First Principles in Finance

Imagine you're building a bicycle from scratch. You're not starting with a pre-existing bike frame; you're starting with the fundamental truths: two wheels provide stability, a chain transfers energy, and pedals provide force. You're building based on physics, not on copying what already exists. This is first principles thinking.

It’s the practice of boiling a problem down to its most fundamental, undeniable truths and reasoning up from there. It’s how Elon Musk figured he could make rockets cheaper by building them himself instead of buying astronomically priced ones. It’s how Aristotle defined it: the "first basis from which a thing is known."

We’re surrounded by financial advice that is the opposite of this. It’s analogical thinking: "This is what everyone does." "This is what my parents did." "This is what the expert on TV said to do." It’s accepting the pre-built bicycle without questioning if it's the best design for your journey.

The First Principles of Money

Before we can build, we must deconstruct. Let's strip personal finance down to its bare essentials. At its core, money is a tool for three primary functions:

A Store of Value: Money allows you to preserve the economic value of your labor and time for future use.
A Medium of Exchange: It facilitates the transaction of goods and services.
A Unit of Account: It provides a standard measure of value, allowing us to price things and track financial performance.

From these three bedrock principles, everything else flows. Your financial life, therefore, is the management of these functions over your lifetime. The goal is to optimize them.

Application 1: Budgeting

The Conventional Wisdom: "Follow the 50/30/20 rule." "Use this app to track your coffee spending." This often feels like a diet, a list of restrictions that creates resentment.

The First Principles Approach: Let's break down a budget. What is it, really?

It is a plan for allocating your finite monetary resources (your income) to fulfill your unlimited human needs and desires over a period of time.

Reasoning up from there:

First Principle: Your income is finite. Your desires are not.
First Principle: Your happiness is derived from the fulfillment of needs and the pursuit of meaningful wants, not from mindless consumption.

The New System: "Conscious Allocation"
Instead of tracking every penny you spent last month, you design the life you want and then allocate money to make it happen.

Identify Your Fundamental Needs: What are the non-negotiable costs of your survival and basic well-being? (Housing, nutritious food, healthcare, utilities).
Define Your Values-Based Wants: What brings you genuine joy, fulfillment, and growth? Is it travel? Learning? Time with family? This is not about denying yourself; it's about funding what truly matters to you, not to the influencer you follow.
Assign Your Money Accordingly: Now, allocate your finite income. You might discover that spending less on a fancy car (a low-joy want for you) frees up massive amounts of money for more traveling (a high-joy want). Your budget is no longer a cage; it's the blueprint for your designed life. The goal isn't to restrict spending, but to maximize life satisfaction per unit of currency.

Application 2: Retirement

The Conventional Wisdom: "You need $1 million (or another scary, round number) to retire." This is abstract, anxiety-inducing, and often wrong.

The First Principles Approach: Let's deconstruct retirement. What is it?

It is the phase of life where you cease trading your time for money and must live solely on the resources you have accumulated.

Reasoning up from there:

First Principle: You need a system that generates enough passive cash flow to cover your living expenses, indefinitely.
First Principle: This cash flow can come from two places: the yield generated by your assets (interest, dividends, rent) or the drawdown of the assets themselves.

The New System: "The Income-Focused Goal"
Forget the $10 million. Ask a better question: "What monthly income do I need to live comfortably in retirement?"
Let's say that number is $4,000 per month.
Now, work backward from that first principle:

Scenario A (Yield-Focused): If you build a portfolio of dividend stocks and bonds that yields 4%, you need a portfolio of $1.2 million ($1,200,000 x 0.04 = $48,000/year).
Scenario B (Total Return Focused): Using the "4% Rule" (a safe withdrawal rate from a balanced portfolio), you would need $1.2 million ($4,000 x 12 / 0.04).

Suddenly, the problem is clear, concrete, and solvable. You're not chasing a vague number; you're building an income-generating machine. This shifts your entire investment strategy from "get the highest returns" to "build the most reliable and efficient income stream."

Application 3: Investment

The Conventional Wisdom: "Buy this hot stock!" "Time the market!" "Diversify with these 10 funds!" This is noise. It's based on what others are doing, not on fundamental truths.

The First Principles Approach: Deconstruct investing. What is it?

It is the process of exchanging capital (money) today for an expected return of more capital in the future.

Reasoning up from there, we land on the fundamental drivers of all investment returns:

First Principle: Asset Class Return (Beta): This is the return you get for simply being exposed to a broad market. By owning a tiny piece of every company in a stock index fund, you are paid for the risk of owning a business as the global economy grows. This is the most reliable, powerful force in investing.
First Principle: Managerial Skill (Alpha): This is the return you get from someone's skill (or luck) in picking specific investments that beat the market. This is incredibly rare, expensive to access, and unpredictable.

The New System: "The Market Capture Engine"
Knowing that Beta is the most reliable driver, you engineer your portfolio to capture it as efficiently as possible.

Your foundation is a low-cost, globally diversified portfolio of index funds. This guarantees you will capture the entire return of the global stock and bond markets. You are not betting on a few horses; you are owning the entire racetrack.
You accept that market downturns are a fundamental part of the system (the price of admission for long-term growth) and do not panic-sell.
You minimize all "friction": high fees, active management costs, and taxes, because they directly eat away at your compound returns.

You stop trying to be a genius stock-picker and start being a disciplined engineer of your own financial future.

The Mindset Shift: Becoming the Architect

Applying first principles to finance requires a shift from being a tenant to being an architect.

The Tenant lives in a house built by others. They follow the rules on the wall, complain about the leaky faucet, but never feel true ownership. This is the person who blindly follows financial fads.
The Architect understands the physics, the materials, and the purpose of the structure. They design a home tailored to their specific needs, knowing why every wall is placed and every wire is run. This is the person who builds a financial life from the ground up, based on their own truths.

You May Ask

Isn't this a lot of work?
The initial deconstruction is the heavy lift. But once you've built your system based on first principles, it requires far less daily work and mental energy than constantly reacting to market news and trying to follow complex, often contradictory, advice. It's a one-time setup for long-term peace of mind.

What about debt?
Deconstruct it. Debt is simply a financial tool that allows you to consume today by borrowing against your future income. The first principle is that it comes at a cost (interest). The question becomes: Is the utility of the consumption today (e.g., a university education, a necessary house) greater than the future cost? If not (e.g., high-interest credit card debt for a lavish dinner), it is a destructive tool that erodes your store of value.

How do I handle financial advice?
Use first principles as your filter. When you hear a piece of advice, "You must buy a house!", ask: "What fundamental problem is this solving?" Is it solving for a forced savings mechanism? For stability? Run it through your own first principles framework. If it doesn't align with your fundamental truths and goals, discard it.

Where do emotions fit in?
First principles don't ignore emotions; they account for them as a fundamental part of the system. The volatility of the stock market is a first principle. Knowing that fear and greed will cause you to make irrational decisions is a first principle. This is why you build a system (like automatic investing) that operates despite your emotions, not because of them.

Rebuilding Your Financial World

First principles thinking in finance is an act of liberation. It frees you from the tyranny of "should" and empowers you with the clarity of "why."

You stop budgeting and start designing your life.
You stop saving for retirement and start building an income machine.
You stop gambling on stocks and start owning the market itself.

The conventional wisdom is a pre-fabricated box. It might fit, but it will always be cramped. First principles thinking gives you the tools to tear down the walls and build a custom structure, one with room to breathe, grow, and truly live a life that is not just funded, but fundamentally enriched.

The raw materials are there. It's time to pick up your tools and start building.