All Analogies Are Wrong But Some Are Destructive
God is in the Details: Why Nuance Matters in Finance and Life
Tldr Misguided mental models and framing result in flawed reasoning, poor investment decisions, and sub-optimal asset allocation.
I talked about mangled metaphors last week, and in this post I will continue hating on Mental Models-style thinking (it’s mostly fine but their self-righteousness smugness is undeserved).
Consider the US federal budget deficit as a household budget frame. The similarities are obvious: households and the federal government have both revenue and expenses. And just as households can borrow via credit cards, mortgages, bank loans, and payday loans, governments can borrow by issuing debt through bonds, treasury notes, and other financial instruments.
In both cases, when expenses exceed income, households and governments have several choices: cut back on expenses, increase revenues, borrow money, or some combination of these. At first glance, the analogy tells a coherent story that resonates.
But on closer examination, the government-as-household analogy obscures some fundamental, disqualifying differences. For instance, even as people create new households, other households are dissolving (divorce, death, disaster), and their assets are broken up and redistributed (even family offices experience principal erosion over a few decades).
Unlike a household, the USA will not dissolve itself i.e. its needs and interests are perpetual. Investments such as the Louisiana & Alaska Purchases, the Interstate Highways, NIH research, etc. needed ongoing borrowing. The analogy overlooks the government's unique ability to sustain long-term debt for national interests, contrasting with the relatively short duration of a household1.
Despite these differences, the government-as-household analogy still resonates a lot because it wrong swaps out a complex, unfamiliar question for a simpler, familiar one.
You are no longer asked “hey, how should the 535 members of Congress bring the federal budget into sustainable balance over the next few decades?”, you are instead asked: “hey, how would your family balance its household budget?”.
You happily accept the swap because the analogy is surface-level acceptable which is the whole point of the cognitive swap. And how can you resist? The analogy is internally coherent: how can debt be good?! The federal budget expects us to be in debt for decades—who wants that?!
A few other analogies that are a lot more flawed than they seem at first glance:
The stock market is a casino
Diversification is putting your eggs in different baskets
"Derivatives are financial weapons of mass destruction"
The herd mentality
“Renting is just throwing money away", "your landlord is getting wealthy because from your labour”, “Why rent when you can buy?!"2
Once emotions are triggered it becomes hard to rebut such “conclusions” with logic alone. Like the pickpocket who distracts his mark, this clever swap distracts from the analogy’s disqualifying flaws.
Finance and Reality have a surprising amount of detail. The more you take time to observe and understand the nuances before squeezing them into analogies, the better your decisions and outcomes will be.
P.S. One of the more amusing investing analogies I’ve seen is from Byrne Hobart:
Looking at a growth company is basically like the process of canonizing a saint: you have some basic criteria to check off, but you spend most of your time on assessing the truth value of a handful of extraordinary claims.
I do not support “Modern Monetary Theory” because I have more than a dozen neurons. This American Banker article from 2021 has good analysis on the Federal debt situation from early 2021 with the fog of war.
"Why buy steak, when you can buy the whole herd?” and as if you’re throwing money away when you stay at hotel – you’re paying for the optionality and lower friction costs should you want to move or find another house, and also avoiding the costs associated maintenance, property taxes, etc.