Principles and thinking tools for investment decisions
Start with why you hold a view, not just where you expect prices to go. Separate facts from assumptions, consider the loss if you are wrong, and name the evidence that would change your mind. These principles and thinking tools offer a way to examine your own decisions under uncertainty.
Start with one decision on your mind
Two people can read the same news and reasonably choose different actions. One needs the money soon; the other can wait. Their existing holdings and capacity for loss may differ too. Turning a market view into a personal decision begins with those conditions, not the forecast alone.
You do not need to use every tool at once. Bring one decision to mind, look for a missing principle, then choose a tool that helps you examine it. A sentence or two in response to the closing questions creates a record you can revisit later. This guide does not tell you which asset to buy or sell.
Principles for investment decisions
Before acting, examine the purpose and the risk. After acting, watch for evidence that should change the view. Clear grounds and manageable exposure matter more than the strength of a conviction.
01
Define the purpose, horizon, and constraints
Money needed soon is not the same as capital that can stay invested for years. Before comparing assets, write down when the money may be needed, which funds are unavailable, and the costs, taxes, or obligations that matter. Compare returns within those limits.
- The purpose is invented after the price moves, or money needed soon is treated like capital that can remain invested for years.
- What is this decision meant to achieve, when will it be judged, and which constraints cannot be violated?
02
Leave room for the next decision
A large loss shrinks more than an account balance. It can remove the option to wait or change course. Before considering the upside, examine the money, liquidity, and emotional capacity that would remain if the view proved wrong.
- Attention stays on maximum upside while a single adverse outcome is allowed to break the entire plan.
- Under a severe but plausible outcome, would there still be enough capacity to make the next decision?
03
Separate facts, interpretations, and assumptions
A release showing slower inflation is a fact. The view that pressure for tighter policy has eased is an interpretation. A forecast of lower rates is an assumption. Separating these layers shows where the evidence ends and your reasoning begins.
- An opinion is treated as confirmed fact, and later evidence is reshaped to preserve the original narrative.
- Which statements are observed facts, which are interpretations, and which remain untested assumptions?
04
Use scenarios instead of one forecast
Even the most plausible forecast has alternatives. Sketch base, upside, and downside paths, with the conditions and rough likelihood of each. The useful part is not an impressively precise number. It is knowing which signals would make you give a path more weight.
- Only the most vivid or desirable outcome is considered, while a low-probability but damaging path is ignored.
- What are the main paths, their early signals, and the range of outcomes attached to each?
05
Distinguish a good outlook from a good price
Good news does not always lead to a higher price. If an even better result was expected, the same release may disappoint. Consider both the outlook and what you believe the price already reflects, then identify the difference between them.
- Positive news is collected without considering that other market participants may already expect the same result.
- What base case appears to be reflected in the price, and exactly where does this view differ?
06
Compare likelihood with the size of the outcome
Several small gains can be outweighed by one large loss. Expected value considers the likelihood of each outcome alongside its size. Put potential gains, losses, and costs in the same comparison, and allow for the possibility that the estimates themselves are wrong.
- The chance of being right is emphasized while upside is precise and the size of failure remains vague.
- Have likelihood and payoff been compared together, and how would the decision change if those estimates were wrong?
07
Write down what would change your mind
A thesis explains why you believe an opportunity exists. Invalidation conditions name the evidence that would make that explanation hard to sustain. Record an adverse price move separately from a change in the central reasoning: they are not necessarily the same thing.
- The entry case is detailed, but no evidence can change the view, so every new fact is interpreted as support.
- What observation would show that the thesis is wrong or no longer relevant?
08
Size from a risk budget, not conviction
A risk budget is the amount of loss you plan to tolerate across your capital. Use it to examine position size, volatility, and risks shared with other holdings. It is a planning boundary, not a guarantee that actual losses will stop at that amount.
- Size rises with recent performance or emotion, while the same hidden risk across several positions is counted separately.
- If the thesis fails, how much of the total risk budget is exposed, including correlated positions?
09
Look at what happens when risks overlap
Imagine a sharp price move while trading becomes thin and other holdings also come under pressure. Leverage magnifies the change in profit or loss, while poor liquidity makes it harder to reduce exposure at the intended price. This is why leverage, liquidity, and changing correlations belong in the same review.
- Margin or recent volatility is treated as the full measure of risk, excluding calls for more capital, slippage, and simultaneous declines.
- Can the exposure still be managed if prices gap, liquidity falls, and correlations rise at the same time?
10
Review the process with the outcome hidden
A profit does not prove that every step was sound. A loss does not prove that the entire process was wrong. Review the information available at the time and the rules set in advance. That helps distinguish a lucky or unlucky result from a process worth keeping or changing.
- A profit is taken as proof that every step was sound, while a loss causes useful rules to be abandoned immediately.
- Would this still look reasonable if the outcome were hidden, and what is the single best improvement for next time?
Useful thinking tools
Choose the question that fits the difficulty. If the assumptions are unclear, try first principles. If failure paths are missing, try inversion. The aim is to reveal a blind spot, not to use every tool on every decision.
01
First-principles thinking
Pause when an explanation amounts to “that is how it works.” Break the claim into smaller parts: cash flow, supply and demand, contract terms, or funding. Which of those parts must hold for the larger claim to make sense?
- Trying to reinvent every practice from scratch or ignoring real institutional and historical constraints.
- What basic facts and causal links must be true for this claim to hold?
02
Base rates
Before asking why this time is different, ask what usually happened in similar cases. That frequency is the base rate. Once the comparison group is clear, examine whether the differences in the current case justify a different expectation.
- Choosing a comparison group that favors the conclusion or applying history after the underlying structure has changed.
- What normally happens in the best available reference class, and what concrete evidence makes this case different?
03
Inversion
If the route to success is unclear, ask what would make failure likely. An unaffordable position or a shortage of needed funds may reveal more than another optimistic forecast. Work backward from those conditions to the risks that can be reduced now.
- Generating an anxious list of negatives without translating them into avoidable or manageable conditions.
- If this ended in a major failure, what would be the most likely cause, and which part can be reduced now?
04
Second-order effects
The first effect of a change may alter what someone does next. Higher costs, for example, raise questions about pricing decisions and demand. Follow that next step, while naming the conditions and time needed for it to occur.
- Extending an endless chain of speculation without identifying testable links or a useful time horizon.
- Who changes behavior after the direct effect, when might that happen, and where could the effect travel next?
05
Probabilistic thinking
There is a wide space between “certain” and “impossible.” Describe how much confidence the evidence supports and what range of outcomes remains plausible. If you use a number, keep visible that it is an estimate rather than a known fact.
- Attaching precise numbers without evidence or treating a low probability as if it meant impossible.
- How much confidence does the available evidence support, and which unlikely outcome still requires preparation?
06
Bayesian updating
When new evidence arrives, compare how naturally it fits the current thesis and an alternative explanation. Evidence that distinguishes them is a reason to shift the weight of a view. A surprising headline alone is not a reason to reverse the conclusion.
- Reversing the conclusion after every headline, or fixing the initial probability so firmly that no evidence can move it.
- Which explanation made this evidence more likely, and how much should it change the current view?
07
Falsification
Supporting material is often easy to find. Falsification asks the question in the other direction: what would you expect to observe if the explanation were wrong? Name that evidence first, then look for it in the available information.
- Changing the thesis so that it explains every result, or assuming that any adverse price move disproves every underlying claim.
- If the explanation were wrong, what evidence would probably appear, and has that evidence been sought?
08
Opportunity cost
Choosing one option leaves less money and time for another. Put the current choice beside another asset, a simpler approach, or doing nothing for now. Include the attention and ongoing work it requires, not just the capital committed.
- Considering only the benefits of the current option while ignoring the next-best alternative and the cost of complexity.
- What is the best alternative use of the same capital and attention, and why is this choice better?
09
Systems thinking
A price can be a cause as well as an outcome. A move may affect collateral or funding; the resulting actions may then feed back into prices. Look for the loops that amplify or soften the move, and the delays between each step.
- Building an elaborate map without separating decisive variables from decorative links and time delays.
- Which feedback loops could amplify or dampen the move, and what delays stand between cause and effect?
10
Incentive analysis
When reading what a person or institution says, also ask which choices are rewarded. Governments, firms, and financial institutions face different rules and funding pressures. Those conditions can help explain why stated goals and actual behavior may diverge.
- Reducing every action to immediate financial gain while ignoring rules, reputation, and long-term relationships.
- How is each participant rewarded or constrained, and where might that make actions differ from statements?
11
Margin of safety
Estimates can be wrong. A margin of safety is the room left in price, size, time, or liquidity to account for that possibility. Identify which estimate could miss, by how much, and whether the plan would still hold. A buffer does not remove risk.
- Using the phrase as a synonym for vaguely cheap or treating it as a device that removes risk altogether.
- Where is the buffer, and would it remain adequate if the central estimate were reasonably wrong?
12
Premortem
Before acting, imagine that the decision has already failed. Write down why, alone or independently of others. For each possible cause, identify an early signal and a response. This turns a vague concern into a condition that can be checked.
- Producing a ceremonial risk list without assigning early signals, responsibility, or a response.
- What signal would reveal failure earliest, and who should take which action when it appears?
A short record before and after the decision
An unanswered question is useful information too. Rather than filling every blank, note what still needs checking. Later, compare the outcome with what you actually believed at the time, not the story that became clear afterward.
01
When defining the problem
- State the purpose, evaluation horizon, and when the capital may be needed.
- Separate observed facts, interpretations, and assumptions.
- Identify the main expectations already reflected in price.
- Choose an appropriate base rate and comparison group.
02
Before deciding
- Describe base, upside, and downside scenarios with outcome ranges.
- Explain the thesis and invalidation condition in one sentence each.
- Compare the opportunity cost and the option to do nothing.
- Review size against the loss boundary and total risk budget.
03
When testing vulnerabilities
- Check leverage, possible calls for more capital, and severe plausible loss.
- Consider reduced liquidity, slippage, and interrupted trading.
- Look for hidden overlap with other exposures.
- Use a premortem to define failure signals and response conditions.
04
When reviewing the outcome
- Judge the process using only information available at the time.
- Separate rule-following from a lucky or unlucky result.
- Record how unexpected evidence should update the view.
- Choose one practice to retain and one to change next time.
Reference material
This guide was independently written in the language of Futures Compass after consulting the following public investor-education resources and decision-research references.
- Investor.gov · Asset Allocation and DiversificationHow goals, time horizon, risk tolerance, and diversification relateOpens in a new tab
- FINRA · RiskMarket, liquidity, and concentration risk, including capacity for lossOpens in a new tab
- CFTC · Futures Market BasicsPublic guidance on volatility, leverage, and customer risk in futures and optionsOpens in a new tab
- Stanford Encyclopedia of Philosophy · Bayesian EpistemologyBackground on uncertain belief and updating judgments with evidenceOpens in a new tab
- Nobel Prize · Daniel KahnemanAn overview of research on judgment under uncertainty, heuristics, and behavioral economicsOpens in a new tab