Think Right, Decide Better

Decision making is the most critical aspect of investing. Therefore all our decisions must be well thought out. But today we live in a world where technology and telecommunication are a part of our lives by default. This brings with it an endless number of opinions and tips and constant advice. This makes decision making the biggest challenge that investors face today. Charlie Munger's mental models are of great help in this regard. Munger has always put his decision making abilities down to his mental models. These mental models are is a set of multidisciplinary rules, principles and concepts for decision making. These models can be applied across any field, including investing. So today we will see how the most important of these models work. We will also understand how we can apply them to improve our decision making and investment behaviour.

Inversion 

The concept of inversion states that the best way to answer a question is to invert the question and then answer it. Let us understand how this concept applies to investing. We all know that the goal of investing is to make money. But to make money we must first not lose money. Therefore, our investment decisions must be risk centric and not return centric.

This would help us avoid making rash knee jerk decisions which ultimately lead us to financial ruin. And if we avoid unnecessary risks, returns will automatically come over time.

Critical Mass

This is a mental model derived from the field of Physics. It refers to the tipping point beyond which something becomes self sustainable. Beyond this point growth would come with little or no external effort. Sometimes the tipping point is reached after a long wait. But the subsequent results more than make up for the wait. Let us now understand how this applies to investing. Our investments need time to grow. Returns may seem insignificant in the initial years of our journey. But we must not lose heart. Provided we choose the right products, a few years of disciplined investing helps our portfolio reach its critical mass. From there, it virtually goes into autopilot. Our money makes more money, and that money makes more money. From there, a little maintenance whenever required would then lead to satisfactory results. So we must always choose the right products, be disciplined with our investing and invest with a long term outlook.

Mean Reversion

This model finds its roots in the field of Statistics. It states that when anything deviates significantly from its average, it reverts to the average over time. This couldn't be more true when applied to investing. Market performance follows a cyclical pattern. Instances of excessive positivity or negativity in the markets keep arising. The duration of such excesses cannot be predicted. But they will eventually end. Markets will surely revert to the mean. So our behaviour should neither be rigidly cautious nor reckless. It must remain prudent and well calibrated regardless of what the markets are doing.

Occham's Razor

This model states that complexity in decision making causes decision fatigue. This model therefore states that the best solution to a problem is the simplest one.

Applied to investing, it means that we must only choose simple products that we fully understand for our portfolios. The best example for such a product is the humble index fund. They can easily be understood based simply on common sense and intuition. Understanding them does not require the use of complex tools and techniques. Investors would therefore benefit from using index funds for their portfolios.

The Lindy Effect

The Lindy Effect states that anything which has survived over long periods is much less likely to be replaced by something new. This is because its ability to survive shows that it has the capability to overcome challenges in the future as well.

The best example of this is that of regular money versus cryptocurrencies. Over the past few years cryptocurrencies have been touted as a replacement for paper currencies. But paper currencies have seen a number of disruptive events over the years and lived to tell the tale. So they are less likely to become completely irrelevant. Cryptocurrencies or at least a virtual currency could be the way of the future. But there isn't enough fundamental evidence to suggest that its moment is now. And certainly not in its current avatar. It needs a lot more evolution and refinement before we can start taking it seriously. And only time will tell if such evolution would happen. So we would be better off not believing the hype surrounding cryptocurrencies for now.

The Law Of Small Numbers

The law states that outcomes should not be generalised based on a limited number of desired outcomes. For example, smokers may generally justify their actions by saying that they know few people who smoke, but still live a healthy life. But there are such exceptional cases in all walks of life. And assuming that smoking isn't harmful based on such exceptional cases is dangerous. The best investing parallel for this is the comparison between index funds and actively managed mutual funds. A small number of actively managed funds may beat the index after costs over any given period. But these are exceptional cases. Index funds beating actively managed funds after costs is the norm. So we would be better off not investing in actively managed mutual funds based on few exceptional outcomes. 

Closing Thoughts

There are several other models but these are the most important ones regarding investing and finance. There is no single mental model that can be used universally across any and every situation. The choice of model depends on the situation and the kind of decision required. Sometimes, multiple models would be required to come to a decision. It is up to the decision maker to assess the requirements and choose a suitable model. But basing our decisions on these models and their principles would lead to more rational decisions and improve our investment behaviour. This would give us an edge to our investing which would see us stand out from the crowd.