7 Mental Models That Will Make You a Better Investor
In 1994, Warren Buffett’s business partner and friend Charlie Munger gave a speech at USC Business School about the art of stock picking.
What students didn’t know was they were really in for a lecture on how to become a better thinker – or, as Munger put it, proficient in elementary, worldly wisdom.
“What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back,” says Munger.
“If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience – both vicarious and direct – on this latticework of models.”
This was the speech that popularized the idea of Mental Models.
“The first rule is that you’ve got to have multiple models,” says Munger “Because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does… It’s like the old saying, ‘To the man with only a hammer, every problem looks like a nail.’”
Today I’m sharing with you a few of my favorite mental models. Munger believes you should have around 90-100 good models. I’m only giving you seven. But I hope you’ll take what I give you and explore further.
If you want to read the full transcript from Munger’s famous speech, click here.
Mental Model #1 – Pareto Principle
The Pareto Principle was named after Vilfredo Pareto, an Italian polymath who noticed that 80% of Italy’s land was owned by about 20% of its population. When you apply this lens to everyday life, you start to see this statistical distribution everywhere. The 80/20 rule not only applies to wealth, like how much land is owned, but in sports, productivity, and stocks. Look at your portfolio today and you’ll probably see that only a handful of stocks contribute to the majority of your yearly profits.
Mental Model #2 – The Law of Large Numbers
The law of large numbers states that over a large number of occurrences the average of the values of the occurrences approaches the mean. For example, if you tossed a coin 10 times, you might get 8 heads (80%) and 2 tails (20%); but if you tossed the same coin 1,000 times, the law of large numbers would direct the heads/tails results closer to the average of 50%. Another name for this phenomenon is “gambler’s fallacy.” If you’re winning in a casino, cash out early. The more you keep playing, the more likely you are to lose money since casinos are set up such that the house always wins.
Mental Model #3 – Specialization
This might sound obvious now but during the 1700s, this was a revelation. First recognized in Adam Smith’s book Wealth of Nations, specialization theory shows us that workers are far more productive if you break up large jobs into smaller ones and have workers specialize in performing these smaller jobs. Smith also warned that specialization could lead to unhappiness as workers are subject to performing the same task repeatedly.
Mental Model #4 – Cumulative Advantage
Cumulative Advantage or The Matthew Effect follows the old saying that “the rich get richer, the poor get poorer.” If you’ve played Monopoly, then you’ve seen the Matthew Effect in action. Everyone starts Monopoly as equals but as the game goes on and more players accumulate properties and cash, the players with the most properties keep building on their riches while the laggards struggle to stay afloat.
Mental Model #5 – Comparative Advantage
This one is a bit counterintuitive. In 1817, Scottish economist David Ricardo developed a theory to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries. A country has comparative advantage if it can produce a good or service for a lower opportunity cost than other countries. That’s why oil-producing nations typically have comparative advantage in chemicals.
Mental Model #6 – Hindsight Bias
You’ve definitely experienced this before when an event takes place and you reason that you should have known it all along. This is simply your brain playing games with you. A good way to keep hindsight bias in check is to keep a journal of important decisions you make. Then, if one of those decisions results in an unforeseen outcome, you can look back at what information was available to you at the time of the decision instead of convincing yourself that you knew it all along.
Mental Model #7 – Mr. Market
Introduced in Benjamin Graham’s 1949 book The Intelligent Investor, Mr. Market is an allegory that helps explain daily fluctuations in the markets. Graham asks you to imagine that you’re one of two owners of a business, along with a partner called Mr. Market. The partner frequently offers to sell his share of the business or to buy your share. Graham says this partner is what today would be called manic-depressive, with his estimate of the business’ value going from very pessimistic to wildly optimistic. You’re always free to decline Mr. Market’s offer, since he’ll soon be back with an entirely different offer. Remember this scenario when the markets turn and you’ll keep a cool head.
This is a very short list of mental models I see on a regular basis. I suggest you start making a list of models you encounter in your daily life and slowly build your latticework.
To a richer life,
Editor, Rich Life Roadmap