I am a big fan of mental models – they are a way to organize our reality and understand the world.
They can also offer you rules of thumb – psychologists call them heuristics – that allow you to make better decisions in your daily life.
Charlie Munger, Warren Buffett’s older and smarter (but poorer) investment partner, has long focused on the importance of mental models. In fact, Munger attributes his worldly success to one thing: identifying a set of mental models and applying them to investing.
Munger is not alone. Many of the world’s top investors – George Soros, Ray Dalio – attribute their success to applying the right mental models to the right situations.
I have dubbed these kinds of mental models “critically counterintuitive” rules.
These models are critical because once you understand them, you realize that little else matters.
They are also counterintuitive because few of these mental models “feel right” at first. In fact, they often conclude the exact opposite of what you would have otherwise thought.
These days there are dozens of mental models out there, their ranks boosted by the recent work of psychologists and behavioral economists.
Today, I want to discuss three of my favorite mental models as they apply to investing.
No. 1: The Map Is Not the Territory
This is a meta-model – a model that applies to all other models.
All investors – from little old ladies in Pasadena to the heads of the world’s most successful hedge funds – have a map of the world.
But it is crucial to keep in mind Polish scientist Alfred Korzybski’s observation: “The map is not the territory.”
Think about it…
Even the very best street maps are imperfect. All maps are just representations of reality – snapshots of a point in time.
In the same way, there is no perfect “map” for investing. There is no single holy grail.
Each investment philosophy – whether it’s growth, value or momentum – is just a map. You can also think of each as a specific lens through which you understand your investments.
You’ll find that your philosophy needs to fit both your own individual preferences as well as current market conditions. And expect your map to evolve as your understanding of investing deepens.
Keep this in mind as you think through competing investment opportunities.
No. 2: Fooled by Randomness
This mental model became deeply etched into my mind after reading Nassim Taleb’s Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets.
Taleb argues that most of what happens in the world is the product of random, nonsequential, non-ordered events.
The way your life has turned out – your success or failure, the spouse you married, the chance meeting that launched your career – is more the result of random events than you care to admit.
Taleb argues that we are “fooled by randomness” when we weave stories – “narrative fallacies” – to explain the causality of events that are actually outside of our control. In truth, outcomes in our lives are less predictable than we think they are.
The lesson for investing?
If you win big on a particular stock by buying at just the right time… you can chalk it up to dumb luck as much as your unique insight.
No. 3: Mr. Market’s Mood Swings
I have already invoked this mental model several times here on Liberty Through Wealth.
Benjamin Graham introduced “Mr. Market” to investors in Chapter 8 of The Intelligent Investor to represent the vicissitudes of the financial markets. As an investor, you should view Mr. Market as a business partner who offers to buy and sell stocks every day.
As Graham explains, Mr. Market is a pretty unstable character. Sometimes he wakes up happy, and sometimes he wakes up sad. Your job is to take advantage of his mood swings by buying when he’s down in the dumps and selling to him when he’s euphoric.
Warren Buffett has said that if you read this chapter (along with Chapter 20 on “margin of safety”), “You don’t need to read anything else and you can turn off your TV.”
Of course, there are dozens of other mental models out there that you can apply to both your life and investing. I’ll be discussing more of these in the future.
As I survey these many mental models as they apply to investing, however, I am struck by one thing: Not a single one has come from the insights of Nobel Prize-winning modern financial theory as taught in the world’s business schools.
That has led me to yet another critical – and counterintuitive – conclusion… It’s highly unlikely you’ll become rich by following the arcane rules of academic financial theory.
But you just might stand a chance by doing the opposite.