Stripped down business models: Why

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A good first step in discussing a complex business is articulating a simple business model, not a complex one.

Despite the fact that conventional wisdom, the KISS principle (keep it simple, stupid) and host of other heuristics would lead one to this not-so-earth-shattering conclusion, it amazes me how difficult it can be to actually keep it simple and avoid the trap of piling on complexity.  Building a stripped down business model is a great exercise in sticking to the basics and describing the business idea at its economic core.  It also creates a powerful, accesible visual communication tool for promoting an idea.

In an informative post on how consumer internet startups make money, Steven Carpenter uses a downloadable set of financial models to focus the reader on the key drivers of various startup business types.  These are not complex discounted cash flow models; they are simply 5-10 lines of text that describes the various drivers and associated values that plug into a very basic algebraic equation.   That’s all.

Very rarely does one have the opportunity to interact with people (in business and in life) who know exactly what one is talking about.  Starting from the most accessible set of relationships, concepts and figures is a solid approach.  But its not nearly as easy as it sounds.  Taking the time to write out (in a spreadsheet, on scratch paper, in the dirt with a stick, etc.) a stripped down business model is a good habit. It encourages good communication and a simple, elegant organization of thoughts.

 

 


Bootstrapped decision-making models: When

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In practice, bootstrapped models have many uses.  The most scalable way to use these models are for informal analysis “gut checks.”  The human mind works in funny ways.  Simply having a parallel bootstrapped model to casually refer to can quell fears or heighten suspicions, potentially improving even a poorly codified decision-making processes.

Performance benchmarking is another useful area for bootstrapped models.  By removing random error, a bootstrapped model can serve as a useful benchmark for analyzing and evaluating decisions to figure out what went wrong (or what went right).

Risk management is another interesting application.   Hard-coding checks to catch decisions that lie outside a predefined range of outcomes/values (derived from bootstrapped models) is a direct way to catch exaggerated instances of an analyst’s natural human inconsistency.  And it’s fundamentally different from a purely quantitative risk management methodology, since the measure of risk is a deviation from what a human would have theoretically done following her or his own approach.

Finally, one could go all in and build fully employed decision making tools from bootstrapped models.   The resulting tools would loosely resemble a true quant model, though using a model in this manner still requires updating the model as the human perspective changes.


Bootstrapped decision-making models: Why

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What’s better – using pure quantitative models or more qualitative, human based decision-making?

Who knows.  Regardless of the answer, one should consider an analytical technique that combines the attractive aspects of both approaches: the use of “bootstrapped” models.

Building a bootstrapped model involves taking a set of decisions made by a human, breaking them down (statistically) to see which decision criteria are the key drivers and then using that criteria to re-build (or “bootstrap”) a quantitative model that closely resembles the human knowledge that was mined in the first place.  This is not nearly as circular as it sounds.  In theory, the rebuilt model should take the best of human decision-making and smooth some of the inconsistencies that are natural to human behavior.

Why does this work?

Humans are not perfect.  The strength of human decision-making (in my humble opinion) is the mind’s ability to port concepts from different areas and apply this “unrelated” learning to new situations. This is in effect a description of innovation, and humans (along with nature, more broadly) have proven adept at pursuing this.  Human decisions, over time, lead to innovative outcomes and insight.

However, this attribute comes with a steep price: inconsistency. Quantitative models will always win in terms of consistency. In many decision-making situations that humans face, the consistency of the decisions can make or break results, so quantitative approaches have a key attribute that cannot be ignored.  Because a quantitative model is inherently limited by the inputs and weighting logic of decision criteria, the following question arises: are quantitative models too rational for their own good?

Bootstrapped models can rectify these shortcomings by finding a middle ground.  It is a classic case of leveraging human insight through quantitative approach (as opposed to building a quantitative model and then using human insight to fix it when it breaks – that’s a much different beast).


Bootstrapped decision-making models: How

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Quick and dirty:

  1. Build exhaustive criteria list for a decision
  2. Insert criteria values
  3. Elicit predictions from a human for an outcome value in each case
  4. Run linear regression
  5. Use significant criteria weights in a formula to predict outcomes

Long Description:

Bootstrapped models employ a hybrid qualitative/quantitative approach to create a decision-making aid.  In “bootstrapping” a model, one seeks to quantitatively emulate the qualitative decision-making approach used by a human.

To create such a model, first build an exhaustive list of all possible and practical decision criteria.  In what specific ways does the one think about the decision?  Keep in mind that each of these decision criteria needs to be quantified, so think in terms of numbers, binary values, etc.  The next step is to populate the criteria fields with values that reflect real data. Repeat the act of populating the criteria fields to create an expanded data set.

Here’s the crux: Have the person (that you are seeking to bootstrap) look at each instance in the data set and use their qualitative judgment of the values across criteria to predict what the outcome values will be.  No calculations or formulas – just have the person use qualitative judgment to produce an outcome value.  Now run a linear regression with the predicted outcome value as the dependent variable and the criteria as independent variables.

Use the resulting weights for each significant independent variable to build a formula, which will become the bootstrapped model. To use it, you simply have to input the values for decision criteria to obtain a predicted outcome value that will closely match the value that the human subject you bootstrapped would have predicted.