In investing and life, using mental models gives you a competitive advantage.
Mental models allow us to understand the problem holistically and make the most optimal decisions.
What are Mental Models?
What are Mental Models?
Mental models are the basic units which construct one’s world view. They are key ideas from each discipline (e.g. Mathematics, Physics, Accounting, etc), that helps you to understand life, make decisions, and solve problems.
Think of them as handy tools in your brain’s toolbox.
Having a well-equipped mental toolbox allows you to run a search in your brain and derive the most rational solution, instead of running to a-man-with-a-hammer-tendency.
As Charlie Munger said,
“To every man with a hammer, every problem looks like a nail.”
These are my top 8 mental models & frameworks for investors:
1) Know the Difference Between Price and Value
In his early days, Warren Buffett followed a cigar butt investing style which Charlie Munger has convinced him to move away from.
The cigar butt investing style is analogous to purchasing an undervalued stock that can be compared to a discarded cigar butt, which only has one more puff left before it is discarded.
This means purchasing a stock below it’s net asset value, also known as a “bargain stock”. When the business sells at such a discount to net asset value, it usually spells trouble.
Companies that are trading at low multiples and have a low price tag might be a value trap. These companies are undergoing financial instability and have limited growth, which is the reason why they are priced cheaply in the market.
There is no price too low for a melting ice cube.
Stay away from companies in a secular decline, and those that are experiencing disruption in their business models.
As Buffett says,
“Price is what you pay, value is what you get. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
2) Second Order Thinking
In The Most Important Thing, Howard Marks distinguishes between “First order thinking” and “Second order thinking”. Those who practiced second-order thinking in investing tend to achieve superior investment returns.
First level thinking is superficial and obvious. Everyone comes to the same conclusion.
Second level thinking is higher order, thinking in terms of systems, not silos.
For example, COVID-19 sparked a sell off in all equities, including tech stocks as most people think that spending will go down.
Although spending did go down, businesses needed to spend and build their online infrastructure quickly. Nobody considered this second order effect and tech stocks skyrocketed.
Here is another illustration by Howard Marks:
First-level thinking says “it’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”Howard Marks, The Most Important Thing
First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The out-look stinks, but everyone else is selling in a panic. Buy!”
Second order thinking is difficult and requires practice. As Charlie Munger said, “It’s not supposed to be easy. Anyone who finds it easy is stupid”.
That said, second-order thinking is a superpower we have all within us. We just have to be intentional with it.
How can we practice Second Order Thinking?
- Ask yourself “And so what?”
- Think long-term: What will the consequences be in 6 months, 12 months, few years?
Extraordinary performance comes from seeing things that others can’t see.
3) Circle of Competence
Warren Buffett coined the term “circle of competence”, and believes that every wise investor should stay within their circle.
Circle of competence is defined as one’s knowledge level and expertise. Your circle of competence is where you are familiar with the products/services of the business, which gives you an edge as it allows you to easily process other important company information.
For example, investing in a manufacturing stock would imply that the investor has an understanding of the manufacturing industry, how the business makes money, the unit economics, the competitors and the future prospect of the company and the industry.
Often, the BIGGEST mistakes in investing comes from the unknown unknowns (things that you don’t know, you don’t know). This is the danger zone.
That is why it’s important to know the parameters of your circle – distinguish between what you know and what you do not know. This helps to protect yourself against risk that comes from not knowing what you are doing.
Your circle of competence is not perfect. Even experts are prone to making mistakes in their analysis. Their overconfidence in a specific field causes errors due to a mix of arrogance and laziness, and they take a backseat when analysing new information, rendering their circle of competence useless.
Stay within your circle of competence and only purchase a stock if you understand the business, not simply because your friend told you that the stock is good or it’s the “hype”. When the stock prices are fluctuating, you won’t panic sell if you are certain that the investment thesis holds true. Do your own due diligence because conviction can never be bought.
Don’t feel frustrated about the things that are not within your circle. In fact, “what you know that you don’t know” can be useful if you recognise them as distractions away from your core focus. Recognise that in reality, there will always be unknown unknowns. This helps you to stay vigilant and be on your toes in identifying these risks when they arise.
4) Margin of Safety
Warren Buffett once said that the 3 most important words in investing is “Margin of Safety”.
Always ensure that you have a margin of safety in your investments, by buying a stock at a significant discount to the intrinsic value.
A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.
– Seth Klarman
It’s all about the price you pay. Margin of safety is designed to make you money by not losing money.
Having a margin of safety protects you from the “unknown-unknowns” and gives you a buffer from making extreme losses in this kind of market volatility.
Said to be the “8th wonder of the world” by Albert Einstein, compounding is a mathematical concept that lays the foundation for finance but can be applied to other domains as well.
In investing, it pays to play the long-term game.
It’s all about the “n”, your time in the market.
Start compounding early, not only in terms of money, but also your relationships, habits and health.
Do not interrupt it. Reap the rewards.
Inversion is a way of thinking, in which you consider the opposite of what you want.
When I first learned of it, I didn’t realise how powerful and applicable it could be for investing and everyday life.
“Think forwards and backwards — invert, always invert. Many hard problems are best solved when they are addressed backward. The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I’d even say usually are easier to solve, if you turn them around in reverse.”
– Charlie Munger
Inversion is a rare and crucial skill that nearly all great thinkers use to their advantage.
- Define the problem: What is the problem you are trying to solve?
- Invert: How could you guarantee the failure of your objective?
- Find a solutions: What would you do to avoid the failure that you identified in the previous step?
7) Role of Luck
Randomness, chance and luck influence our lives more than we realise.
A lot of our successes are due to luck but we keep attributing them to our skills and abilities.
Since investing is an activity where there is a reasonably high degree of luck involved, luck should also be factored in when analysing our decisions.
“In activities where luck plays a strong role, the focus must be on process… A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.”Michael Mauboussin
Remember, the correctness of a decision should be judged based on the analysis and rationality of the judgement, not the outcome itself.
You can be a lucky idiot.
8) Crushed Your Cherished Beliefs
Don’t hold on too strongly onto your opinions. When the facts change, your ideas must change.
Charles Darwin who famously said that we must strive to crush our most cherished beliefs, had an interesting method for this. Whenever he found new evidence that contradicts his previous beliefs, he will write it down quickly within 30 minutes. Otherwise, he knows that his mind will start rejecting the new evidence for his cherished beliefs.
Charlie Munger once said,
“Once should recognise reality even when one does not like it. Indeed, especially when one does not like it”.
The world’s most successful and accomplished people are changing their beliefs all the time. You don’t have to stick to your beliefs 100%.
Never fall in love with a stock. Never fall in love with a CEO.
Investing should be unemotional and you should be willing to crush your cherished beliefs.
Here is a recap of the 8 mental models & frameworks:
- Know the Difference Between Price and Value
- Second-order thinking
- Circle of Competence
- Margin of Safety
- Role of Luck
- Crushed Your Cherished Beliefs
On top of having mental models, keeping an investing checklist is essential when purchasing a stock.
Here is Warren Buffett’s Checklist for selecting stocks.
Building a latticework of mental models is a lifelong journey.
And as Munger said, “You don’t have to know everything. A few really big ideas carry most of the freight.”