Three Mental Models That Will Help You Make Better Decisions
At some stage in your career, you might consider starting a business.
Millions of people make this decision every year.
Starting a business is a high risk, high reward proposition.
You would have heard the statistics, 20% gone in the first year, by year five, less than 50% are still operating.
Whether the statistics are accurate or not isn’t important. We can agree a high number fail.
The entrepreneurs that succeed are good decision-makers.
Different Types Of Decisions
In his 1997 letters to shareholders, Jeff Bezos outlined the way he views decision making. He put decisions into two buckets; irreversible (Type 1) and reversible (Type 2)
Regarding type one decisions, Bezos Wrote:
“If you walk through and don’t like what you see on the other side, you can’t get back to where you were before. We can call these Type 1 decisions.”
“[These] decisions must be made methodically, carefully, slowly, with great deliberation and consultation,”
Type 1 decisions are our sink or swim moments, like the ‘should I start a business?’ decision. They will have a significant effect on our lives.
I’d like to share a couple of mental models that have helped me make better ones.
There’s More to Risk vs. Reward Than Meets The Eye
Some of us mistakenly assume the more risk we take on, the more rewards we will receive. It’s not that simple.
For each decision we make, we also need to consider the opportunity cost and probability of success.
We need to ask:
• What is at stake?
• What is the opportunity cost?
• What is the reward?
• What is the probability of success?
Before becoming the co-founder of Paper Not Foil, I was a customer of the company. As soon as I discovered the product, I was instantly intrigued and wondered how I could get involved.
Falling back on my finance background, I used a risk vs. reward assessment to understand whether the opportunity was worth pursuing.
1. What is at stake? Initially, this was just my time. I wanted to contact the creator and explore any opportunities to get involved.
2. What is the opportunity cost? I had spare time. My only investment was time. So the opportunity cost was low.
3. What is the reward? Right from the start, I thought the potential was huge.
4. What is the probability of success? I couldn’t see a scenario where the product didn’t succeed. I believed it had a high chance of at least moderate success.
So my opportunity cost was virtually nothing, the reward was high, and the probability of success was high. I decided to proceed.
Think Beyond First Order Consequences
There’s never been an easier time to start a business, especially in New Zealand, where we’re currently ranked the easiest country in the world to start a business in.
In some ways, it is now easier to start a business than get a job. Easiest is not always best.
Deciding between two alternatives based on the path of least resistance is what’s known as first-order thinking. First-order thinking is short-sighted; it doesn’t take into account the many flow-on effects decisions incur.
I’ve made this mistake many times.
From his book “The Most Important Thing,” Howard Marks sums this up beautifully in the context of buying shares in a company.
“First-level thinking says; it’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
To follow this up, Howard writes;
“First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favourable, meaning the stock will go up.” Second-level thinking is deep, complex, and convoluted.”
Let’s look at this In the context of starting a business vs. gaining employment.
Registering a business, opening a bank account, etc.. can be completed in a couple of days and requires almost no financial outlay. You don’t have to go through job interviews to start a business.
On the face of it, starting a business can look like the best option.
The problem is, as Ray Dalio writes in his book “Principles.”
“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. Never seize on the first available option, no matter how good it seems, before you’ve asked questions and explored.”
So how do we uncover these second-order consequences? Ask questions and answer objectively.
Look at your decision across different periods. If you make ‘XYZ’ decision today, how would this change your life now, three months from now, one year from now, five years from now?
To improve this question, throw in additional parameters, such as; Financials, Relationships, Family, Health, etc.
I.e., How will this decision affect my family now and in the future or how will this decision affect my health now and in the future.
It’s impossible to consider all outcomes, but being mindful of 2nd order consequences definitely helps.
Popular Is Not Necessarily Best
Entrepreneurship has become somewhat popular and cool.
You don’t have to look any further than Facebook or Instagram to see the proof. 1000’s of people now label themselves as entrepreneurs in their bio’s as a symbol of status.
However, what’s popular or cool is not necessarily the best.
Jumping on a bandwagon is also known as “social proof.” In Robert Cialdini’s book “The Science of Persuasion,” He lists “social proof” as one of the six fundamental persuasion principles. Caldini writes;
“The greater the number of people who find any idea correct, the more the idea will be correct…We will use the actions of others to decide on proper behavior for ourselves, especially when we view those others as similar to ourselves…”
Following on from this
“First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t…Social proof is most powerful for those who feel unfamiliar or unsure in a specific situation and who, consequently, must look outside themselves for evidence of how best to behave there… Since 95 percent of the people are imitators and only 5 percent initiators, people are persuaded more by the actions of others than by any proof we can offer.”
This suggests that when we are unsure about the right way to proceed. We tend to look to others for the “right way.” The more uncertain we feel about a particular decision, the more we seek affirmation from those around us.
Only we know when we’re following the herd and not being true to ourselves.