5 Mental Models That Will Help You Become A More Intelligent Investor

"Being able to draw on a repertoire of mental models can help us minimize risk by understanding the forces that are at play."

Jan 15, 2024

Ever since reading “The Great Mental Models” by Shane Parrish, I’ve been hooked on learning mental models.

Mental models have truly changed the way I see the world, avoid problems before they happen and improve my decision-making.

In this week’s newsletter, I write about 5 mental models that have helped me be a better investor.

Check out my recent interview with Tim McElvaine, a highly experienced value investor.

Tim and I covered value investing, frameworks to play to your competitive advantage, mental models for better positioning, and life lessons from working with Peter Cundill.

1 - Know The Difference: Price Vs. Value

In his early days, Warren Buffett shifted away from the "cigar butt" investing style, advocated by Charlie Munger.

The cigar butt approach is akin to snagging undervalued stocks resembling discarded cigar butts—on their last puff.

Buying a stock below its net asset value, known as a "bargain stock," was the strategy. However, such stocks, selling at a discount, often signal trouble.

Beware of companies with low multiples and a tempting price tag—they might be value traps. These firms, priced cheaply due to financial instability and limited growth, are risky investments.

Remember, there's no price too low for a melting ice cube.

Stay away from companies in a secular decline, and those that are experiencing disruption in their business models.

As Buffet says:

“Price is what you pay, value is what you get. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

2 - Margin of Safety

Warren Buffett once said that the three most important words in investing are “Margin of Safety”.

Always ensure that you have a margin of safety in your investments, by buying a stock at a significant discount to the intrinsic value.

As famously said by Seth Klarman:

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”

It’s all about the price you pay. The margin of safety is designed to make you money by not losing money.

Having a margin of safety protects you from the “unknown-unknowns” and gives you a buffer from making extreme losses in this kind of market volatility.

3 - Inversion

Unlock the power of inversion—a thinking approach where you consider the opposite of your goals. Initially underestimated, it's a potent tool for both investing and life.

As highlighted by Charlie Munger:

“Think forwards and backwards—invert, always invert. Many hard problems are best solved when they are addressed backward. The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I’d even say usually are easier to solve, if you turn them around in reverse.”

Inversion is a rare yet crucial skill employed by great thinkers. Apply it by defining the problem, inverting it to identify potential failures, and then crafting solutions to avoid those pitfalls.

4 - Role of Luck

Recognize the profound impact of randomness, chance, and luck on our lives.

Acknowledge that our successes often stem from luck, yet we tend to attribute them solely to our skills. In investing, where luck plays a significant role, it's crucial to factor luck into decision analysis.

As noted by Michael Mauboussin:

“In activities where luck plays a strong role, the focus must be on process… A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.”

Evaluate the correctness of a decision based on the analysis and rationality of the judgment, not solely on the outcome.

Always remember, you might be a lucky fool.

5 - Challenge Your Beliefs

Don't cling too tightly to your opinions. When facts change, your ideas must change.

Following Charles Darwin's advice to crush our most cherished beliefs, adopt an intriguing method: write down conflicting evidence swiftly, within 30 minutes. This prevents your mind from rejecting new information that challenges your beliefs.

In the words of Charlie Munger:

“Once should recognise reality even when one does not like it. Indeed, especially when one does not like it”.

The most successful individuals are in a constant state of belief evolution. You don't have to remain steadfast in your convictions.

Avoid falling in love with a stock or CEO. Successful investing demands an unemotional approach and the willingness to challenge and change your beliefs.

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Thank you for reading. I hope you learned a lot today!

Best,

Ben Mumme