“Rules of thumb” in investing abound.
And chances are, many are already familiar to you.
These rules include…
- “Cut your losses and let your profits run.”
- “It’s not timing the market but time in the market.”
- “Buy the rumor, sell the news.”
Psychologists call these rules of thumb “heuristics.”
We use heuristics to help us navigate decision making in the everyday world.
Each of the investing-related heuristics above is timeless.
And each remains true no matter who’s president… what the state of the economy is… or whether the stock market is in a bubble.
But there is another set of investing heuristics that is less well-known.
I’ve called these heuristics “mental models” in the past.
Here are three more of my favorites as they apply to investing.
1. The Pareto Principle
You may have heard about this mental model by its other name: the “80-20 rule.”
Pareto observed that 20% of the population owned 80% of Italy’s wealth.
Soon, experts across many disciplines found that the Pareto principle applied, with uncanny accuracy, to many different situations.
As it turns out, the Pareto principle also applies to investing.
Take a look at your investment portfolio with this principle in mind. Chances are, you’ll likely find 80% of your gains come from 20% of your investments.
Whether that distribution is exactly 80-20 matters little.
(As another economist – John Maynard Keynes – observed, “It is better to be roughly right than precisely wrong.“)
The point is that investment returns are not linear.
The top few positions in your portfolio are likely to be responsible for the bulk of your gains.
Venture capitalists understand this better than stock-picking portfolio managers.
In a portfolio of 10 companies, a venture capitalist expects two or three companies to go belly-up…
Five or six to stagnate (called the “living dead”)…
And one or two companies to generate almost all the gains.
2. Being “Right” Matters Less Than You Think
We all like to be right.
After all, being right affirms our insights and judgments.
If you were a good student in school, being right – and being right often – likely shaped a big part of your self-esteem.
But successful speculators operate according to a very different mental model.
Top speculators readily admit that they are right less than 50% of the time.
The best trend-following traders are right only about 40% of the time.
And they understand that mistakes are just part of the process.
George Soros – the greatest speculator in history – understood this well.
As Soros observed, “It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”
3. The Mental Model of Inversion
Here’s a habit that I developed a couple of decades ago…
Whenever I come across a consensus view, I ask myself, what if the opposite were true?
Only later did I learn that habit approximated one of Charlie Munger’s favorite mental models in investing.
Munger has called this approach to thinking “inversion.”
This sounds awkward to the English-speaking ear.
That’s because it was inspired by the German mathematician Carl Gustav Jacob Jacobi.
Jacobi advised a simple strategy to solve any problem: “Man muss immer umkehren” (or, loosely translated, “invert, always invert“).
Put another way, it’s not enough to think about a difficult decision one way.
You need to think about it forward and backward. And inversion forces you to consider different perspectives.
In many ways, inversion is a cousin of contrarian thinking.
Let’s see how inversion could apply to the world of investing.
Every day you read about how cruise lines are going out of business.
Consider if the opposite were true.
Last week, I read Oceania Cruises recently sold out its 180-day 2023 world cruise in a single day.
Does that sound like an industry that is going out of business?
How about the hated energy sector?
Every investor “knows” that traditional energy companies are a lousy investment.
After all, they are succumbing to the juggernaut that is the green revolution.
What if the opposite were true?
After all, 80% of the world’s energy still comes from fossil fuels. And while that percentage will only fall – albeit slowly – energy companies will adapt in the meantime, much like automobile manufacturers are adapting to electric vehicles.
Whether you agree with this conclusion or not…
Inversion has forced you to look at the question from the opposite point of view.
And no matter what you conclude, inverting the question will likely help you arrive at a better decision.
So, do you have a favorite rule of thumb or mental model when it comes to investing?
Share it in the comments below.