To evaluate the potential of any business, an individual or an analyst needs more than just business/segment information. They also need to understand the lenses through which this information passes. Lenses are not handy thing rather it gets created, refined, and polished over the course of time with layers of observations, experiences, and learnings. Such lances are better placed when you have a robust mental model.
Charlie Munger, the less-known face in the investing world and partner to the famous Warren Buffett, once said in an interview while explaining the importance of the mental model, “I've long believed that a certain system - which almost any intelligent person can learn - works way better than the systems that most people use… What you need is a latticework of mental models in your head. And you hang your actual experience and your vicarious experience (that you get from reading and so forth) on this latticework of powerful models. And, with that system, things gradually get to fit together in a way that enhances cognition."
By building up a network of models in your mind, you can approach problems from multiple angles and gain a more nuanced understanding of the situation. These mental models can be based on various concepts and principles such as psychology, economics, physics, biology, and history, among others. Munger believes that having a wide range of mental models is a key factor in making good investing decisions.
Unfortunately, business schools think it is numbers that matter and it is very crucial to have great knowledge about how to extract data and run through various financial models in Excel to arrive at investment decision-making. But, what they miss is various qualitative sides to the business which only get analyzed efficiently by the various mental models. Principles/Concepts like networks effects, the economy of scale, first-mover advantage, non-linearity, psychological biases, collective behaviour/trend, winner-takes-all, zero-sum, leverage, first-mover-advantage, Darwinian evolution, self-organized criticality, incentives/agency costs, autocatalysis, etc. can actually help you evaluate the real competitive strength, sustainability and potential of the business.
Charlie Munger further said, “It’s more likely if you have studied typical finance, you missed the large part of what’s critical in the investing. Most finance courses fail to cover the psychology and financial history.”
To reiterate further on this point, the veteran named Peter Lynch once said, “As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics.”
To quote more wisdom from veterans, Glenn Greenberg, a founder of an investment advisory firm based in the USA said, “I have been in the business since 1973, so I have been looking at companies for a long time. There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn’t going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models.”
James Seddon of Hosking Partners said, "We don't really use screens. Instead, we use 'mental models' which help us find good investments. Some examples of these are the capital cycle, the power of incentives, and insider ownership."
Li Lu, a Chinese-born American investor said, "You have to be naturally interested and curious about everything – any kind of business, politics, science, technology, humanities, history, poetry, literature, everything really affects your business. It will help you. And then occasionally you will find a few insights out of those studies that will give you tremendous opportunities that other people couldn't think of."
Biases, on the other hand, are the real enemy of decision-making, especially financial investment. The more you are aware of biases and keep them away from your model, the more effective you can be in decision-making.
The Lollapalooza effect is the best way to describe how various psychological biases can ruin your mental model and can make you act against all the learnings and intelligence. We, humans, have many inherent biases and tendencies that can sway our behavior one way or another. When several of them act in concert to drive us toward a particular action, you have a Lollapalooza effect.
The Lollapalooza effect when apply to investing, causes millions of investors to buy one sector, sell off another sector, or otherwise act as a "herd." This herd mentality is every investor's worst enemy. After all, if you sell when everyone else is selling, then you're probably eating huge losses in something which is going to sustain going forward. For example, Covid led to many investors selling off stocks and businesses at throw-away prices as if there is no tomorrow. If you do the opposite and buy when everyone else is selling, then you're likely getting bargain prices for businesses most of the time. So, before you make an investment based on what others are doing, it's wise to think about how different psychological factors might be causing an irrational reaction in the market.
The 2007-2008 mortgage crisis is a textbook example of the Lollapalooza effect. Before the mortgage market imploded, brokers were more concerned about the creditworthiness of borrowers, as lenders had a practice of keeping mortgages on their books and thus stood to lose a great deal in the event of a loan default. However, when Wall Street introduced the concept of selling mortgages to the financial markets (CDO), it created a gigantic Lollapalooza effect. Suddenly every player in the market had a different motivation: Brokers wanted to make money, investors who bought the mortgages wanted to make money, banks wanted to make money, and borrowers wanted to purchase their dream homes regardless of whether they could actually afford them. No single player thought about the long-term consequences, and as a result, the mortgage market collapsed because of an overwhelming dose of human misjudgement.
Achieving success as an investor is often a matter of avoiding situations that are extremely difficult to predict due to the number of moving pieces involved. In other words, if there's no good way to determine whether an investment is a smart one, then you may be better off staying away. That’s one more principle to add to the mental model.
Investing is a game of elimination. Lesser the mistakes, the higher the chances of winning. All you need to do is avoid the areas where you’re not sure about the outcome. Charlie once said, “All I want to know is where I'm going to die so I'll never go there”
The frequency of correctness does not really matter (batting average), what matters is how much money you make when you are right versus how much money you lose when you are wrong (slugging percentage). Generally, we suffer losses roughly twice as much as we enjoy comparably sized gains. In other words, we like to be right a lot more than to be wrong. But if the goal is to grow the value of a portfolio, slugging percentage is what matters.
Falling in love is something that harms investors more in the world of investing. Be ruthless in selling when you feel you have made a mistake buying the business. When new information arrives, great investors would access the probabilities again and revise their thesis, and they would not mind changing their decisions based on the latest information. English economist John Maynard Keynes asked, “When the facts change, I change my mind. What do you do, sir?”
One might question now how to build a strong mental model which can help in investment decisions. The process is rather slow, and long and requires discipline. These are some steps and guidance to build the Lettice of a mental model.
Start with the basics: Begin by learning the fundamental mental models that are relevant to your field of interest. For example, learn about concepts such as compounding, diversification, margin of safety, and other models mentioned earlier in the article.
Read widely: Read widely on a variety of subjects. This will help you develop a diverse set of mental models that you can draw upon when making decisions. Consider reading books, articles, blogs, and other resources that cover a range of topics.
Make connections: Look for connections between different mental models. This will help you see how they relate to each other and how they can be applied in different contexts. For example, you might see how the concept of compounding can be applied to both investing and personal life.
Build models: Create mental models for specific situations or problems. This will help you think through complex issues and make better decisions. For example, you might create a mental model for evaluating a startup or for analyzing an investment opportunity.
Test your models: Test your mental models by applying them to real-world situations. This will help you refine your models and identify any weaknesses. For example, you might test your mental model for evaluating a business, taking hypothetical decisions for them, and tracking the outcome of your decisions.
Revise and refine: Continuously revise and refine your mental models based on new information and feedback. This will help you develop a more accurate and comprehensive lattice-work of mental models over time.
Remember, building mental models is an ongoing process. It requires continuous learning, reflection, and refinement. With practice, you can develop a powerful set of mental models that will help you make better decisions in all areas of your life.