Leveraging 15 Mental Models for Managing Risk

“All models are wrong but some are useful.” — George Box

A mental model is essentially a framework or a set of ideas that helps us understand and interpret the world around us. These models are like mental shortcuts or templates that simplify complex situations, allowing us to process information quickly and make decisions more efficiently.

Each model provides a different perspective or approach to solving problems or understanding situations. When faced with a new challenge or decision, we can draw upon these models to rapidly form a mental picture that guides our thinking. Mental models are like lenses through which we view the world, each offering a unique way to analyze, interpret, and respond to the complexities of our environment.

1. The Map Is Not The Territory

Reality is too complex to be captured in full detail. We use models and maps as simplified representations to navigate the world. The only usefulness of a map depends on similarity of structure between the empirical world and the map.

“The map appears to us more real than the land.” — D.H. Lawrence

Application in risk management: Recognize that risk models are simplifications. They're helpful, but can never account for every variable. Regularly update and challenge your risk assessments.

Examples:?

• A business relying on customer behavior predictions based on past data was caught off-guard by the sudden change in consumer habits during the COVID-19 pandemic.
• A financial analyst should not rely solely on historical data to predict a market downturn, as unforeseen factors can lead to different outcomes.

2. Circle of Competence

Recognizing what you're good at is key. It's not only about your knowledge but realizing where you shine. The circle may seem trivial, but it's crucial. Know its boundaries and stick to them. This insight lets you dodge issues, play to your strengths, and put your time or money where it counts the most.

"It is not shameful to acknowledge what you do not know, the shame lies in pretending to know all." – Confucius

Application in risk management: Operate within your areas of expertise when making risk decisions. When outside it, consult with experts.

Examples:?

• Warren Buffett often avoids investing in technology companies, citing a lack of understanding as opposed to his proficiency in insurance and consumer goods sectors.
• An IT professional should avoid making complex legal compliance decisions and instead consult the legal department.

3. First Principles Thinking

Breaking down complicated problems into basic elements and then reassembling them from the ground up.

"You must build up from the most basic principles." – Elon Musk

Application in risk management: Assess risks by first understanding their fundamental components, which leads to innovative solutions.

Examples:?

• Elon Musk's approach to SpaceX's reusable rockets started by questioning why rockets were not reused and breaking down the costs of raw materials.
• When assessing the risk of a new product launch, start by evaluating the fundamental market need the product addresses, rather than comparing to similar product launches.

4. Thought Experiment

Imagining a scenario without having to execute it, to predict possible outcomes.

"All of science is nothing more than the refinement of everyday thinking." – Albert Einstein

Application in risk management: Use thought experiments to anticipate risks and outcomes of decisions without facing real-world consequences.

Examples:?

• NASA frequently conducts thought experiments simulating potential failures in space missions to ensure astronauts are prepared for all scenarios.
• Consider a hypothetical data breach in your company to plan the necessary steps to mitigate this risk.

5. Second-Order Thinking

Considering not just the immediate results of an action, but also the subsequent effects.

"We must consider the consequences of our actions, and their consequences in turn." – Howard Marks

Application in risk management: Look beyond the immediate effects of a risk to see its potential downstream impacts.

Examples:?

• A city planning to cut costs by reducing flood management funding did not consider the second-order effects, which resulted in higher costs due to flood damage.
• Before implementing a strict return policy to reduce losses, consider the potential long-term impact on customer loyalty and brand reputation.

6. Probabilistic Thinking

Estimating the likelihood of various possible outcomes.

"Life is a school of probability." – Walter Bagehot

Application in risk management: Use probability to gauge the chance of risks and to inform decision-making.

Examples:?

• Pharmaceutical companies use probabilistic models to determine the likelihood of success for new drugs in development, affecting their investment decisions.
• In health risk management, consider both the likelihood of an illness occurring and the potential severity of the outcome in creating preventative strategies.

7. Inversion

Approaching problems backward. Instead of aiming for success, you focus on how to avoid failure.

"Invert, always invert: Turn a situation or problem upside down. Look at it backward." – Charlie Munger

Application in risk management: Invert problems to see what could cause failure and then work to prevent those scenarios.

Examples:?

• Toyota, through its '5 Whys' technique, improves manufacturing processes by looking at what could cause failures and addressing the root cause.
• To improve cybersecurity, focus on the various ways security breaches can occur and work backwards to prevent them.

8. Occam's Razor

The principle that the simplest explanation is usually correct.

"Entities should not be multiplied without necessity." – William of Ockham

Application in risk management: Simplify risk assessments by eliminating unnecessary complexities.

Examples:?

• When diagnosing patient symptoms, doctors often start with the most common illnesses that present similar symptoms before considering rarer conditions.
• When a system fails, investigate the simplest explanation first, such as a power outage, before exploring more complex scenarios.

9. Hanlon's Razor

Never attribute to malice that which is adequately explained by neglect or error.

"Never attribute to malice that which can be adequately explained by stupidity." – Robert J. Hanlon

Application in risk management: When assessing risks, consider incompetence before malevolence. This can prevent paranoia and focus on more likely scenarios.

Examples:?

• When a major software outage occurred at GitLab in 2017, it was initially assumed to be a complex issue but was actually due to an accidental removal of data by an employee.
• If an employee misses a deadline, consider a lack of training or resources before assuming negligence.

10. Pareto Principle (80/20 Rule)

A small number of causes (roughly 20%) are responsible for a large percentage (roughly 80%) of the effect.

"You will find that a few things are vital and most are trivial; focus on the vital few and ignore the trivial many." – Richard Koch

Application in risk management: Focus on the critical few risks that could cause the most significant damage or have the highest likelihood of occurrence.

Examples:?

• Microsoft noted that by fixing the top 20% of the most reported bugs, 80% of the related errors and crashes in a given system would be eliminated.
• Focus on the 20% of cybersecurity vulnerabilities that could cause 80% of the problems.

11. Regression to the Mean

Extreme events tend to be followed by more moderate ones, as data points will tend to move towards the average over time.

"What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact." – Warren Buffet

Application in risk management: Avoid overreacting to extreme successes or failures. Anticipate a return to average performance levels in the long run.

Examples:?

• After Tiger Woods' extraordinary early career performance, his subsequent performances were expected by some to be exceptional, but they regressed to mean levels over time.
• After a year of exceptionally high returns in an investment portfolio, prepare for the following years' returns to be closer to historical averages.

12. Black Swan

An event that is extremely rare, has severe impact, and is only explainable after the fact.

"History does not crawl; it jumps." – Nassim Nicholas Taleb

Application in risk management: Prepare for the unpredictable and ensure that your strategy is robust enough to handle unexpected shocks.

Examples:?

• The 2008 financial crisis was considered a Black Swan event for many in the financial industry who did not foresee the collapse of the housing market.
• Keep an emergency fund or insurance for unforeseen and rare financial disasters that could be devastating.

13. Antifragility

The capacity to benefit from stress, shocks, volatility, noise, mistakes, faults, attacks, or failures.

"Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors." – Nassim Nicholas Taleb

Application in risk management: Develop systems and approaches that grow stronger when exposed to volatility and stressors.

Examples:?

• Small businesses that adapted quickly to online sales during lockdowns benefited from the otherwise disruptive event of the pandemic.
• Diversify investments across different asset classes to benefit from market volatility.

14. Via Negativa

The concept of improvement by subtraction rather than addition.

"Subtracting your sorrows is true happiness." – Nassim Nicholas Taleb

Application in risk management: Instead of adding new elements to manage risk, look for what can be removed or reduced to lower risk.

Examples:?

• A major airline improved flight safety by removing complex and rarely used cockpit switches, thus reducing pilot errors.
• Improve project outcomes by identifying and eliminating unnecessary processes that contribute to project risk.

15. Lindy Effect

The future life expectancy of some non-perishable things, like a technology or an idea, is proportional to their current age.

"If a book has been in print for forty years, I can expect it to be in print for another forty years." – Nassim Nicholas Taleb

Application in risk management: Favor processes, technologies, and strategies that have stood the test of time.

Examples:?

• Commercial airlines continue to use the decades-old but incredibly reliable Boeing 737, expecting it to be in service for years to come due to its long history of safe flights.
• Trust in well-established, time-tested technologies in critical systems rather than adopting new, unproven innovations.

Key Takeaways

Here are the key takeaways from the article discussing various mental models and their applications in risk management:

1. Map Is Not The Territory: Models are simplifications and should be regularly updated. Realize that they cannot capture every variable.
2. Circle of Competence: Understand your strengths and limits. Stay within your area of expertise for better decision-making and risk management.
3. First Principles Thinking: Break down problems to their fundamental elements for innovative solutions and better risk assessment.
4. Thought Experiment: Use hypothetical scenarios to predict outcomes and prepare for risks without real-world consequences.
5. Second-Order Thinking: Consider not only immediate effects but also subsequent impacts of actions in risk management.
6. Probabilistic Thinking: Estimate likelihoods of various outcomes to inform decision-making and assess risks.
7. Inversion: Approach problems by focusing on avoiding failure, and work backward to prevent negative scenarios.
8. Occam's Razor: In risk assessments, prefer simpler explanations and eliminate unnecessary complexities.
9. Hanlon's Razor: Assume incompetence before malevolence to focus on more likely risk scenarios and avoid paranoia.
10. Pareto Principle (80/20 Rule): Focus on a small number of critical risks that have the most significant impact or probability.
11. Regression to the Mean: Expect extreme performances to be followed by more moderate ones over time.
12. Black Swan: Prepare for rare, unpredictable events with severe impact, ensuring robust strategies to handle unexpected shocks.
13. Antifragility: Develop systems that grow stronger when exposed to volatility and stressors.
14. Via Negativa: Improve risk management by removing or reducing elements rather than adding new ones.
15. Lindy Effect: Favor long-standing processes, technologies, and strategies, as their life expectancy is proportional to their current age.

These mental models provide frameworks for understanding, interpreting, and responding to complex situations, particularly in the context of risk management.