The intricacies of the human mind, coupled with the complexities of our surroundings, present difficulties in making sense of the world around us. Recent years have witnessed significant strides in computer modeling and neuropsychology, shedding light on human decision-making processes. As a result, we have devised mental frameworks that serve as invaluable tools for enhancing decision-making in investing and the broader scope of life. One of these frameworks is first-principles thinking.

Elon Musk founded SpaceX in 2002 with the ambitious goal of making space travel more affordable and accessible. In 2008, SpaceX became the first privately funded company to successfully deliver a payload to the International Space Station (ISS). In 2017, SpaceX became the first commercial company to send a crew to the ISS. And in 2019, SpaceX began launching Starlink satellites, a constellation of thousands of satellites designed to provide global internet coverage.

These otherworldly accomplishments are not just the result of hard work and expertise. Such feats could not have occurred in such a short timeline without first-principle thinking. Investors, too, possess the potential to harness the power of this mental model to enhance their decision-making and unearth opportunities.

First-principles thinking is a way of thinking about problems by starting with fundamental truths or axioms rather than relying on assumptions or preconceptions. This contrasts our default mode of thinking: thinking by analogy. Analogical reasoning entails the comparison of two analogous entities, from which we derive inferences regarding their shared characteristics. In other words, this mode of thinking leans on prior knowledge and experiential insights to formulate presumptions.

Reasoning by analogy is not inherently bad or wrong. It expedites and streamlines the problem-solving process, facilitating many of our daily decisions. However, this mode of reasoning remains susceptible to errors and the limitations of our preexisting knowledge. It is also influenced by the information we consume, so sometimes it is helpful to start from scratch with first-principles thinking to get a fresh perspective.

How Does First-Principles Thinking Work? 

When asked about his knack for solving big problems, Elon Musk said, “I tend to approach things from a physics framework. Physics teaches you to reason from first principles rather than by analogy.” He starts by asking fundamental questions about how things work rather than relying on conventional wisdom or past experiences.

For example, when Musk began developing a new rocket, he asked questions like:

“What are the fundamental principles of rocketry?”

“What is a rocket made of?”

He then used his understanding of these principles to design a new rocket that was more efficient and affordable than anything that had come before.

Why is first-principles thinking important for investors?

Elon Musk didn’t start by copying and trying to improve an existing rocket. If he had, Space X would not have become the innovative space company it is today. While investing isn’t rocket science, it can help investors think more independently and focus on the signal rather than the noise. 

Deeper Understanding

First-principles thinking allows investors to better understand an investment opportunity's fundamental drivers and dynamics. By breaking down complex problems or industries into essential components, investors can gain insights beyond surface-level analysis. This understanding helps identify key value drivers, competitive advantages, and potential risks.

Fresh Perspective

Through first-principles thinking, investors can uncover hidden opportunities and emerging trends. This approach liberates investors from the influence of traditional views and groupthink, allowing for a fresh perspective on investment problems. Investors can make more objective and rational choices by examining the fundamental truths and principles underlying an investment.

Long-Term Thinking

It also encourages investors to adopt a long-term perspective and focus on enduring principles rather than short-term market fluctuations. By understanding the fundamental principles underlying a company’s value and competitive advantage, investors can assess the potential for enduring value creation over time. This mindset aligns with a patient and disciplined investment approach, which is often associated with superior long-term returns and helps resist the temptation of short-term trading.

Unbiased Analysis

First-principles thinking can help investors sidestep the sway of our emotions and biases. When investors make decisions based on emotions or biases, they are more likely to make mistakes and stray from their financial and investment plans.

Here are some tips for using first-principles thinking:

• Start by asking fundamental questions.

  • What is investing? What makes a good investment? What am I trying to achieve? Are markets efficient?

• Don’t be afraid to challenge conventional wisdom.

  • Just because something has always been done a certain way doesn’t mean it’s the best way.

• Be patient. It takes time to master first-principles thinking.

  • Don’t expect to master this framework overnight.

First-principles thinking is not a silver bullet. It is one of many mental tools that can be used to make better decisions, but it is not a guarantee of success. However, by understanding the fundamental principles of first-principles thinking, investors can improve their chances of making sound investment decisions.