by elmads

“The more models we have, the better able we are to solve problems. But if we don’t have the models, we become the proverbial man with a hammer. To the man with a hammer, everything looks like a nail. If you only have one model, you will fit whatever problem you face to the model you have”

-Charles T. Munger

Mental models are systems of guides where we base upon how we approach and handle certain situations. Don’t get me wrong, because there is no such thing as the perfect answer to every dilemma, but there are certainly ways where we can manoeuvre ourselves to find solutions to some of the problems that we could encounter.

Most our problem solving approach came from models that we’ve collectively learned both directly & indirectly from others, e.g. our parents, friends, our life experiences and views of the world.

The ecology and society organization defined mental models as; “Conceived of as a cognitive structure that forms the basis of reasoning, decision making, and, with the limitations also observed in the attitudes literature, behaviour. They are constructed by individuals based on their personal life experiences, perceptions, and understandings of the world.”

Since I started to further delve into the world of investing, I get to somehow, even in a tinniest bit, understand and apply the models that coincides with my personality and innate gifts.

In this article, I’ll be sharing to you the simple Mental Models that as of today, has formed and supported my investment philosophy. Models that has been aiding me to cope and approach the world of investing with its complexities, noises, cognitive biases, euphoric and despondent states. An area where emotions and behaviour have very strong impact to a participant’s potential success.

Take note, I wrote “As of today”, because as time passes by, my views and strategies will surely change. Why did I say that? well because to have a shrivel of chance to become an okay enough investor and achieve our own personal success in this endeavour, one must be willing to be a forever learner, re-learner and un-learner, not just in investing but also in other aspects of our lives.

NOTE: There are hundredths of mental models out there. I only specifically treasure 6 because It’s always better to have a few that we truly know and can truly follow. The simplest things are always the best things, Occam’s Razor (we’ll talk about this on my 2nd mental model).

Compound Interest

It is said that compound interest originated and was practiced in the old Babylonian period around 2,000 BCE, they called it back then as “Interest on Interest”.

Compound interest is a mathematical phenomena where the interest on the initial number used, stacks up over time. Contrary to simple interest, where the interest gains are only based on the initial number utilized. Compound interest has always been the back bone and power behind investing. It has always been behind all successful investors’ massive increases in wealth, over a long stretch of time.

In layman’s terms, the initial money utilized will exponentially grow over time, the longer the runway the larger the potential gains will be. Opposed to simple interest, where its growth trajectory is only linear.

See chart down below.

I’ve discussed Compound Interest in detail and how it is computed in my blog titled “Simple & Compound Interest”.

Simple and Compound Interest

HOW I USE IT: The mental model of compound interest substantially helped me with my investing philosophy. It is the core of any investment endeavour.

Understanding how it works gave me the confidence and understanding of our resources, on how we can harness it to make more of it, in this case money.

Every investment decisions I make is always based on compound interest. I always ask an investment question to myself, how will I make 10-15% Compounded Annual Growth Rate (CAGR) with my money? that’s where then I’ll look for public companies that can compound my capital based on my personal required rate of return (10-15% per year over a long period of time).

Furthermore, compound interest is not only applicable in a mathematical sense, because it can also be practiced in other aspects of our lives, such as wanting to get in shape, being knowledgeable in certain fields, wanting to reach our dream position, and others more.

Probably you’re asking yourself, how? it’s through small consistent and disciplined actions that will bring us nearer to our personal goals. Exercising, reading, not wasting our precious time, and being more efficient when working to name a few.

For exponential growth to materialize, not just in investing but also in other parts of our lives, we must do things consistently, with focus, discipline and most especially doing it for very long periods of time.

On the flip side, compound interest is a neutral force, it doesn’t discriminate. It is a force that can be used not only for our own self improvement, but also for our own demise.

For instance, if we want to get in shape, lose weight or for our own good health, what should we do? it is known that we need to do at least the following, have a balanced diet, exercise, and by doing it consistently for a long time (not just seasonally), and even better is doing it for a lifetime. But! what if we flip it around? eating unhealthy food and having a sedentary lifestyle for decades? what do you think would happen to us?

No matter what consistent long term action or inaction we take, there will always be an absolute corresponding long-term consequences. Either it’ll be for a positive or negative exponential growth.

Do you compound your habits for the better or for the worse? The compound Interest of life.

The Downside of Compound Interest: Ineffective for very impatient people, and for those who want to see results now.

Occam’s Razor

This is a problem solving principle that has been coined by William of Ockham, a 14^th century English-Franciscan Philosopher and Theologian.

Occam’s Razor is also know as the “Law of Parsimony”. It states that “More things should not be used than are necessary.” In other words, when trying to make sense of some phenomenon (especially between two competing alternatives), it’s best to avoid the more elaborate explanation—shave it off, like a razor. -Dictionary

Furthermore, it also says that “Entities are not to be multiplied beyond necessity.” It is generally understood in the sense that with competing theories or explanations, the simpler one, for example a model with fewer parameters, is to be preferred. -Wikipedia

“All things being equal, the simplest solution tends to be the best one”.

HOW I USE IT: I don’t complicate my value investing strategy. I just have a very simple framework that I follow. I look for public companies that I understand, with a management that has integrity, has a long-term business runway and should be trading at reasonable price before I purchase it.

Subsequently, I do a superficial (not in-depth yet) discounted cash flow of the company. This is the simple way “for me”, with the help of TIKR.com for a quick look and fast accessibility of, almost all companies’ financials around the world.

Why I focus on financials first? because numbers are more honest than what the management usually says. Though, there can be fraud with numbers, it is still easier to detect shenanigans with it, and be counter checked by the auditors, than validating what management says. In short, number are mostly objective while management statements are subjective in nature.

That being said, seeing our current investment environment, I must say that Dollar Cost Averaging in Index Fund is the best example of Occam’s Razor. Why beat the market when you can just be invested in the general market and get its average returns in the long run.

As like what the late John C. Bogle have said; “Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game”.

Even Warren Buffett advised this for 99% of the people. That, It would be better if most individuals will consistently invest a portion of their salary in a low cost index fund over a long period of time.

Occam’s Razor and investing also strongly reminds me of the book I read last June of 2022 titled “A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan” by Ben Carlson. A great book to read for new investors and even for experienced investor ( as this will serve as a reminder for them).

The simplest solution stems from the fundamental core theories of all fields.

The Downside of Occam’s Razor: It’s hard to use Occam’s razor for individuals who truly believe and think that complex methods are the most accurate, and only way to solve all problems.

Inversion

The best person to explain this is Mr. Charles T. Munger. He is the vice chairman of Berkshire Hathaway and the long time business partner of Warren Buffet. He is also known to possess and practice various mental models both in business and his personal life.

This is what Charles T. Munger said about inversion thinking.

“Invert, always invert: Turn a situation or problem upside down. Look at it backwards. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there?

“Instead of looking for success, make a list of how to fail instead–through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die so I don’t go there.”

He even expanded this concept by explaining that; If you’re to take anything away from inversion let it be this: Spend less time trying to be brilliant and more time trying to avoid obvious stupidity. The kicker? avoiding stupidity is easier than seeking brilliance.

In other words, inversion reframes a challenge and allows you to identify areas to avoid, simply or just shake up your assumptions and fixed perspectives.

In life, we could use this easily. The best way to explain this mental model is by asking ourselves some questions.

• How to have a long lasting and happy relationship/marriage ? ? ? ? ? ? ? ?

Were you able to give an immediate answer? if yes, how many answers were you able to think of? or do you need some more time to come up with your answers?

let’s then try using inversion, shall we?

• How to destroy your relationship/marriage ? ? ? ? ?

For most people, this is easier to answer.

This is inversion, it’s easier to spend time thinking about the opposite and see the negative things that we are afraid to happen. I guess being cautious and somehow pessimist is prevalent with us human beings. Well this is not all bad because thanks to it, our species have survived for over two millennia already.

Therefore, by utilizing the innate survival instincts we have, practicing inversion will be not as hard as everyone thought it would be. It is a matter of continuous application and practice.

Invert, then avoid all of the answers you came up with. That’s is the inversion mental model

HOW I USE IT: I start it from top to bottom, on finding and analysing a potential public company to own.

As an example, if I would invest in Alphabet (parent company of Google), the things I would ask my self are the following. “How will Google be dethroned as the king of online advertising?” or to put it simply “how will Google lose its market share?”.

The answers that I could think are the following below:

• Massive government intervention.
• Breaking down Google into smaller companies based on their revenue streams
• Banning Google in other countries,
• Capping the usage of Google in different states, or parts of a certain country (I don’t know if this is possible)
• Google becomes complacent and stops reinvesting in their online advertising platform (their bread and butter revenue stream)
• Changes in consumer and business preferences, like a move from google chrome to other web browser provider. This would reflect a declining online advertising market share and margins for Google.

Those are the things I could think of. It’s not a solid basis, but these are the things that would raise alarms for me. Also, this would require a deeper understanding and review of the company based from these inverted thinking scenarios, if ever it does pan out.

The next step then for me is to know how likely this would happen, and this is through applying the next mental model that I personally think helps with inversion thinking, and that’s the mental model of “Probabilistic Thinking”.

Downside of Inversion: When emotions have the complete rule over our minds and has the monopoly of our actions. We definitely know that there are certain acts that could have a direct detrimental outcome to our lives in the long run, but for some reason, we disregard logic in favour of our own desires.

I’ll discuss the remaining three mental models next week, on the 2^nd part of this article. “The Investment Mental Models I Follow & Practice – Part 2” Starting with Probabilistic Thinking.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.