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Mental Models – Investment Edition

Rustic Tools

Anyone who’s done the slightest amount of handiwork around a house knows the greater the variety of tools at your fingertips, the better. Sure, you can hang frames using just a hammer and nails, but sometimes better accuracy, precision, and utility can be achieved with the help of a drill and screwdriver instead.

The same applies to our minds. Through our experiences, education, and perspectives, we build mental blueprints and toolkits from which we draw when reasoning and problem solving. Like the physical toolkit, the more fulsome the mental toolkit, the stronger the reasoning and easier the problem solving.

This concept of mental models was first put forth by American philosopher Charles Sanders Peirce in the late 1800s, and later coined by Scottish psychologist Kenneth Craik in 1943. Craik believed the mind constructs “small-scale” models of reality to help us understand, reason, and explain.

More recently, Charlie Munger popularized the concept in the early ’90s by extracting the parts of the theory that could be applied to everyday life. Simply put, his version of mental models defines them as helpful tools to remember important ideas and concepts. These models can range from old adages to experiences to definitions of terms that apply to multiple aspects of life. Some are cautionary, others explanatory; while some are realities of our world, and others point out biases, or opportunities.

The main goal is to learn, create, and aggregate as many mental models as possible, crossing as many disciplines as possible. In theory, the more models you have in your mental toolkit, the better rounded and reasoned your arguments, perspectives, and opinions will be.

Many of the models below come from Gabriel Wienber’s great article on the mental models he uses, while others I’ve acquired and borrowed from a variety of sources, such as, Warren Buffet, Munger, himself, or through Farnam Street. As the saying goes, you don’t need to reinvent the wheel.

That being said, I have tinkered with some definitions or interpretations to suit my needs and preferences. I will likely modify it over time as I learn and grow, but feel free to use it as a guide when compiling your own list. Not all will apply to you so take what you want and leave what don’t.

Lastly, although there are many other models that can be helpful in various areas of your life, this list is specifically designed for investing and investors.

Hope you enjoy!

Asset Allocation refers to the asset mix or balance between various asset classes in an investor’s portfolio. A portfolio’s risk profile—as well as returns—is heavily influenced by the asset allocation. For example, a portfolio of all equities will generally have a higher expected rate of return, but will also be far more volatile than a portfolio of high-quality bonds, especially in times of market crashes. It’s a good idea to make sure your portfolio is properly diversified.

Fear of Missing Out (FOMO) is the pervasive apprehension that you’re missing out on what your peers are doing or know about. You’re likely to make decisions out of fear that you’ll miss out on a rewarding experience or memorable moment if you had otherwise opted out.

Margin of Safety is the difference between the intrinsic value of a security and its market price.

Compound Growth refers to growth on growth. It’s the result of keeping funds invested in order for growth in the next period to be earned on the principal sum plus previously accumulated growth. (Related: Compounded interest)

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. (Related: Real vs nominal value, hyperinflation, deflation, debasement)

Gross Domestic Product (GDP) is a monetary measure of the market value of all final goods and services produced in a period (quarterly or yearly). (Related: GDP per capita)

Efficient-Market Hypothesis refers to asset prices that fully reflect all available information. It has long been disputed both empirically and theoretically.

Purchasing Power Parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be at par with the purchasing power of the two countries’ currencies.

Home Country Bias, and Representativeness and Familiarity, refers to investors’ natural tendency to be most attracted to investments in domestic markets. Investors tend to focus on their home markets and the companies that do business within these markets because they are more familiar with them. This extends beyond the home country to the industries investors work within or are passionate about.

Social Proof is our tendency to be influenced by the majority as opposed to our own logic and reason, and to make decisions based on this tendency.

Recency Bias, or Over-Considering the Past is the tendency to overweigh the recent past in our investing. Instead, we should view the recent past as just another period of time and assign it the same weight as those that came before it.

Availability Bias is the tendency for us to heavily weigh our decisions on information that comes to mind most readily, instead of looking for additional information that can provide an additional perspective.

Scarcity is when you’re unduly attracted to an investment because of its relative rarity, rather than based solely on its merit as an investment. 

Get-Evenitis refers to an investor’s desire to hold onto a security until it returns to the price they originally paid for it, or until they’ve broken “even” on it.

Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically adding or trimming assets in a portfolio to maintain a desired level of asset allocation.

Overconfidence is a phenomenon where the investor overestimates their own abilities, not only to their actual level, but also in relation to that of others. Overconfidence often results in taking risks in excess of what is usually warranted for the situation. It is observed more often in men than women.

Survivorship Bias is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not because of their lack of visibility.

Regression to the Mean is when a value, episode, or event returns to, or close to, its natural state or normal observed average following an extreme occurrence. It can loosely be used in reference to a security or market observing poor returns after a sustained period of strong returns, or vice versa. For example, if the TSX returned 25% in one year, but historically, it averages 7% per year, you could expect the following year’s performance to be closer to the average of 7% than 25%.  

Confirmation Bias is the tendency to search for, interpret, favour, and recall information in a way that confirms one’s pre-existing beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. (Related: cognitive dissonance)

Supply and Demand is an economic model of price determination in a market. In a competitive market, the unit price for a particular good, or other traded item, will vary until it settles at a point where the quantity demanded (at the current price) will equal the quantity supplied (at the current price), resulting in an economic equilibrium for price and quantity transacted.

The Butterfly Effect occurs in systems (usually open systems) in which small causes can have unexpectedly large effects. 

An Ecosystem refers to the fact that in today’s world people, securities, markets, and economies are all interconnected. This interconnectedness means that what happens in one area of the ecosystem may, but also may not, have a dramatic effect on another.

Folly of Predictions refers to the foolishness of attempting to predict economics and markets, as well as to trust these predictions, given the extreme interconnectedness of markets and the sheer number of random variables.

Black Swan is when an unexpected, unpredicted, and extremely rare event occurs that can often lead to game-changing results.

Randomness is an understanding that events and returns within various asset classes often don’t manifest in a historical, predictable, or even logical manner.