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10 Mental Models that Make You a Better Investor and Decision-Maker
Here are 10 Mental Models that improve your decision-making and thus your skill as an investor. Make sure to study and apply these whenever you can.
1. First Principle Thinking - Rethink complex problems or ideas from the ground up. You want to break down the complexity by stripping the problem to its fundamental, foundational elements.
This involves questioning assumptions and relying on fundamental, undeniable truths to understand and solve the problem rather than accepting existing solutions or conventional wisdom.
By deconstructing issues into their essential components, you will think more creatively and come up with innovative, new solutions.
2. Second-Order Thinking - Brought to me by Howard Marks, this concept is about going beyond simple, first-level analysis. It involves considering not only the immediate consequences of a choice but also second or third-order consequences, so-called ripple effects.
Performing this extra step is essential in every situation that demands outsmarting competition. A prime example of that: Investing.
3. Inversion - Inversion is the idea of approaching a problem in reverse. Instead of focusing on what you need to do, you focus on what you must avoid. Look for potential negative outcomes or obstacles to prevent or mitigate. That way, you’re reducing risk and increasing your chances of success.
You’ll also realize that a thousand different ways lead to your goal, but only a handful of things can prevent you from reaching it.
This concept is at the heart of my Search Process Checklist for Investing. One of my six Checklists I use for investing. If you want to know what they are, you can access all six Checklists plus ~40 pages of further explanation for just $1.99 here:
(As a Paid Subscriber, you get this product and all future ones for free. Message me if you do not have it yet)
4. Opportunity Costs - This model comes from Economics. It refers to the value of the next best alternative that you must consider when you make a choice. It’s considering the dilemma of trade-offs in decision-making. If you step through one door, every other door closes…
According to Charlie Munger, one of the fundamental mental models to use in investing. You must always compare an opportunity to the next best.
5. Leverage - The idea of leverage is to use a small amount of effort, money, etc. to achieve a disproportionately larger result. It's a strategy of amplifying the effectiveness of your actions or investments by utilizing external factors or tools.
In investing, I advise against using leverage. In life, you must use it. According to Naval Ravikant, there are three forms of leverage. Labor (people work for you), Capital (capital works for you), and Products with no marginal cost of reproduction.
The E-book about my Investment Checklists is such a product. After it is produced, there are no costs or limits to selling it. So it can’t be out of stock when you look for it ;)
Jokes aside, the internet made this form of leverage accessible to everyone. Use it.
“Give me a lever long enough, and I shall move the world.” - Archimedes
6. Margin of Safety - The core concept of a margin of safety is planning for errors in your decision-making or, rather, the assumptions you make. This concept was popularized in investing circles by Benjamin Graham.
The idea is to buy assets below their intrinsic value. Since intrinsic value is just an estimate, you should plan with a “puffer” that allows for mistakes on your side. Also, the higher the margin of safety, the more exponential your returns will be.
I’ve explained this concept in more detail in a recent article:
7. Occam's Razor - When analyzing competing hypotheses or explanations, choose the simplest one. The simplest one is characterized by having the fewest assumptions. If that explanation doesn’t hold true, go on to the next simplest one.
Especially smart people have a tendency to prefer complexity. But this is a bad trait when you try to be right…
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8. Law of Diminishing Returns - The more of a variable input (such as labor or capital) you add to a fixed resource (like land), the less additional output or benefit you gain will from it. Eventually, the value will actually decrease.
9. Map vs. Territory - This idea highlights the distinction between a representation, the map, and the actual reality, the territory, it represents.
The map is a simplified, abstract model of the territory and can almost never capture the complexities of reality. The Map vs. Territory concept is a reminder that emphasizes the importance of recognizing that our mental models, beliefs, and perceptions are not equivalent to the objective reality they represent.
10. Asymmetric Bets - In asymmetric bets, the potential upside significantly outweighs the potential downside or loss. The more of these bets you take, the higher your chance of success.
There’s no successful investor who isn’t looking for these exact bets. The margin of safety concept we discussed earlier also plays a role here too. It limits your downside and leaves surprises open only to the upside.
That’s it for today!
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