Last Updated on December 2, 2024
Overview – Understanding Mental Models
While there is no shortage of media coverage and attention placed on Warren Buffett, a lot of people overlook his business partner and Vice-Chairman of Berkshire Hathaway, Charlie Munger. Just because Mr. Munger doesn’t get nearly as much attention as Mr. Buffett doesn’t mean he doesn’t have any wisdom to share.
One of the nuggets of wisdom Mr. Munger has previously shared is the importance of creating robust mental models.
The term “mental model” may elicit connotations of something that is very hard to understand, but in reality, they aren’t all that complicated. In fact, you may already be using a variety of mental models in your personal and professional life.
If mental models are so powerful, then surely they can be another tool that investors can add to their ever-expanding toolkit. We will go over what mental models are, and how they can be of help to investors.
What are Mental Models?
A quick search for the term “mental model” returns the following definition:
“an explanation of someone’s thought process about how something works in the real world. It is a representation of the surrounding world, the relationships between its various parts and a person’s intuitive perception about his or her own acts and their consequences.”
Although this definition is a bit wordy, a mental model is essentially something that relates your own knowledge and experiences to how things should work in the real world. Based on what you know and the experiences you’ve gathered, you can reasonably infer how certain things will pan out.
Interestingly, this definition isn’t that different from how a “model” is defined in science and engineering.
In a scientific context, a model is simply a set of equations, theories, and observations that can be used to study, explain, and predict certain phenomena. Models apply regardless of scale, that is, the observations that are made with the model will also apply to the real thing, no matter how big or small it is (with some exceptions).
That last point is critical. Because models usually work on all scales, they can be used to test and study things that normally can’t be studied because of size or cost restraints.
For example, to study the aerodynamic properties of a skyscraper, engineers and scientists usually make small replicas for testing purposes. It’s very impractical and costly to make a full-sized skyscraper solely for testing, but it’s a lot cheaper and easier to do so on a model.
Because the model version is just a smaller version of the real thing, the aerodynamic properties observed in the model should also be observed in the full-sized version.
This idea of models being scalable should also work with mental models. What works in one particular situation should also work in another, even if the scale is different.
To give an investing-related example, say that you have a specific mental model when analyzing banks. You have a clear idea of what to pay extra attention to, what to ignore, and other details to focus on. Whether you’re analyzing a local bank or one of the largest in the country, your mental model will, for the most part, still apply – the major difference is the scale these banks are working at.
Different Ways to Use a Mental Model
Now that we have a clear idea of what mental models are, how exactly can they be used, specifically in the context of investing?
One immediate application of mental models is to use them when making investment decisions. Mental models can help bridge the gap between theoretical investment paradigms and the real-world strategies we end up forming.
Another application is to prevent investors from panicking. That’s because mental models can help create a clear picture of “normality” and “abnormality”. If an investor has a clear idea of how things should and shouldn’t look, then they can adjust their actions accordingly.
We will explore these ideas further in the next couple of sections.
Using Mental Models to Form Your Investment Strategies
In a previous article, we looked at how investment goals, strategies, and paradigms relate to one another. When studying how these three elements influenced the others, the following visual was shown to demonstrate that relationship:
We know that mental models help us study, test, and predict phenomena based on our knowledge and experiences. Based on what we know, we can reasonably expect certain outcomes to happen based on specific, underlying principles.
Therefore, the argument can be made that mental models fall somewhere between investment paradigms and investment strategies.
Investment paradigms dictate an investor’s overall intellectual framework. If an investor’s chosen investment paradigm is value investing, this means they fundamentally choose to approach and think about investing in a very specific way as opposed to someone who adheres to, let’s say, growth investing.
Meanwhile, strategies are the specific plans and actions an investor intends on executing. These specific strategies depend on the investment paradigm being adhered to. It would be unreasonable to expect a value investor to follow the same strategies as a growth investor.
Mental models can help bridge the gap between theory and reality by confirming which theoretical elements of an investment paradigm are actually observed in the real world, and if these observations can lead to some practical investment strategies.
For example, say the investment paradigm you adhere to is socially responsible investing (SRI). This means that the dominant criteria you look at in prospective investments are their impact on society and the environment.
How can you take this paradigm and form strategies that work in the real world?
While you’re well aware of what SRI investing entails, based on your real-world experience you know that not every theoretical aspect of the paradigm translates nicely in practice.
Perhaps you learn that there’s more to SRI investing than a company’s environmental, social, and governance (ESG) record, or that socially responsible companies will need to make some compromises in order to maintain adequate profitability.
Bit by bit you essentially piece together a mental model that confirms which theoretical elements of socially responsible investing work in the real world, and which elements don’t. Because of this, you can form more effective strategies when it comes to pursuing SRI investments based on your theoretical knowledge and real-world experience with them.
Using Mental Models to Prevent You From Losing Your Cool
There have been dozens of aircraft-related accidents and tragedies through the years, many of which ended catastrophically. However, Qantas Flight 32 is one of the few incidents that avoided disaster.
The full details of the incident are beyond the scope of this article (but are covered in-depth in the book Smarter, Faster Better), but long story short, Qantas Flight 32 was forced to make an emergency landing in Singapore shortly after take-off. That’s because one of its engines failed, and subsequently led to a fire.
To complicate matters even further, the hydraulics, pneumatics, and wing all sustained significant damage because of the burning engine. This meant there was no guarantee that the landing gear would deploy.
Fortunately, the pilot in command, Captain Richard Champion de Crespigny had flown more than 15,000 hours as a pilot and had practiced disaster scenarios like the one he was currently in dozens of times in simulators. As a result of his training and experience, he had a clear picture in his mind of how to respond to these scenarios.
Additionally, de Crespigny used a mental model of himself flying a small Cessna, one of the first planes he ever flew. At their core, a Cessna and an Airbus A380 follow similar principles, just on different scales. So, de Crispigny asked himself “What if I just visualize that I’m flying a Cessna?”
As the plane headed towards the airport and alarms continued to blare, de Crespigny’s prevailing mental model was that of flying a simple, small plane, helping him keep his cool. He was able to land with just 100 meters of runway to spare.
This is a textbook example (and by far one of the most extreme) of using mental models to keep your cool under the most mentally demanding circumstances. It’s reasonable to assume that had de Crespigny not been equipped with such robust mental models, a lot of lives would’ve been lost that day.
As an investor, hopefully, you’ll never run into such an extreme scenario yourself, but the point still stands – mental models can be used to help you keep your cool and prevent you from taking actions that will only exacerbate your problems.
Remember, mental models do more than help you predict which outcomes are likely to happen. After experiencing the same scenario over and over again a mental model can also be used to
Let’s go back to our socially responsible investing example from earlier. As you gain more exposure to different types of socially responsible companies, you probably have a clear picture of what a “typical” socially responsible enterprise looks like thanks to your mental model.
Imagine that one day, you get word of an up-and-coming socially responsible company that’s got the entire SRI community talking. Naturally, you decide to investigate it yourself.
Upon further analysis, while this company looks good at a glance, it goes against your mental model of what a typical socially responsible enterprise looks like. Despite the hype, it’s clear that based on your model this company isn’t as great as it seems, helping you avoid a potentially bad investment decision.
Another common scenario to use mental models to keep your cool is during a market crash. Many investors are quick to panic in this situation, but for those who’ve experienced market upheavals before, they most likely have a clear mental model of what constitutes a “typical” market crash. As a result, they can stay calm because they know how what to expect in these circumstances.
There’s no need to panic if you have a very clear image in your mind of what “normal” operating conditions look like.
A Mental Model Can, and Should, Always Be Improved
In science and engineering, as new information becomes available, models that depend on that information are updated appropriately. Using an incorrect model can lead to some very serious consequences, so it’s no surprise that great effort is taken to update them regularly.
Mental models are very powerful tools, but just because they work today doesn’t mean they will remain valid indefinitely. There’s always room to further improve and refine them.
Investing realities, knowledge, and theories change all the time, so it shouldn’t be surprising that your investing-related mental models will need to be updated every now and then. Using a faulty or outdated mental model can put investors in a very precarious situation, so it’s in their best interest to keep their models up to date as best they can.
Wrapping Up
Mental models are powerful tools that, if used correctly, can assist an investor greatly.
Not only can mental models help guide an investor’s decision-making and strategy formulation, but can also help them avoid panicking by creating a clear image of normalcy. There’s no need to panic if you know what typical operating conditions look like.
So, if used properly, mental models can help streamline an investor’s work process while also helping them avoid potential catastrophes.
While mental models are very powerful, they are imperfect, and as a result, must constantly be improved upon and revised. A model that works today may soon be obsolete in the near future – it’s an investor’s responsibility to prevent that from happening.
