of finance itself. Knowledge, capability, ideas, relationships, and so on all build on the basis of compound interest. Naval Ravikant has said: Play iterated games. All the returns in life, whether in wealth, relationships, or knowledge, come from compound interest.

Understanding the time value of money is crucial because compounding plays out over the long term. In the short term, incremental gains are often hardly noticed.

Churn

Churn is a form of entropy. Basically, it's the measure of the number of people or items moving out of a collective group over a specified period of time (think customers of insurance companies or subscription services). Reducing churn requires constant care of the group.

Churn and growth rates are diametrically opposed factors as one measures the loss of a group and the other measures acquisition into the group.

Law of Large Numbers

The law stating that the average of the results obtained from a large number of events should be close to the expected value of those events and will tend to become closer to the expected value as even more events occur. It was proved in 1713 by Swiss mathematician Jakob Bernoulli.

In business, the law of large numbers is evident in relation to percentage-wise growth rates. As a business grows larger, the percentage rate of growth becomes increasingly difficult to maintain.

Probability Distributions

Statistical functions that describe all the possible values and likelihoods that a random variable can take within a given range. How the distribution of these values is laid out is dependent on its standard deviation, skewness, and kurtosis. The most common of these is the normal distribution - or bell curve - which is found frequently in finance, investing, science, and engineering.

Central Limit Theorem

If you add a large number of independent random variables, possibly with different probability distributions, but with finite variances, the sum will go towards a normal distribution.

Primary source: Pierre-Simon Laplace

Confidence Interval

The measure that explains to what degree a sample estimate might explain the true value of a parameter when tested on a population. It's the range of values we are fairly sure our true value lies in. Not understanding the confidence interval is often what creates financial trouble.

Regression to the Mean

The occurrence that happens when a number of observations follow the law of large numbers. If a random variable is extreme on its first measurement, regression to the mean suggests that it will be closer to the mean or average on its subsequent measurements.

It's easy to understand the concept. But not understanding its limitations or where it's applicable can prove very dangerous. For example, large amounts of money have been subject to opportunity cost in the stock market by erroneously buying below-average price-to-book companies believing their values will follow the regression to the mean principle. That is until the investor realizes that the price is just the numerator and the book value - the denominator - starts to turn on the thesis.

Order of Magnitude

A quantitative measure generally used to make very approximate comparisons. If two numbers differ by one order of magnitude, one is about ten times larger than the other.

Kelly Criterion

In 1956, a young scientist at Bell Labs named John Larry Kelly Jr. came up with a simple formula for optimal bet sizing based on the better's edge and odds of winning. It was essentially built on Claude Shannon’s information theory and Bernoulli’s St. Petersburg Paradox.

The formula is:

Edge / odds = Fraction of your bankroll to bet each time

As an example, taking a positive risk/reward bet of 1:2 with a 50% chance of either outcome, the Kelly criterion suggests that the optimal bet size of the bankroll is 25% (reward, if positive odds play out, is 2 and edge is 0.5, so 0.5 / 2 = 25%). No other approach can increase wealth faster than the Kelly criterion without increasing the odds of wiping out the bankroll.

Primary source: John Larry Kelly, Jr.

J-Curve

An effect where a curve initially falls, then steeply rises above the starting point.

The model is usually applied in terms of analyzing the path of a country's terms of trade following a devaluation or depreciation of its currency, under a set of conditions.

In private equity, the J-curve is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature.

Base Rate Neglect

A tendency to ignore the a priori probability of something by putting heavier weight on appealing information about an individual's case. Only 6% of applicants make it into this school, but my son is brilliant. I'm sure they're going to accept him!

Primary source: Daniel Kahneman; Amos Tversky

Anscombe’s Quartet

Developed by statistician Francis Anscombe, Anscombe's quartet is when presumably identical sets of numbers do not at all look identical when graphed. Numerical calculations are exact, but graphs are rough.

Primary source: Francis Anscombe

Selection Bias

An experimental error that happens when sample data is not representative of the population as a whole.

Berkson’s Paradox

A case where conditional probability and correlations are counterintuitive due to a sampling or selection bias.

Suppose a stamp collector has 1000 postage stamps, of which 300 are pretty and 100 are rare, with 30 being both pretty and rare. 10% of all the collector's stamps are rare and 10% of the pretty stamps are rare, so prettiness tells nothing about the rarity of the stamps.

Primary source: Joseph Berkson

Apophenia

A psychological phenomenon where random and meaningless impressions are perceived as meaningful. It's a way to comfort the mind in explaining how the world works. To see patterns and connections when none are present is also called patternicity.

Primary source: Klaus Conrad

Neglect of Probability

The tendency to disregard probability in decision making under uncertainty. Small risks are either neglected entirely or hugely overrated. Hindsight bias is a common result of the tendency to neglect probability.

Ergodicity

Born from the field of thermodynamics, ergodicity is a case where population probabilities don't apply to individual events but are evened out as time passes. One might not die from a single game of Russian roulette but will most certainly die if playing the game enough times.

Primary source: Ludwig Boltzmann

Moral Luck

The act of praising a person for a good deed they didn’t have full control over. As Nassim Taleb puts it: Avoid calling heroes those who had no other choice.

Primary source: Bernard Williams

Friendship Paradox

Most people have fewer friends than their friends have, on average. The reason is a type of sampling bias in which people with more friends are more likely to be one of your friends. In reality, the friendship paradox is a contradiction because most people believe that they have more friends than their friends have.

Primary source: Scott L. Feld

Clustering Illusions

Falsely assuming that streaks or clusters of small samples in a large pool of data in random distributions indicate a non-random distribution.

Primary source: Thomas Gilovich

Nonlinearity

Closely related to the Kantian fairness tendency, nonlinearity is a situation where there is not a straight-line or direct relationship between an independent variable and a dependent variable. The output is not proportional to the change of the input, posing to sometimes appear chaotic, unpredictable, or counterintuitive. A very important topic to understand.

Moderation

A situation where the relationship between two variables depends on a third variable. If two objects are stuck together in thick and thin, that might be due to a third variable - glue.

Denomination Effect

Even though a $50 bill has the same value as 10 $5 bills, we tend to feel that the 10 bills are worth less. The denomination effect is also evident in the case of stock splits.

Primary source: Priya Raghubir; Joydeep Srivastava

Woozle Effect

When frequent citation of previous information that lacks evidence misleads individuals into believing it's evidence. As Daniel Kahneman puts it: A reliable way to make people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth.

The Scientific Method

An empirical method of acquiring knowledge through systematic observation, measurement, and experiment, and the formulation, testing, and modification of hypotheses.

Proxy

A variable that serves instead of an immeasurable other variable. The proxy must be close to the replaced value in order for it to be a good proxy.

Inflection Point

A point on a curve at which the curve changes from being concave (concave downward) to convex (concave upward), or vice versa.

Simpson's Paradox

A case where a certain trend seems evident in different groups of data but is not evident when these groups are combined.

Primary source: Edward H. Simpson

Surface Area

The amount of space that is outside of a solid object. If building a tank larger than it is, the amount of steel used to grow the tank will be able to hold more. It's a non-linear relationship.

Maxima and Minima

Known collectively as the extrema, maxima and minima are the highest and lowest points of value in a function. Pierre de Fermat was one of the first mathematicians to propose a general technique, adequality, for finding the maxima and minima of functions.

Sensitivity Analysis

A method of assessing the stability of research results by changing conditions in each variable.

Benford's Law

Describes how different figures are distributed as first figures in statistics. For example, Benford's law states that the number 1 should be the first digit in 30.1% of the cases, the number 2 in 17.6% of the cases and the figure 9 in 4.6% of the cases in a very large amount of data.

Primary source: Frank Benford

Black Swan Events

Rare events that have a large impact are difficult to predict and are beyond normal estimates.

Primary source: Nassim Taleb

Models in Thinking

Decision Trees

A tree-like visualization of how action leads to another series of possible consequences and outcomes. Algorithms are largely based on decision trees.

Probabilistic Thinking

Probabilities are the rules of the world, and thus probabilistic thinking is one of the most critical traits and skills to adopt. But John Maynard Keynes also said: It's better to be roughly right than precisely wrong.

Second-Order Thinking

Thinking in terms of effects and the effects of those effects. Second-order thinkers ask themselves the question; and then what?

Second-order thinking is largely related to thinking in terms of permutations and combinations in combination with decision trees. This is crucial in the investment business. As Ray Dalio says: Failing to consider second- and third-order consequences is the cause of a lot of painfully bad decisions, and it is especially deadly when the first inferior option confirms your own biases.

Bayesian Updating

The method of updating a probability estimate for a hypothesis as new evidence or information becomes available. It's hugely in line with how the world works because Bayesian updating is closely related to subjective probability. It was named after Reverend Thomas Bayes.

Primary source: Thomas Bayes

Bloom's Taxonomy

Created by Benjamin Bloom in 1956, Bloom's taxonomy is a set of three hierarchical orders of thinking of any subject in terms of levels. It consists of three learning domains: the cognitive, affective, and psychomotor, and it then assigns to each of these domains a hierarchy that corresponds to different levels of learning where each level subsumes the levels that come before it.

The levels of the cognitive domains are ordered as knowledge, comprehension, application, analysis, synthesis, and evaluation.

Primary source: Benjamin Bloom

Circle of Competence

Moving out of one's circle of competence is prone to blind spots that one is unaware of. Yet often, when one is not able to define or think about one's circle of competence, it leads to the same degree of confidence as to when one is really operating within the circle of competence. This is dangerous.

The concept is important because it allows bright people to utilize limited, really valuable insights in a very competitive world when they’re fighting against other very bright, hardworking people.

Primary source: Warren Buffett

First Principles

The basic assumptions that cannot be deduced any further in a specific field. Aristotle defined first principles as; the first basis from which a thing is known. It's the idea of breaking down complicated problems into its basic and only essential elements.

Primary source: Aristotle

Thought Experiment

An imaginary experiment used to solve difficult problems and their potential consequences. The concept was very effectively used by Einstein to discover the theory of relativity by imagining traveling on a beam of light.

Inversion

A thinking tool to get to the root of a problem by thinking of it in reverse. Carl Gustav Jacob Jacobi told his students that when looking for a research topic they should; invert, always invert.

Primary source: Carl Gustav Jacob Jacobi

The 5 Whys

Asking yourself 5 whys about a given subject is a great way to push yourself to find the truth and achieve rationality.

Primary source: Sakichi Toyoda

Occam's Razor

All else equal, Occam's razor is the idea of preferring the theory with the fewest assumptions. Also called the parsimony principle, it's a basic idea to all science and suggests to choose the simplest scientific explanation that fits the evidence. In terms of tree-building, this means that, ceteris paribus, the best hypothesis is the one that requires the fewest evolutionary changes.

Primary source: William of Ockham

Hanlon's Razor

Inspired by Occam's razor, it's a way of eliminating unlikely explanations for human behavior. Robert J. Hanlon said: Never attribute to malice that which can be adequately explained by stupidity.

Primary source: Robert J. Hanlon

Maslow's Hammer

If all you have is a hammer, everything looks like a nail. Also known as the law of the instrument. It's a law because an instrument can pretty much only be used in one way to fulfill its purpose of creation.

Primary source: Abraham Maslow

Divergent vs. Convergent Thinking

Divergent thinking is the process of thinking by exploring multiple possible solutions in order to generate creative ideas. Convergent thinking is the process of figuring out a concrete solution to any problem. The key is to strike a balance.

Primary source: Joy Paul Guilford

Chronological Snobbery

The argument or thinking that the stuff of earlier times is inferior to that of the present, simply due to societal progress.

As C.S. Lewis puts it: The assumption that whatever has gone out of date is on that account discredited. You must find why it went out of date. Was it ever refuted (and if so by whom, where, and how conclusively) or did it merely die away as fashions do? If the latter, this tells us nothing about its truth or falsehood. From seeing this, one passes to the realization that our own age is also ‘a period,’ and certainly has, like all periods, its own characteristic illusions.

Lewis made it a rule of thumb that one should read at least as many old books as new ones.

Primary source: C. S. Lewis; Owen Barfield

Weasel Words

The illusion that when someone wants to make it seem like they've given a clear answer to a question or made a direct statement when actually they've said something inconclusive or vague. Words like "better", "improved", "gains" do not say how much in terms of a complete argument.

Knightian Uncertainty

Economist Frank Knight argued that risk applies to situations where we don't know the outcome of a situation but can measure its probabilities. On the other hand, uncertainty applies to situations where we can't know all the information needed in order to set accurate probabilities in the first place.

Primary source: Frank Knight

Map-Territory Relation

The relationship between an object and a representation of that object is always abstract - like a map vs. the territory it represents. A person who has seen and heard descriptions of an apple, but has never tasted it, will not know how it tastes.

Primary source: Alfred Korzybski

All Models Are Wrong

Closely related to the map-territory relation, it's an aphorism in statistics commonly stating: All models are wrong, but some are useful. Attributed to statistician George Box, the thinking is considered applicable to all scientific models.

Primary source: George Box

Middle Ground Fallacy

The fallacy of compromising two opposing views to land on the middle ground just because it's the middle ground. For example, if one person says that all elephants can fly, another says that no elephants can fly, it's a fallacy to agree that perhaps some elephants can fly.

Eisenhower Matrix

Dwight Eisenhower, the 34th President of the United States, had to make tough decisions continuously about which of the many tasks he should focus on each day. And so he created the Eisenhower matrix to decide on and prioritize tasks by urgency and importance, sorting out less urgent and important tasks which he should either delegate or not do at all. He said: What is important is seldom urgent, and what is urgent is seldom important.

Primary source: Dwight Eisenhower

Systemics

The study of systems, how they work, how they are related to larger systems, and how they break down or are prone to bottlenecks. It's a disciplined approach for examining problems more completely.

Primary source: Mario Bunge

Lateral Thinking

First coined by Edward de Bono in 1967, it's a method of thinking across otherwise irreconcilable dialectical disciplines and then arriving at solutions that cannot be arrived at via deductive or logical means. We might call this "thinking outside the box".

Consider this: A man walks into a bar and asks the barman for a glass of water. The barman pulls out a gun and points it at the man. The man says thank you and walks out. Why?

The man had hiccups.

Primary source: Edward de Bono

Historical Wisdom

Studying the past intensely to understand the present and the future because the past makes up the vast majority of events. Scottish historian Niall Ferguson has said: The dead outnumber the living 14 to 1, and we ignore the accumulated experience of such a huge majority of mankind at our peril.

Paradigm Shift

When an important change occurs that replaces the usual way of thinking about or doing something.

Primary source: Thomas Kuhn

Abduction

A term related to both induction and deduction, where the researcher moves between theory and empiricism to gradually allow understanding to emerge.

Primary source: Thomas Kuhn

Chauffeur Knowledge

Charlie Munger explains in the story of Max Planck and his chauffeur: I frequently tell the apocryphal story about how Max Planck, after he won the Nobel Prize, went around Germany giving the same standard lecture on the new quantum mechanics.

Over time, his chauffeur memorized the lecture and said, "Would you mind, Professor Planck, because it’s so boring to stay in our routine. [What if] I gave the lecture in Munich and you just sat in front wearing my chauffeur’s hat?" Planck said, "Why not?" And the chauffeur got up and gave this long lecture on quantum mechanics. After which a physics professor stood up and asked a perfectly ghastly question. The speaker said, "Well I’m surprised that in an advanced city like Munich I get such an elementary question. I’m going to ask my chauffeur to reply.'

Planck knowledge has paid the dues and gained the aptitude. Chauffeur knowledge just learned the talk.

Primary source: Charlie Munger

Pascal's Wager

Blaise Pascal's famous argument for believing in God. Pascal argued that it's always a better "bet" to believe in God because the expected value of the gain to be achieved by believing in God is always greater than the expected value in the case of unbelief.

On the question of God's existence, a third option is excluded (tertium non datur). There are only two options:

  1. God exists
  2. God does not exist

Thus, one will be forced to bet on one of the options:

  1. If one bets that God exists, one would win everything if one is right and would lose nothing.
  2. If one bets that God doesn't exist, nothing can be won, but one can lose everything.

Primary source: Blaise Pascal

Models in Systems

Scale

As a system or an organization performs more and more of the same type of work, it will tend to acquire efficiencies over time, but it might also acquire inefficiencies - like bureaucracy. When scale turns into an advantage, it's due to positive feedback loops.

It's safe to conclude that scale advantages can create extremely durable economic moats, but it's also important to recognize that economies of scale don’t necessarily create moats. As other car producers closed the gap with Ford’s level of productivity, Ford’s scale advantage disappeared.

Pareto Principle

Also known as the 80/20 rule and as a form of power law, the Pareto principle states that, for many situations, roughly 80% of the situation's effects come from 20% of the causes. It was developed by Vilfredo Pareto who showed that approximately 80% of the land in Italy was owned by 20% of the population.

The principle can be applied in a wide range of areas such as manufacturing, management, human resources, and personal time management. However, though broadly applied, it does not apply to any scenario. Be careful with it.

Primary source: Vilfredo Pareto

Law of Diminishing Returns

In all productive processes, adding more of one factor of production will, ceterus paribus, at a certain point result in lower incremental per-unit returns. The law is existing because there are always constraints in the world. Too many cooks spoil the broth.

Algorithms

A way to solve a problem by way of termination. An algorithm consists of sets of rules to complete the task in a series of steps. An obvious example is a recipe.

Primary source: Muḥammad ibn Mūsā al-Khwārizmī

Margin of Safety

Warren Buffett has said on the margin of safety: You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.

While useful in investing, the margin of safety is a methodological issue that is an incredibly useful concept in nearly any life endeavor.

Primary source: Benjamin Graham

Network Effects

If only one person is participating in a social network, that social network will have no value. Since network effects work in terms of returns to scale, the network's value is driven by the number of users coming into the network. Sometimes, that turns into a winner-take-all scenario.

Primary source: Theodore Vail

The Tipping Point

Popularized by Malcolm Gladwell, the tipping point is the point at which a product or trend goes viral - or turns into an epidemic. Gladwell introduces three variables that create the tipping point: the law of the few, the stickiness factor, and the power of context. A powerful mental model for how things gain traction in society.

Primary source: Malcolm Gladwell

Entropy

A measure of the number of possible arrangements the atoms in a system can have. In other words, it's a measure of uncertainty or randomness. Essentially, entropy is evident because of probability since there are only a limited set of ordered states in a system but an infinite amount of chaotic states.

Primary source: Rudolf Clausius

The Second Law of Thermodynamics

Directly related to entropy, the second law of thermodynamics states that the total entropy of an isolated system will inevitably increase over time and will only remain still if all processes in the system are reversible.

Imagine a bunch of balls bouncing around in a box in an initially ordered way as a pattern. Over time, the balls will inevitably bounce around more chaotically and the entropy of the system thus increases.

Primary source: Rudolf Clausius

Principle of Minimum Energy

As a restatement of the second law of thermodynamics, the principle of minimum energy states that for a closed system with fixed entropy, the total energy is minimized at equilibrium.

Feedback Loops

When the outcome of a system amplifies and reinforces the system itself in either positive or negative fashion. The output is rooted back as an input for the next stage. A great way to think about really difficult problems is to try and depict cause-and-effect relationships by connecting them in loops.

It's largely related to systems thinking. Systems thinking is not linear and it doesn't happen in a straight line — it happens in cycles, loops, contours.

Reflexivity

With George Soros as its primary proponent, reflexivity is a theory that feedback loops between expectations and economic fundamentals can cause price developments that substantially and persistently deviate from equilibrium prices. Soros’s theory of reflexivity runs counter to the ideas of economic equilibrium, rational expectations, and the efficient market hypothesis.

Primary source: George Soros

Complex Adaptive Systems

An extremely important mental model in which a perfect understanding of the individual parts in a system does not automatically convey a perfect understanding of the system's behavior as a whole. Examples of complex adaptive systems include cities, large corporations, markets, governments, and so on.

Michael Mauboussin explains: If you examine the colony on the colony level, forgetting about the individual ants, it appears to have the characteristics of an organism. It’s robust. It’s adaptive. It has a life cycle. But the individual ant is working with local information and local interaction. It has no sense of the global system. And you can’t understand the system by looking at the behavior of individual ants. That’s the essence of a complex adaptive system—and the thing that’s so vexing. Emergence disguises cause and effect. We don’t really know what’s going on.

Pari-Mutuel System

A betting system in which all bets are placed in a collective pool and payoff odds are calculated by sharing the pool among all winning bets after house take. A common example is horse race betting.

Charlie Munger has said: The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market.

Bufferfly Effect

A phenomenon where a small change in an initial condition can have a huge effect in a future condition. The term comes from an analogy where a butterfly flaps its wings in Chicago and a tornado occurs in Tokyo.

The social impact of the butterfly effect theory is undeniable in today’s inter-connected world. Butterfly effects make social systems fundamentally unpredictable.

Preferential Attachment

When what is popular or perceived as better grows even more than what is less popular. Network effects feed on preferential attachment.

Emergence

When the sum of something cannot be explained by simple additions of its components, e.g. when the sum is greater than the parts.

Irreducibility

When a system or object is incapable of being reduced, diminished, or simplified further.

Tragedy of the Commons

When a depletable resource is shared in a system where the individual users act in their own self-interest, it will tend to be depleted.

If fishing provides an income and no is there to regulate the fishing pond, then each fishers would act according to their own interest and try to catch as many fish as possible even if all the other fishers are doing the same thing.

Primary source: William Forster Lloyd

Gresham's Law

A system named after financier Sir Thomas Gresham where "bad money drives out good". The law was originally based on how minted coins tended to decrease in terms of the amount of precious metals used in them.

Consider two coins with the same legal tender face value. One of them is made of silver and the other of copper. According to Gresham's law, individuals will hold onto the silver coins and use just the copper ones for payment.

The law is not only applicable to currencies. Avoid participating in systems where good behavior cannot win.

Primary source: Sir Thomas Gresham

Antifragility

Nassim Taleb, the originator of the term, said the following on antifragility: Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure, risk, and uncertainty. Yet, in spite of the ubiquity of the phenomenon, there is no word for the exact opposite of fragile. Let us call it antifragile. Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.

Primary source: Nassim Taleb

Redundancy

The concept of backup systems in engineering. It involves duplication of critical components or functions of a system with the intention of increasing its reliability, or robustness. A suspension bridge's numerous cables are a form of redundancy.

Via Negativa

The action of improving a system by removing elements from it. The paradox of choice states that more options can lead to poorer decisions. Via negativa is the solution.

Warren Buffett's 5/25 rule is a method of via negativa: List 25 goals you want to achieve in the next ten years. Select the top five and ignore the remaining 20 at all costs.

Lindy Effect

The idea that non-perishable objects, ideas, or technologies are expected to live proportionally to their current age. If something has lived for X years, it can be expected to live for another X years. Because every additional period of survival implies a longer remaining life expectancy, expected mortality decreases with time.

Primary source: Albert Goldman

Bullwhip Effect

A chain reaction where an initial reaction to an expected outcome turns to bigger reactions later in the chain because of a lack of complete information about expectations earlier in that chain.

Primary source: Jay Forrester

Parkinson’s Law

Work expands to fill the time available for its completion. It was first coined by Cyril Northcote Parkinson in a humorous essay for the Economist in 1955.

Primary source: Cyril Northcote Parkinson

Symmetry of Ignorance

When a problem is so difficult or impossible to solve that every participant attempting to solve it are basically shooting in the dark.

It's a notion suggested by Horst Rittel in a 1972 article in which he wrote: The expertise and ignorance is distributed over all participants in a wicked problem. There is a symmetry of ignorance among those who participate because nobody knows better by virtue of his degrees or his status. There are no experts (which is irritating for experts), and if experts there are, they are only experts in guiding the process of dealing with a wicked problem, but not for the subject matter of the problem.

Base Rates

The a priori probability of an activity about to be done, e.g. the success rate of everyone who’s done what you’re about to try.

System Justification Theory

People tolerate unjust and inefficient systems if their personal incentives are aligned to defend or maintain it. The theory was initially proposed by John T. Jost and Mahzarin R. Banaji in 1994.

Primary source: John T. Jost; Mahzarin R. Banaji

Sturgeon's Law

An adage cited as ninety percent of everything is crap. Quoted by science fiction author Theodore Sturgeon, it represents the belief that in general, the vast majority of the work that is produced in any given field is of low quality.

Primary source: Theodore Sturgeon

Ringelmann Effect

As a group increases its amount of members, individuals of that group tend to become increasingly less productive. It was named after French agricultural engineer Maximilien Ringelmann.

Consider a tug of war. As more people are involved in it, their average performance tends to decrease because each participant feels that their own effort is not critical.

Primary source: Maximilien Ringelmann

Planck's Principle

Max Planck said: A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die and a new generation grows up that is familiar with it.

Primary source: Max Planck

Group Attribution Error

Falsely assuming that the views and decision outcomes of a collective group reflect the view of each member in that group.

Primary source: Scott T. Allison; David M. Messick

90-9-1 Rule

In a social media network, only 1 percent of users will actively create content; another 9 percent will participate by commenting, rating, or sharing the content; and the last 90 percent will watch, look and read without responding.

Braess’s Paradox

An observation by German mathematician Dietrich Braess who noticed that adding a road to a particular congested road traffic network would make traffic worse due to an increase in shortcuts becoming popular and overcrowded.

Primary source: Dietrich Braess

Perfect Solution Fallacy

Also called the Nirvana fallacy, it's a false dichotomy suggesting that a perfect solution exists to a problem and that courses of action should be rejected if just a small part of the problem remains.

Primary source: Voltaire

Peter Principle

Employees rise in an organization through promotion until they end in a position in which they are incompetent. A principle developed by Laurence J. Peter.

Primary source: Laurence J. Peter

Foundational Species

Species that have a pillar role in supporting an ecosystem or community. Without the presence of these foundational species, many other species in the ecosystem couldn’t sustain their existence. Coral is a foundational species in nature and the Federal Reserve is one in the world economy.

Primary source: Paul K. Dayton

Google Scholar Effect

Google Sholar's algorithm is an enhancer of preferential attachment since highly cited papers appear in top positions and gain more citations. Meanwhile, new papers hardly appear in top positions and therefore get less attention, regardless of their contribution to their fields.

Primary source: Paul K. Dayton

Rebound Effect

If a 5% improvement in car fuel efficiency results in only a 2% drop in fuel use, it means there is a 60% rebound effect. The 3% discrepancy might be explained by driving faster or further than before.

Murphy's Law

All that can happen, will happen.

Primary source: Edward Murphy

Campbell’s Law

Social scientist Donald. T. Campbell has said: The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.

Quantitatively measuring the wrong stuff and, as a result, accidentally setting the wrong incentives is a very dangerous position to put oneself in because it's rarely noticed before the system collapses. Take Enron's accounting procedures. It's an example of the cobra effect.

Primary source: Donald T. Campbell

Path Dependence

In accordance with decision trees, history matters in terms of what options there are to decide on for the future. The set of decisions people face for any given circumstance is limited by the decisions they have made in the past. As explained through the tyranny of small decisions, path dependence might end up as an irreversible negative surprise if not properly applying second-order thinking.

Externality

When a third party is subject to the cost or benefit that it did not have any control over. Industry pollution is a negative externality that may affect the health of nearby residents. A positive externality might be an individual who maintains an attractive house that benefits the neighbors in the form of increased market values of their properties.

Primary source: Henry Sidgwick

Open vs. Closed Platform

An open platform, or system, is one in which its contents or functionalities are able to be altered in other ways than the original creator of the platform intended. On the other hand, a closed platform is one which is "off the rack" - the creator keeps control over its contents.

Moore's Law

The observation that the number of transistors on a microchip doubles roughly every two years while the cost of computers is halved. Experts agree that computers should reach the physical limits of Moore's Law at some point in the 2020s because the high temperature of transistors would make it impossible to make smaller circuits.

Gordon E. Moore said himself about the limits to the law: It can’t continue forever. It is the nature of exponential functions. They eventually hit a wall.

Primary source: Gordon Moore

Metcalfe's Law

The value of a communication system grows proportionally to the square of the number of users of the system (N²) - or, more precisely, with the rate: N(N-1).

Metcalfe's law was originally formulated by Robert Metcalfe about Ethernet, but the law explains a number of network effects of technologies such as the Internet, the World Wide Web, and Microsoft Windows.

Primary source: Robert Metcalfe

Theory of Constraints

A philosophy of governance introduced by Dr. Eliyahu M. Goldratt which helps and leverages organizations to achieve their goals. The title comes from the assertion that any manageable system is limited to achieving several of its goals by a very small number of constraints and that there is always at least one constraint.

Primary source: Eliyahu M. Goldratt

Models in the Biological World

Incentives

Contingent encouragers that motivate humans and animals to do certain actions. It's based on the idea that people do what is in their own best interest. It might be extraordinarily difficult to discourage a behavior if that behavior is incentivized, and it might be equally difficult to encourage a behavior if it’s disincentivized.

Ecosystems

An ecosystem is used to describe a complete environment in nature with all living organisms and non-living elements.

The first basic principle of ecology is that every living organism has an ongoing and lasting relationship with every other element that is part of its environment. Therefore, it is crucial to see all ecological conditions as part of systems development.

Primary source: Arthur Tansley

Niches

In ecosystems, a participant of the system might flourish more in a niche to which it is adapted than it would any other way. Closely related to the circle of competence.

Evolution by Natural Selection

The process by which organisms change over time as a result of changes in heritable physical or behavioral traits - or what is called phenotype. Developed by Charles Darwin in 1859, the theory is one of the best-substantiated in the history of science, supported by evidence from a wide variety of scientific disciplines.

When Darwin worked on the theory, he was a relentless destroyer of his own ideas. He once said: To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact.

Primary source: Charles Darwin; Alfred Russel Wallace

Cooperation

When organisms, animals, or humans find a common good to work for, which is greater than the cooperators' individual selfish benefits, they tend to cooperate towards that common good.

Prisoner's Dilemma

Individual self-interest may not favor cooperation.

The prisoner's dilemma is a problem in which two individuals acting in their own self-interests do not create an optimal outcome. The typical dilemma is set up in such a way that both individuals choose to protect themselves at the expense of the other individual.

Primary source: Merrill Flood; Melvin Dresher

Adaptation

Changes in the structure, function, or behavior of living organisms act in increasing their adaptation to the environment.

Red Queen Effect

Species must continuously adapt and evolve to pass on genes to the next generation as well as to resist extinction when other opposing species are evolving. In the sequel to Alice's Adventures in Wonderland, the Red Queen said to Alice: Now, here you see, it takes all the running you can, to keep in the same place.

Primary source: Leigh Van Valen

Replication

The biochemical process of copying the DNA in a cell. It's a prerequisite for successful cell division since each daughter cell needs a complete set of DNA to function.

Hedonic Treadmill

People repeatedly return to their baseline level of happiness despite major positive or negative events or life changes. Expectations rise with results and the feeling of satisfaction is thus ever fleeting.

Primary source: Campbell Brickman

Self-Preservation

Pain and fear are integral parts of all living organisms, and self-preservation is the behavior that ensures their survival. Sigmund Freud proposed that self-preservation was one of two instincts that motivated human behavior, with the other being the sexual instinct. Later, he combined the two into eros.

It's interesting because self-preservation is not always in the heart. For instance, a mother might sacrifice her own life for her child.

Reward System

Also known as the pleasure center, organisms' reward center is made up of a group of neural structures that are responsible for incentive salience (the desire and craving for a reward), associative learning, and emotions such as joy, ecstasy, and euphoria. Sometimes, unhealthy addictions hijack our reward system if no discipline is exercised.

Exaptation

Evolution through natural selection allows traits that are originally meant for one purpose to enlist for a new main purpose.

Introduced by biologist Steven Jay Gould and Elisabeth Vrba, exaptation makes the point that a trait’s current use does not necessarily explain its historical origin. Feathers are one example of a trait that has evolved through exaptation. First, they were meant for keeping warm or attracting mates. Later on, feathers became essential for modern birds’ flight.

Primary source: Stephen Jay Gould; Elisabeth Vrba

Hormesis

Small doses of something can be good or beneficial for an individual but dangerous or deadly if applied at too large doses - e.g. alcohol or excessive exercise. It's when less is more.

Primary source: Hugo Schulz

Dunbar's Number

In the 1990s, anthropologist Robin Dunbar made a study on the correlation between primate brain size and average social group size. He found that it takes brainpower, specifically through the neocortex, to interact with other animals, to socialize and bond with them, and to remember past interactions. Dunbar then measured the human neocortex and estimated humans’ ability to maintain social relationships, concluding that they can handle around 150 contacts.

Primary source: Robin Dunbar

Epidemic Models

Models used to study and predict epidemics of infectious diseases, with the most commonly known being the SIR model. In their simplest form, epidemic models assume that a disease has a given infection rate and a given removal rate. How the epidemic develops is always a function of these two factors.

While epidemic models are great at mostly explaining the spread of diseases in a biological setting, they are also great mental models for explaining how herd-behavior can occur out of small inflections in various other domains. For example, using epidemic models to understand the transmission of attitude can be used to comprehend the feedback mechanisms that support speculative financial bubbles or religious/political propaganda.

Pollyanna Principle

It’s easier to remember pleasant things than bad ones. Research indicates that the mind tends to focus on the optimistic at the subconscious level, while it tends to focus on the negative at the conscious level.

Declinism

The belief that society is heading towards a decline by putting a stronger emphasis on the negatives in accordance with the Pollyanna principle. One remembers the past as better than it was and expects the future to be worse than it will likely be.

Primary source: Edward Gibbon

Empathy Gap

Underestimating the way behavior is largely affected by one's mental state when an individual is not currently in that mental state. An individual currently feeling calm might find it difficult to predict how they will act if someone angers them.

Primary source: George Loewenstein

Meat Paradox

Socrates thought no one intentionally does anything morally wrong. However, individuals have the ability to adapt attitude to action. For example, people care less about cows' well-being when they have just eaten beef jerky.

Primary source: George Loewenstein

Emotional Contagion

Empathy acts in transferring emotions from some individuals to others through observation. Happiness and misery love company.

Punctuated Equilibrium

Once species appear in the fossil record, they will become stable, showing little evolutionary change for most of their geological history.

Primary source: Niles Eldredge; Stephen Jay Gould

Luck Surface Area

Like emotional contagion, excitement and passion pull others into your orbit. Coined by Jason Roberts, he writes: The amount of serendipity that will occur in your life, your Luck Surface Area, is directly proportional to the degree to which you do something you’re passionate about combined with the total number of people to whom this is effectively communicated. It’s a simple concept, but an extremely powerful one because what it implies is that you can directly control the amount of luck you receive. In other words, you make your own luck.

Primary source: Jason Roberts

Tribalism

The division into or support for a tribe or tribes, especially policies characterized by tribal loyalty. In conformity, tribalism can refer to a way of thinking or behavior in which one is more loyal to one's tribe than to one's friends, one's country, or another social group.

Models in the Physical World

Velocity

Velocity is a vector size that describes how far and in which direction something moves per unit of time. The size (length) of this vector is the scalar known as speed. Going one step forward and one step back shows no velocity but shows speed.

Relativity

The natural world allows no ruling frames of reference. When something is moving in a straight line at a constant speed with no acceleration, the laws of physics are the same for everyone. A man moving inside a train will not experience movement like an outside observer of the train would.

And because of matter, the faster you go, the heavier things become, and the more it will resist efforts to go faster. Albert Einstein proved that nothing that has a mass can ever reach the speed of light.

Primary source: Albert Einstein

Activation Energy

The energy needed to produce a certain reaction. The sparks that occur when steel is rubbed against flint provide the activation energy to initiate combustion in a Bunsen burner. The blue flame will sustain itself after the sparks have been extinguished because the continued combustion of the flame is now energetically favorable.

Primary source: Svante Arrhenius

Catalysts

A catalyst is a substance that increases the rate of a chemical reaction without itself being converted or consumed by the reaction. A catalyst is therefore involved in a reaction but is neither a reactant nor a product.

Leverage

Archimedes said: Give me a lever long enough and I shall move the world. Leverage is a very sensitive area since, depending on its application, its force might be incredibly powerful or incredibly devastating.

Inertia

All things with a certain even rectilinear speed will continue to move in that direction until it is affected by an external force that causes it to either lose speed through negative acceleration (e.g. the braking effect in a car), increasing its speed through positive acceleration (e.g. giving a vehicle gas), or caused to change direction.

Consider a billiard ball that has just been pushed. Only when the ball strikes the band or another bullet does it change speed and direction under the influence of the force (reaction) that occurs at the encounter with the object it bumps into.

Primary source: Isaac Newton

Kinetics

A sub-area of technical mechanics that describes the change in movement quantities (location, speed, and acceleration) under the influence of forces and also takes into account the mass of the moving body. Kinematics, on the other hand, describes the movement of a body (location, speed, acceleration) without taking into account forces or masses.

Alloying

When a metal is combined with other substances, it can create a new metal with superior properties. The alloy may be stronger, harder, tougher, or more malleable than the original metal.

Viscosity

The inertia of a liquid, gas, or plasma - or its internal friction. Water is "thin" whereas honey is "thick", which is why water has a lower viscosity than honey.

When measuring viscosity, the substances are divided into two groups: Newtonian and non-Newtonian fluids.

Newtonian fluids are homogeneous and viscosity is independent of how fast the liquid is stirred. Such fluids are defined by exact proportionality between the viscosity of the liquid and the tension it takes to make shifts in the liquid. Non-Newtonian fluids are heterogeneous and change viscosity as the rate of stirring changes. Rubbing resistance - or friction - is an expression of the force that pulls opposite of moving bodies and inhibiting movement.

Irreversibility

A concept arising frequently in thermodynamics, irreversibility means that the state of a system cannot be precisely restored to its initial state by infinitesimal changes in some property of the system without spending energy. Irreversible processes increase the entropy of the universe.

Primary source: Rudolf Clausius

Clark's Third Law

Any sufficiently advanced technology is indistinguishable from magic. And Clark's fourth law: For every expert, there is an equal and opposite expert.

Primary source: Arthur C. Clarke

Flywheel

A classic mechanical device that can retain kinetic energy in rotation over a shorter or longer period.

Another purpose of the flywheel is the gyroscope effect with an ability (tendency) of the rotating body to maintain a steady direction of its axis of rotation.

Primary source: James Watt

Half-Life

The time elapsed before an exponentially decreasing size is halved. The concept is mainly applied to decay processes that are exponential, e.g., radioactive decay, or approximately exponential such as biological decay.

Heisenberg Uncertainty Principle

Certain pairs of physical magnitudes cannot be determined with arbitrary accuracy. The more accurately one can measure the momentum (or velocity) of a particle, the less accurately one can know its position, and vice versa.

Primary source: Werner Heisenberg

Atomism

According to ancient atomism, the world is made up of countless small particles, atoms, separated by voids. Atoms differ in shape and size and cannot be perceived through senses. They constitute the basic substance of the world and are, as the name implies, indivisible. When atoms are combined in different formations, the physical objects that constitute the phenomena of the sensory world arise. From an initially unstructured state, the world evolves gradually as a result of the random movements of atoms. Any explanation is thus strictly mechanistic and materialistic.

Primary source: Leucippus

Autocatalysis

A chemical reaction in which an end product acts as a catalyst for the reaction. The continuous formation of this catalyst accelerates the reaction as long as sufficient starting materials are still available. It's a positive feedback loop.

Recursion

When something is defined in terms of itself. Recursion is used in a variety of disciplines, from linguistics to logic. The most common application is in mathematics and computer science, where a function is defined as applied to itself. Although this clearly defines an infinite number of instances (function values), it is often done in such a way that no loop or infinite chain of references can occur.

Electromagnetism

Electromagnetic force gives rise to most everyday phenomena, such as induction, friction, normal force (the force that prevents objects from flowing into each other), chemical reactions, and so on.

Primary source: Hans Christian Ørsted

Quantum Mechanics

A physical theory that describes the properties and laws of states and processes in matter. In contrast to the theories of classical physics, it allows the correct calculation of physical properties in the size of atoms and smaller.

Quantum mechanics forms the basis for describing the phenomena of atomic physics, solid-state physics, and nuclear and elementary particle physics, but also related sciences such as quantum chemistry.

Primary source: Werner Heisenberg

The Shannon-Hartley Law

A formula for calculating transmission capacity over any communication channel. The law provides the theoretical maximum that can be achieved with a hypothetical optimal channel coding, without providing information about which method can be used to achieve this optimum.

Primary source: Claude Shannon; Ralph Hartley

Models in Military and War

Asymmetric Warfare

A type of warfare in which two parties have different military capabilities or methods of war. In such a case, the weak party must take advantage of its special advantages or the opponent's weaknesses in order to have any opportunity to achieve its goals.

Attrition Warfare

A warfare where the warring parties are so strong that an end can only be reached through an extended and mutual depletion of each other's resources. The winner becomes the one with the largest reserves.

Two-Front War

Usually, parties prefer to fight on one front only since it makes it easier for them to concentrate on military efforts.

Another front usually arises when an ally intervenes in the war which means that both fronts will be weaker as it is more difficult to move forces from one front to another than moving them back and forth along a single front.

Choke Point

A small or narrow area that a larger number of soldiers cannot pass at the same time. They thus have a harder time attacking and can be more easily defeated by a less powerful enemy.

Counterinsurgency

As one of the more extensive areas of asymmetrical warfare, counterinsurgency describes various tactics and strategies used to combat armed insurgency. Its the blend of comprehensive civilian and military efforts designed to simultaneously contain insurgency and address its root causes.

Mutually Assured Destruction

A strategic doctrine originally formulated by Robert McNamara in response to the Cuban crisis of 1962. The doctrine implies that if one of two parties to a conflict uses its nuclear weapons, it results in the destruction of both parties. It is based on theories of terror balance, which argue that powerful weapons are essential in the effort to deter the enemy from using the same weapons. As a consequence of the doctrine, the warring parties had to point the weapons at the enemy's big cities.

Guerilla Warfare

Denotes an organized, armed struggle intended to influence or govern a state government. The states concerned will generally have an interest in classifying such movements as guerrilla movements. This implies that actions that are regarded as resistance struggles or freedom struggles on one side are regarded as armed rebellion and guerrilla movement on the other.

Fighting the Last War

The act of using strategies or tactics that worked successfully in the past, but are no longer useful.

Empty Fort Strategy

Contains elements of psychology and consists of convincing the opponent that an empty fortification is really full of hidden soldiers or traps which in turn induces the enemy to retreat.

Potemkin Village

A construction (literal or figurative) built solely to deceive others into thinking that a situation is better than it really is. It's named after the Russian prince Grigorij Potemkin who, before the emperor Catherine II's trip to Crimea in 1787, built theater decorations along her route depicting prosperous villages to give the impression that he had quickly achieved prosperity on the newly conquered peninsula.

Trojan Horse

A strategy in which a warring party is lured into letting in the enemy behind his defenses. Originally conceived by Odysseus.

Blitzkrieg

A strategy that is intended to prevent a conflict from escalating into total war and to achieve this through a rapid operational victory.

Primary source: Heinz Guderian

Decapitation

A massive strategic attack on the political and military leadership structures of the opponent with the intention of eliminating or at least significantly reducing its ability to counterattack.

Defeat in Detail

Bringing a large portion of one's own force to attack small enemy units in sequence, rather than engaging the bulk of the enemy force all at once.

Pincer Ambush

A strategy in which the opponent is enclosed by coordinated attacks around both flanks. If the military units carrying out the pincer ambush make contact with each other on the opposite side, the opponent is closed in and cannot retreat, but must strike out of the ring or get help from outside.

Shock and Awe

A strategy of using overwhelming power to try and achieve rapid dominance over the enemy.

Swarming

Use of a decentralized force against an opponent in a manner that emphasizes mobility, communication, unit autonomy, and coordination/synchronization.

Turning Movement

A strategy that allows an attacking force to reach the opposing rear guard by separating the defenders from their main defensive positions.

Win Without Fighting

Sun Tzu argued that a brilliant general was one that could win without killing anybody.

Defense in Depth

A strategy in which the defending side places its units so that they gradually absorb the strength of an attacking enemy.

Fortification

A semi-permanent or permanent defensive structure that gives physical protection to a military unit.

Fabian Strategy

A strategy that aims to avoid field battles and frontal attacks by wearing out the opponent instead, e.g. through disruptions in logistics or by affecting morale. Used by warring parties who have time on their side or when there is no other alternative.

Primary source: George Washington

Scorched Earth

A tactic that consists of destroying buildings, factories, fields, and the like during a retreat. The purpose is to prevent them from falling into the hands of the enemy and thus contributing to its resources.

Turtling

Continuous reinforcement of the military front until it has reached its full strength followed by an attack with the now-superior force.

Models in Political Failure

Chilling Effect

The reluctance or unwillingness to exercise one's right due to fear of legal sanctions. A common example is that of free speech.

Primary source: John Milton

Third Rail of Politics

A metaphor for any subject so controversial that it is "untouchable" in the measure that any politician or public official who dares to approach the subject, invariably suffers politically.

Primary source: Kirk O'Donnell

Regulatory Capture

A form of political corruption that occurs when a government body, rather than acting in the interests of society, represents the commercial or special interests of a particular interest group (lobby) that dominates the industry or sector.

Primary source: George Stigler

State Capture

A type of systemic political corruption in which private interests significantly influence a state's decision-making processes to its advantage.

Shirky Principle

Institutions will try to preserve the problem to which they are the solution.

Primary source: Clay Shirky

Models in Rule of Law

Burden of Proof

A party's obligation to present evidence of a claim in a conflict.

Common Law

Legal systems characterized by the fact that courts have legislative function in the sense that they have the opportunity not only to interpret law but also create it through precedents.

Precedents

Prior judgments, decisions, or rulings in a court of law used as a rule or guide in later cases or cases with similar circumstances.

Due Process

A procedural legal principle according to which everyone has the right to certain minimum guarantees, aimed at ensuring a fair and equitable result in the process.

Duty of Care

An obligation to pay certain attention and reasonable care required by law while performing any acts that could foreseeably harm others.

Good Faith

Also called bona fides, it denotes a party's excusable ignorance of a particular relationship. What matters in this context is an assessment of what a sensible person would have done in the same concrete situation.

Negligence

When something is caused by carelessness amongst specified circumstances.

Presumption of Innocence

The basic principle of criminal procedure that gives the person suspected of a crime the right to be regarded as innocent until the contrary has been proved. The principle is considered so important that many democracies have explicitly stated it in their laws or constitutions.

Reasonable Doubt

Evidence that is beyond reasonable doubt is the standard of evidence required to validate a criminal conviction in most prosecution systems.

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Mental models act as the first level of our Decision Levels framework that we use at Junto Investments to make sense of observations and make important decisions. The next level of the framework is through the use of principles.

Dig deeper to find what principles we operate by, whether it's business, life, or learning.

Next section: Principles

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