Mental models are ideas of how things work. As an investor, mental models may serve as tools to improve your strategies and help you make better investing decisions.
In this post, we'll cover 5 mental models that may help you invest better. For those of you interested in the subject, you can visit Farnam Street for a comprehensive list of over 100 mental models.
The statement above serves to remind us that maps are representations of reality, not reality itself. A map can also be a snapshot of a point in time, representing something that no longer exists.
When it comes to investing, charts or company financials are often used as "maps" that guide investors on their decisions. However, it's worth remembering that there are many variables that may impact the price of stocks and that the market is often not as predictable as we'd hope.
Being familiar with your circle of competence is about knowing what you understand and being humble enough to admit what you don't. Warren Buffett explained how this relates to investing in his 1996 shareholder letter:
"What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital"
Second-order thinking is about being able to visualize mid and long-term developments. It's about being able to think about how things will unfold over time.
For instance, a stock market downturn may be bad in the short-term, but it can also provide opportunities to buy stocks at a cheaper price and potentially make money in the long-term.
“All I want to know is where I’m going to die, so I’ll never go there.”
The quote above is from Warren Buffett's business partner Charlie Munger and it pretty much sums up what inversion is all about: thinking backwards.
An investor might consider the question "How can I make money?". The inverted version of that question, on the other hand, might look something like "How can I avoid losing money?".
Inversion can potentially help us make better decisions by avoiding bad ones. As Shane Parrish from Farnam Street puts it "Avoiding stupidity is easier than seeking brilliance".
Pursuing one career might mean not being able to pursue another. Investing in one stock might mean not being able to invest in another.
When you make a decision, you are also likely making some sort of trade-off. That's something investors should probably keep in mind whenever they put their money into a stock, for example.
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