First Principles Thinking

investment tips personal development Jun 01, 2021

 

First principles thinking is one of the most effective ways to reverse-arrange complex situations and unlock creative possibilities. The idea of breaking down complicated problems into basic elements and then reassembling them from the ground up has earned it the name of “reasoning from first principles.” The exercise helps you move from creating conventional linear results to unconventional non-linear results.

The first-principles thinking approach currently being used by some enormously successful personalities such as Charlie Munger and Elon Musk, was also used by the philosopher Aristotle. It allows people to see through the smokescreen of insufficient analogies and crude reasoning, and helps them see opportunities others fail to. Incidentally, the search for first principles is not unique to philosophy, all great thinkers use it.

Let us take the example of Elon Musk. It is not what he thinks, it is how he thinks. He recommends three simple steps to solve a problem.

  1.   Identify and define your current assumptions.
  2.   Break down the problem into its fundamental principles.
  3.   Create new solutions from scratch.

He believes in understanding reality with what is true, not with his intuition. When Musk wanted to build a rocket, he started with the first principles of the problem. What was the problem? The cost – a staggering $65 million. Rockets are atrociously expensive, and Musk wants to send people to Mars. His mind went straight into the relevant basic questions such as physics behind it, the cost, the time. And, then he asked himself, “how much cheaper can I make it?” Although Musk might be an exceptional case as he knows economics, physics, business, organization, and governmental issues yet he still used the first principle theory to solve the problem.

Musk found out the details of raw material to build the rocket, the value of these materials in the commodity market, and realized that the materials cost of a rocket was around two percent of the typical price. Musk, a self-learner, literally learnt rocket science and decided to create SpaceX to explore the possibility of building rockets from scratch.

In an interview, he gave an interesting example about battery packs. The conventional pricing methods would calculate the historical cost $600 per kilowatt-hour. Here again, he used the first principles – what materials go into the batteries, their cost etc. He figured that if he broke that down on a material basis, the cost of these on London Metal Exchange comes to $80 per kilowatt-hour. All one has to do is procure those materials and assemble them in the shape of a battery cell. Problem solved. Elon Musk believes in reasoning from first principles rather than by analogy. And, that made it possible for him to create SpaceX without facing the problem of high costs.

So, how do we know the difference between conventional analogy-based knowledge and first principle-based knowledge?

Take the example of a fashion designer and a tailor. The fashion designer is the trailblazer. She has intricate knowledge of the fabric, shapes, sizes, colours, fashion, pricing and design. The tailor, on the other hand, might know how to make some designs too, but he is primarily focused on tailoring. If the tailor loses the design, he is in a soup. He is just following what someone else has structured. But, the fashion designer doesn’t need not worry about losing the design because she can redraw the structure with all the original elements. The tailor cannot use the first principle thinking unless he has also gone through the same intricate details. Here, the designer is credited with the first principle thinking ability.

Applying first principle thinking to investing

Scenario 1

Similar to the earlier example, a broker, banker or relationship manager showcases you a financial product or service he thinks is suitable for you. His pitch is that his firm is recommending a mix of 40:60 in bonds and equities. But, if you ask him why 40:60 ratio and not 50:50, chances are he may not have the answer. Reason for helplessness stems from the fact that he has used convention of “this is what we are recommending to everyone.” The real answer lies with his Product Manager, Chief Investment Officer or Investment Committee that has gone through the optimization process to create thousands of scenarios in a scattergram throwing up various risk/reward ratios. The most rewarding scenario must have been then selected. Now, that would be breaking down the elements of a problem and coming up with reliable solutions.

Scenario 2  

Similarly, investing also can and does use first principle thinking. If you had to start investments, conventional wisdom would encourage you to start looking for what is hot, and avoid what is not. But, if you follow the theory of principle thinking, you will start understanding the different elements of investing (that is different from learning) before you see the end result.

You would start with (internally) asking yourself basic questions:

What is my current financial situation?

What are my future financial objectives – both short and long term?

What is my time horizon?

What is my risk endurance level?

And only then (externally) you would look at:

Asset allocation

Product mix

Selection of specific investments

and finally the execution to construct the investment portfolio.

That is breaking down the elements of your objective and using the knowledge derived from understanding the basics to reach a resolution instead of using the analogy to accomplish the solution. Conversely, a half-baked investment plan without understanding the inherent characteristics, features, and implications could be based on convention and therefore deemed risky.

Scenario 3

Let us say you did not care to consider first principles thinking shown in Scenario 2, and an investment of yours has gone sour. The solution of the problem lies in the said scenario. Instead of piling up on the losing position with little conviction of a turnaround, cutting your losses just at the bottom, or worse – doing nothing about it, you should be breaking down the elements of the whole history of events and analyse them. You will find the problem as well as the solution therein. For instance, a wrong product can be switched into a more suitable one or a focused portfolio can be diversified to reduce the volatility and thereby enhance the overall performance.

 “Reasoning by first principles removes the impurity of assumptions and conventions. What remains is the essentials. It’s one of the best mental models you can use to improve your thinking because the essentials allow you to see where reasoning by analogy might lead you astray.” – Farnam Street.

Breaking down the elements of the situation/problem seems to be the first basic step. Only when you thoroughly understand the problem, can you come up with a solution.

“If I had an hour to solve a problem, I would spend 55 minutes thinking about the problem and 5 minutes thinking about the solutions.”- Albert Einstein

Applying first principles thinking in our daily life

Most of us find it hard to pursue our ambitions, goals, hobbies or career, at least in our early years, primarily because we rely on others’ advice. We merely try to improve upon already existing choices and paths. The lack of our own realistic thinking arrests our growth and limits our capabilities of making better decisions. Try applying the first principles thinking to your problems like:

-          All the good guys are taken

-          I do not have enough money

-          I have no time to work out

-          I cannot do it because no one else has tried it

Conclusion

The first principle forces you to break things down into smaller pieces and look at each component as its own individual moving part. When you break things down in such a way, it drives innovation because it makes you look at things from a different perspective. It diverts your journey of imagination from assumption to actual understanding of the problem, and thus creates a solution.

Analogies cannot replace understanding. Thinking in first principles is the best source of creative thinking. It allows you to adapt to a challenging environment, face the reality, and seize opportunities that others cannot detect. It transforms “what is available” to “what is possible.”                                         

There is a big gulf between methods and principles.

“As to methods, there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.” – Harrington Emerson

Or should we just conclude saying, “first principle thinking is nothing but thinking out of the box, but with logical breakdown of elements.”

- Ramesh Sadhwani

 

 

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