Mental Models in Investing and Decision Making

We make countless decisions daily, from the unimportant to the critical but most people don’t spend a lot of time thinking about their decision making approach. This article will help you to develop your “latticework of mental models” so that you too can start making decisions like the masters of finance, strategy and leadership.

What is a mental model?
A mental model is simply a filter that you run your decision making through. We will run through many mental models below but its important to understand that in order for this to work, you need to have a lot of different different mental models or as Charlie Munger likes to call it, a “latticework of mental models”. A true collection of mental models must come from a wide variety of different disciplines, lest you become the “man with a hammer” that thinks every problem is a nail. A latticework of mental models should be built up over a lifetime, concentrate on the most important models so that they become second nature.

What kinds of models are the most useful?
It’s important to understand as many of the general principals of the fundamental academic disciplines as you can. Things like: The primary laws of physics. The principals of biology and human psychology. The concepts behinds markets and finance. The principals of mathematics and chemistry. You might think, “why in the world would I want to know about a physics principal like ‘margin of safety?’” until you figure out that it applies not just in physics but also when buying a house or stock or even in deciding what time to leave the house for work!

What if the models conflict?
Don’t worry, you are on the right track when different models compete, this is the hallmark of good decision making. Let the models compete, it can be taxing but it’s the only path to the right answers. Other times, many models will harmonise and give you a clear way to the right answer, Charlie Munger calls this “The Lollapalooza Effect”.

A selection of important mental models from different disciplines:

Human Nature & Judgement

Social Proof
Human beings are an extermely social species and we have an innate instinct to look for social guidance of our behaviour. This instinct can lead to positive outcomes for society but can also lead us to do foolish things if our group is doing them as well.

First Conclusion Bias
Charlie munger says that the mind works a little like a sperm and an egg: once an idea gets in, the mind shuts out all opposing ones. Our tenancy to cling to our first conclusions leads us to incorrect judgements and causes us to cease asking questions. This can be countered using techniques such as always carefully considering the counter-arguments whenever we make a decision.

Tendency to Overgeneralise from Small Samples
Often people will base judgements on a statistically insignificant sample size leading them to erroneous conclusions, How often have you heard statements like: “my grandmother lived to 100 she smoked everyday so therefore smoking isn’t so bad”.

Hindsight Bias
As humans we have a bias to look back at decisions as if we had known the outcome all along when we are reasoning with information that was not available to us at the time, “I knew that investment would double, that’s why I made it”. It may be helpful to keep a journal of investment and other decisions so that you are able to review how you were actually feeling at the time.

Survivorship Bias
As humans we tend to over-attribute good judgement and decision making to the successful and ignore the randomness or luck involved. This can lead us to learn false lessons when we study the successful, who may have only been successful by chance or luck, whilst we ignore the many that lost by acting in a similar way but were not as lucky.

Incentives
All creature respond to incentives, this is basic biology and humans are no different. It’s a worthwhile exercise to analyse the potential incentives for all parties involved when making a decision.

Numeracy

Compounding
Compounding is the process by which earned interest is added back to the principle in order to earn interest on a higher principle, which in turn earns more interest that is added back and so on. Warren Buffett refers to it as the “snowball effect”, as the snowball rolls down the hill it increases in size and collects even more snow as it grows. Compounding is not only important in investing, but it’s crucial in all areas of life. For example, in self-development making regular, small positive changes in behaviour and routine can compound massively over time, relationships can compound over time as well.

Multipying by Zero
Mathematics teaches us that no matter how great a number, multiplying it by zero will still lead to zero. Trying to expand and grow in certain areas of life, no matter how greatly can still cause failure if we don’t address our “zeros”.

Randomness
As Nassim Taleb says, humans are often “fooled by randomness”. Much of the way the world works is random and many events are outside our control. We are sometimes fooled by random effects which we may have a tendency to attribute causality to.

Baynesian Updating
The Baynesian method is a school of thought where we take into account all relevant prior probabilities and update our model as new information comes in. This can be particularly useful as we take the historic odds to guide us but also feed in more up to date data as it becomes available.

Systems

Margin of Safety
Engineers always factor in a wide margin of error into all calculations. For example, you would not want them to build a bridge that hold only 20 tons when it’s estimated that it may need to hold up to 18 tons at any one time. The engineers will look for a much wider margin and perhaps build the bridge to carry 50 or more tons, this is known as the margin of safety principle. This principle can be applied when making an investment decision (i.e. if you think a stock is worth $10, then you should perhaps only pay $9 for it and leave a $1 margin) or even when deciding when to leave the house for an appointment (If you need to be somewhere at 12:00 and it takes you 20 minutes to drive there then perhaps you should leave at 11:30 to allow a margin of safety).

Avoidance of Harm

In many systems, the best (and sometimes only) improvements that can be made are a result of removing negative elements rather than adding positive ones. It is a fundamental principal taught to all healthcare students around the world: “first, do no harm”. Often the best improvement we can make is by removing or limiting exposure to people or groups that have a negative impact on us, the same principle can also apply to organisations.

Physical World

Reciprocity
If you do something nice for someone, often they will return the favour. This is how reciprocity works and it’s an important principle in relationships as well as in physics. Often when we want something from someone (e.g. guidance from a mentor), it can be important to consider the reciporcity principle (i.e. how can I add value to this person first so that they may reciprocate, rather than just asking what can they do for me).

Relativity
Relativity is a crucial law of phyics but as a mental model it is most important to remember that an observer cannot truly understand a system of which she is a part. For example, a person standing still on earth does not feel like they are moving but someone on the outside can clearly see that they are. This is the aspect of relativity that also applies to social systems. For example, sometimes it can be important to take a step back and speak to someone on the outside to get a clear view of something that you are a part of.

Catalysts
A catalyst kick-starts or maintains a chemical reaction, but it isn’t actually reactant. Many people experience powerful catalysts that act as change agents in their life and this model also applies to larger systems such as public opinion as well.

Hopefully by now you have gained a decent understanding of mental models and have started your journey to building a “latticework of mental models”, good decision making shall most defininelty ensue. As Charlie Munger says, once you start thinking this way, going back to any other method of thinking will feel like cutting off your hands.