When it comes to investments, most people focus on capital, returns, and risk.
Very few people pay cognizance to the influence of emotions and how it affects the performance of their portfolio. Yet, seasoned and legendary investors have often talked about the importance of controlling your emotions as a prerequisite to making profitable bets in the market.
One way we can control our emotions in the stock market is through the use of mental models.
Legendary investor Charlie Munger popularized the idea of using mental models to make one’s understanding and make good investment choices.
Mental models equip an investor to make educated guesses, simplifying the complex nature of investing. Applying mental models helps to rein in emotions and biases and approach an investment prospect logically based on one's unique attributes.
This article highlights how investors can use mental models to guide their thought processes when making investment choices.
A mental model can be described as the mechanism through which one filters his thoughts to arrive at a decision.
It is a lens through which one views the world and understands phenomena. Mental models are signposts that guide one during decision-making.
Mental models can help us make better investment decisions through rational thinking. It helps us avoid the knee jerk and emotional reactions while making decisions, by allowing us to focus on the facts and outcomes of our investment actions.
Let's have a look at some mental models which can help us make better investment decisions.
Second-level thinking is a mental model which tries to explain the ripple effects of our actions.
When people think of cause and effect, they tend to take a linear approach i.e. think of only the immediate effect. However, our actions have domino effects which are primary, secondary, and tertiary.
Actions have consequences, and these consequences beget further consequences and so on. The second-level thinking model implies that by thinking about these second-level effects, we can make better decisions.
In relation to finance and investment, second-order thinking can help us properly evaluate the impact of our investment decision. It allows us to put the long-term consequences of an investment in perspective, allowing us to make better decisions.
Rather than thinking of financial independence or wealth alone, we should also consider other second effects of investing such as how:
For example, while the market may be euphoric about tech stocks, thereby driving its prices up, a second-level thinker would ask what are the implications of increasing antitrust filings against tech giants?
How would China’s crackdown on tech companies set the pace for further global regulation?
First-principles thinking is a mental model that aims to get to the root cause of the problem.
It is hinged on the assumption that complex problems are not really challenging if we break them down to their most fundamental basis. Elon Musk is one of the proselytizers of this principle, though its origin is credited to Aristotle.
The first principle is an assumption that can't be decided any further. It advocates for peeling back the layers of an issue or problem to get to its core. Once this core has been found, it is easier to resolve the issue.
As regards investing, the first principle can also play a crucial part in helping us make sound decisions. Using these mental models, we can strip bare the complex financial data and research to get to the core.
For example, if you want to invest in a stock, the first principle suggests asking questions like:
By asking questions based on first principles, we would reach assumptions about the business which can’t be deduced any further. This would allow us to know if the stock is worth investing in or not.
This model is named after Vilfredo Pareto, an Italian engineer, and sociologist who sought to explain the unequal relationship between input and outputs.
Pareto states that 80% of the effects come from 20% of our actions. He underscored this principle by observing unequal land ownership and wealth distribution in Italy and other countries.
Pareto noticed that about 80% of the land in Italy was owned by 20% of the population. He discovered a similar pattern after studying other countries in Europe.
The Pareto Principle helps us understand the fact that things are not always evenly distributed. In relation to our investment, we can observe that there is an imbalance of return on assets in our portfolio.
While this may not be distributed in the form of the 80-20 ratio, we all notice that our assets do not have the same returns even if we allocate the same capital to them.
Using Pareto's principle, we can sift the assets that make the most returns and double down on them.
Another way to view this is by looking for those assets or investments which generate the most returns with little capital, energy or time invested. When we discover them, we should double down on them to increase our returns.
We can also use this principle to shed the extra weight in our portfolio, i.e. those assets that underperform and drag the overall performance of the investment down.
For example, if you notice that tech stocks account for most of the returns on our portfolio, using Pareto's principle, we can increase our investment in tech stocks, and reduce our position in the underperformers to optimize our gains.
Though mental models emanate from different fields such as engineering and psychology, they are easily applicable in different aspects of our life, including investment. By using mental models, we can improve our decision-making process which would translate to more profitable investments.