Mental Model: Useful Falsehoods

As an investor, and as an individual seeking success in life, I believe it is important to understand that there are concepts that can be demonstrably proven false while still being useful to behave as if they are true.

This mental model of mine, is one which I think differentiates my investment philosophy from many others because I can separate them in my mind and garner advantages accordingly.

I think the best example is non-investment in nature. Namely, the idea that you should take 100% responsibility for the outcomes in your life.

This is based on a “useful falsehood”. The falsehood being: “You are 100% responsible for your life outcomes based on the choice you make.”

This is demonstrably false. One doesn’t choose to get cancer or get in a car accident. There is some negative randomness in life which you may not be able to avoid. And yet, this falsehood is also useful. If you *behave* as if you have full control of your life. Your life outcomes tend to improve over time.

Taking responsibility, even beyond what is rationally your fault, can lead to life success.

By the same token, there are useful falsehoods that can help improve your investment outcomes.

I think about this a lot because I think there are many areas of investing that may be “book accurate” but can lead you astray. Whether concerning the efficiency of markets, agent/principal issues when it comes to capital allocation, or even understanding portfolio allocation issues associated with something like the Kelly formula.

I don’t know why some investors struggle with this idea, but that’s why I think it’s a useful mental model.

This is what I mean when I talk about dividends being “free money” or something like that. This is a “useful falsehood”. Obviously dividends aren’t free. It costs the company cash to send it to you.

But this concept is *USEFUL*.

For many investors, dividends truly can be a form of free money. This is obvious when you think about it in terms of valuations.

The value of a stock is the net present value of their longterm stream of all future earnings. Often, by short hand it may be approximated with a PE ratio. If a company earns $1.00 per share, I may value it at 15x earnings or $15.00. That valuation takes into account my assumptions about future earnings potential, dividend payout potential, capital allocation etc.

However, this valuation is slow to change and focused on the long term. In the short term, stuff may change the value of the company (in theory) such as paying a quarterly dividend, but since that doesn’t impact my longterm estimate of future cash flows it doesn’t change my valuation of the company.

Say the company pays a $0.10 quarterly dividend. The day before the dividend is paid, I value the company at $15.00. The day after the company is paid, my valuation of the company stays $15.00.

Therefore, from my perspective, dividends truly are free money. I now have an extra ten cents in value that appeared like magic in my account. Again, this is a *useful falsehood.*

We know this isn’t literally true because it breaks down at the extremes. If a company pays a special dividend equal to half its market cap or say 3x its market cap, then it makes sense to adjust your valuation of the company, or at minimum reevaluation is needed. Even if value stays the same.

Yet, this is also a useful perspective because there is an underlying value in receiving small growing dividends over time. A majority of the value and returns in your investment career will come from the dividends a company pays out. These small meaningless coupons add up to extremely large amounts over time despite not impacting day to day valuations.

This is an inherent advantage to investors who *behave* as of dividends have value to shareholders even though by the book, it’s just moving cash from the companies account to your account.

There are behavioral changes that occur at companies that pay dividends. Dividend achievers who raise their dividends every year behave differently than those who do not. And returns to investors reflect it.

As an investor, it’s not about being “right”. Your goal is to make money. Even if that means behaving as if some “useful falsehoods” are actually real so that you can end up wealthier in the end.