2. Take out a blank sheet of paper and write at the top the subject you want to learn. Write out what you know about the subject as if you were teaching it to someone who is unfamiliar with the topic—and not your smart adult friend but rather a ten-year-old child who can understand only basic concepts and relationships.
3. When you must use simple language that a child can understand, you force yourself to understand the concept at a deeper level and to simplify relationships and connections among ideas. If you struggle, you have a clear understanding of where you have gaps in knowledge. This is valuable feedback, because you have now discovered the edge of your mental capabilities. Knowing the limits of your knowledge is the dawning of wisdom.
4. Return to the source material, and then reread and relearn it. Repeat step 2 and compile information that will help you fill in those gaps in your understanding that you identified in step 3. Review and simplify further as necessary.
One sentence written by Feynman encapsulates the power of this technique. What started as a question about our existence has been translated into a single sentence that can be understood even by a middle-school student: “All things are made of atoms—little particles that move around in perpetual motion, attracting each other when they are a little distance apart, but repelling upon being squeezed into one another.”13
Basically, Feynman says that if you know nothing about physics, the most essential scientific knowledge to understand is that everything is made up of atoms. In one simple sentence, Feynman conveys the foundational existence of our universe. Little wonder that he is widely regarded as one of the greatest teachers to have ever lived.
In a similar vein, consider Newton’s law of gravity: the force of attraction between two bodies depends on their distance. Newton needed just a few pen strokes to express that thought mathematically. But from it, he showed why the planets move as they do, where comets fly, and even how high the tides flow. Later generations elaborated on this information, until we were able to send rockets, satellites, and humans into space. From Newton’s earliest thought, the vast field of science and engineering grew to its present state.
To apply first principles thinking to the field of value investing, consider several fundamental truths. Understand and practice the following if you want to become a good investor:
1. Look at stocks as part ownership of a business.
2. Look at Mr. Market—volatile stock price fluctuations—as your friend rather than your enemy. View risk as the possibility of permanent loss of purchasing power, and uncertainty as the unpredictability regarding the degree of variability in the possible range of outcomes.
3. Remember the three most important words in investing: “margin of safety.”
4. Evaluate any news item or event only in terms of its impact on (a) future interest rates and (b) the intrinsic value of the business, which is the discounted value of the cash that can be taken out during its remaining life, adjusted for the uncertainty around receiving those cash flows.
5. Think in terms of opportunity costs when evaluating new ideas and keep a very high hurdle rate for incoming investments. Be unreasonable. When you look at a business and get a strong desire from within saying, “I wish I owned this business,” that is the kind of business in which you should be investing. A great investment idea doesn’t need hours to analyze. More often than not, it is love at first sight.
6. Think probabilistically rather than deterministically, because the future is never certain and it is really a set of branching probability streams. At the same time, avoid the risk of ruin, when making decisions, by focusing on consequences rather than just on raw probabilities in isolation. Some risks are just not worth taking, whatever the potential upside may be.
7. Never underestimate the power of incentives in any given situation.
8. When making decisions, involve both the left side of your brain (logic, analysis, and math) and the right side (intuition, creativity, and emotions).
9. Engage in visual thinking, which helps us to better understand complex information, organize our thoughts, and improve our ability to think and communicate.
10. Invert, always invert. You can avoid a lot of pain by visualizing your life after you have lost a lot of money trading or speculating using derivatives or leverage. If the visuals unnerve you, don’t do anything that could get you remotely close to reaching such a situation.
11. Vicariously learn from others throughout life. Embrace everlasting humility to succeed in this endeavor.
12. Embrace the power of long-term compounding. All the great things in life come from compound interest.
In addition to these fundamental truths, the value investing discipline has certain finer aspects that we come to realize and appreciate only with the passage of time and with experience:
Knowledge is overrated. Wisdom is underrated.
Intellect is overrated. Temperament is underrated.
Outcome is overrated. Process is underrated.
Short-term outperformance is overrated. Long-term adherence to one’s investment philosophy is underrated.
Gross return is overrated. Stress-adjusted return is underrated.
Upside potential is overrated. Downside protection is underrated.
Maximization of returns is overrated. Avoidance of ruin is underrated.
Growth is overrated. Longevity is underrated.
Entry multiple is overrated. Exit multiple is underrated.
Price-to-earnings ratio is overrated. Duration of competitive advantage period is underrated.
Categorization of stocks into large cap, mid cap, and small cap is overrated. Categorization of businesses into great, good, and gruesome is underrated.
Being more frequently right than others is overrated. Being less wrong than others is underrated.
Forecasting is overrated. Preparation is underrated.
Confidence is overrated. Humility is underrated.
Conviction is overrated. Pragmatism is underrated.
Complexity is overrated. Simplicity is underrated.
Analytical ability is overrated. Personal behavior is underrated.
Having a high income level is overrated. Inculcating a disciplined saving habit is underrated.
Competition with peers is overrated. Helping our peers is underrated.
Large personal net worth is overrated. Good karma is underrated.
Talent is overrated. Resilience is underrated.
Being the best investor is overrated. Being the most authentic version of yourself is underrated.
OBTAINING WORLDLY WISDOM THROUGH A LATTICEWORK OF MENTAL MODELS
Study the science of art. Study the art of science. Develop your senses—especially learn how to see. Realize that everything connects to everything else.
—Leonardo da Vinci
Any field you enter, from finance to engineering, requires some degree of specialization. Once you land a job, the process of specialization is only amplified. You become a specialist in certain aspects of the organization you work for. This approach, however, doesn’t help solve problems. Because you don’t know about the big ideas from the key disciplines, you start making decisions that don’t take into account how the world really works. As in the story of the blind men and the elephant, you cannot see the whole picture. And investing is a liberal art that involves cross-pollination of ideas from multiple disciplines.