Mental tools for modelling

I’m not sure if Cara Delevingne has ever considered using mental models, but she has certainly piqued your interest, read on…

With thinking about the course I’m developing and with recently coming across Charlie Munger’s 1995 speech, The Psychology of Human Misjudgment, which introduced me to an explanation of what I’d been doing all my business life – using the power of  applying mental tools from a wide array of disciplines and applying these to the business questions I had.

Last week I introduced tools for understanding the mental or cognitive biases you may have. These mental tools or analogies, or models or heuristics are concepts you can use to help try to explain things to find the answers to the critical questions in your business, this week its how to model.  

 Systems Thinking — “By taking the overall system as well as its parts into account systems thinking is designed to avoid potentially contributing to further development of unintended consequences.” Think about the whole environment and how it impacts what you are studying to understand what could happen in future.

systems thinking

Scenario Analysis — “A process of analyzing possible future events by considering alternative possible outcomes.” Thus, the scenario analysis, which is a main method of projections, does not try to show one exact picture of the future. Instead, it presents several potential alternative future developments. Consequently, a range of possible future outcomes is observable. Not only are the outcomes observable, also the development paths leading to the outcomes. It is useful to generate a combination of an optimistic, a pessimistic, and a most likely scenario. Experience has shown me that around three scenarios are most appropriate for further discussion and selection. More scenarios could make the analysis unclear. In the end you are trying to create a means to make decisions about the future not to create a perfect prediction or an endless string of predictions.

Here’s Blackberries scenario analysis of the future of mobile phones-

http://www.slideshare.net/merragun/blackberry-scenario-analysis
http://www.slideshare.net/merragun/blackberry-scenario-analysis

Power-law — “A functional relationship between two quantities, where a relative change in one quantity results in a proportional relative change in the other quantity, independent of the initial size of those quantities: one quantity varies as a power of another.” For instance, considering the area of a square in terms of the length of its side, if the length is doubled, the area is multiplied by a factor of four.

Screen Shot 2016-07-08 at 5.23.58 PM

Normal Distribution — “A very common continuous probability distribution…Physical quantities that are expected to be the sum of many independent processes (such as measurement errors) often have distributions that are nearly normal.” In its most general form it states that averages of random variables independently drawn from independent distributions converge in distribution  become normally distributed when the number of random variables is sufficiently large. Pretty much everything in the universe shows a normal distribution.

Sensitivity Analysis— a technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond’s price.  Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s).  The example below shows the overall impact on annual profits of changes in a single variable for a charter airline operation.

sensit-sensitivity-analysis-tornado-chart
tornadocharts.com

Cost-benefit Analysis—  involves adding up the benefits of a course of action, and then comparing these with the costs associated with it.  The results of the analysis are often expressed as a payback period – this is the time it takes for benefits to repay costs. Many people who use it look for payback in less than a specific period – for example, three years.

cost_benefit_analysis