Latticework of Mental Models

You can learn how to make better informed investing decisions by studying various conceptions of the world from other disciplines, thinkers and investors, and through your own mistakes.

Mental models are representations of how something works in the real world. They help us simplify complexity, understand and reason about different phenomena, and make decisions based on our assumptions and expectations. Mental models can be based on scientific theories, personal experiences, common sense, or intuition. We use mental models to filter information, fill in gaps, and predict outcomes. Mental models are not always accurate or complete, and they can sometimes lead to errors or biases. Therefore, it is important to be aware of our own mental models, test them against reality, and learn from different perspectives and disciplines. Mental models can be applied to investing in various ways. They can help investors evaluate opportunities, avoid biases, understand risks, and improve performance.

Some examples of mental models are:

Supply and demand: A model that explains how the price of a good or service is determined by the interaction of buyers and sellers in a market.
Pareto principle: A model that states that 80% of the effects come from 20% of the causes. For example, 80% of your sales may come from 20% of your customers.
Confirmation bias: A model that describes the tendency to look for and interpret information that confirms our existing beliefs, while ignoring or rejecting evidence that contradicts them.
Growth mindset: A model that suggests that our abilities and intelligence can be improved through effort, feedback, and learning, rather than being fixed and innate
The map is not the territory: This model reminds us that our perception of reality is not the same as reality itself. We use maps (such as financial statements, valuation models, market trends, etc.) to guide our investment decisions, but we should not confuse them with the actual territory (the underlying business, the competitive landscape, the future potential, etc.). We should always be aware of the limitations and assumptions of our maps, and update them when new information becomes in.
Fooled by randomness: This model warns us that we tend to overestimate the role of skill and underestimate the role of luck in investing outcomes. We also tend to see patterns and causality where there is none, and create narratives to explain random events. We should be humble about our predictions, diversify our portfolio, and focus on the process rather than the results.
Circle of competence: This model advises us to invest only in what we understand well, and avoid areas where we have little or no knowledge or experience. By staying within our circle of competence, we can reduce our risk of making costly mistakes, and increase our chances of finding undervalued opportunities. We should also seek to expand our circle of competence by learning new skills and mental models. The subject area which matches a person’s skills or expertise. In effect, you’ve got to know what you don’t know. Stay within your circle of competence and focus on what you are good at.
Team, product, and market size: This model helps us assess the potential of early-stage investments by looking at three key factors: the quality and fit of the founding team, the value proposition and differentiation of the product, and the size and growth of the target market. A great team with a great product in a large and growing market is likely to succeed, while a mediocre team with a mediocre product in a small and stagnant market is likely to fail.
Margin of safety: This model suggests that investors should buy stocks at a significant discount to their intrinsic value, to account for uncertainty and error. This way, they can reduce their downside risk and increase their upside potential.
Compounding: The process whereby a small change or difference becomes significant over time as it accumulates or grows exponentially. Compounding helps you understand how small actions or decisions can have large consequences over time. Don’t underestimate the power of time or growth; appreciate the value of compounding.
Compound interest: This model explains how money grows exponentially over time when it earns interest on interest. Investors can benefit from compound interest by reinvesting their dividends, holding stocks for the long term, and finding companies that can grow their earnings consistently.
Moat: This model describes the competitive advantage that a company has over its rivals, which allows it to generate above-average profits and fend off competitors. A moat can be based on factors such as brand, cost, network, innovation, or regulation. Investors should look for companies with strong and durable moats that can sustain their market leadership and profitability.
Mr. Market: This model personifies the stock market as a moody and irrational investor who offers to buy or sell stocks at different prices every day. Sometimes, Mr. Market is optimistic and overvalues stocks, and sometimes he is pessimistic and undervalues them. Investors should not be influenced by Mr. Market’s emotions, but rather take advantage of his mispricing to buy low and sell high.
The Map is not the Territory: The map of reality is not reality (an abstraction derived from something is not the thing itself). Maps are imperfect representations of reality and can be incomplete, inaccurate, or biased. Don’t confuse the symbol with the substance.
False Causality: The tendency to assume that because one event follows another, the first event caused the second event. Correlation does not imply causation. Don’t jump to conclusions based on coincidences or patterns without evidence.
Falsifiability: The ability to prove a statement, hypothesis, or theory wrong with evidence or observation. Falsifiability is a key feature of scientific thinking. Don’t cling to beliefs that cannot be tested or disproved.
Razors: A set of principles or rules of thumb that help you cut through complexity and confusion by eliminating unlikely or unnecessary explanations. Examples of razors are Occam’s Razor (the simplest explanation is usually the correct one), Hanlon’s Razor (never attribute to malice that which can be adequately explained by stupidity), and Hickam’s Dictum (patients can have as many diseases as they damn well please).
First Principles Thinking: The act of breaking down a problem into its most basic and fundamental parts. First principles thinking helps you avoid assumptions and conventional wisdom and discover the essence of a problem. Don’t reason by analogy; reason from the ground up.
Second-Order Thinking: The act of considering not only the immediate consequences of an action, but also the subsequent effects. Second-order thinking helps you anticipate the long-term implications and unintended consequences of your decisions. Don’t think one step ahead; think two steps ahead.
Systems Thinking: The act of understanding how different parts of a system influence one another within a whole. Systems thinking helps you see the big picture and avoid siloed or narrow thinking. Don’t focus on individual components; focus on interactions and relationships.
Probabilistic Thinking: The act of estimating the likelihood of various outcomes based on available data and evidence. Probabilistic thinking helps you deal with uncertainty and make better judgments under conditions of risk. Don’t think in black and white; think in shades of gray.
Inversion: The act of reversing or flipping a situation to see it from a different perspective. Inversion helps you avoid errors and solve problems by exposing hidden assumptions and contradictions. Don’t think about what you want; think about what you want to avoid.
Disconfirming Evidence: The act of seeking information that contradicts your existing beliefs or hypotheses. Disconfirming evidence helps you overcome confirmation bias and update your views based on new facts. Don’t look for evidence that supports your opinions; look for evidence that challenges them.
Thought Experiment: The act of imagining a hypothetical scenario to test a proposition or idea. Thought experiments help you explore possibilities, question assumptions, and stimulate creativity. Don’t limit yourself to reality; use your imagination to expand your understanding.
Law of the Instrument: The tendency to over-rely on a familiar tool or method, regardless of its suitability for the problem at hand. Also known as Maslow’s Hammer: “if all you have is a hammer, everything looks like a nail.” Don’t let your tools constrain your thinking; use the right tool for the job.
Scientific Method: A systematic process for testing hypotheses and acquiring new knowledge through observation and experimentation. The scientific method consists of four steps: observation, hypothesis, experiment, and conclusion. Don’t rely on intuition or authority; use empirical evidence to validate your claims.
Laws of Thermodynamics: A set of physical laws that describe how energy and heat behave in natural systems. The laws of thermodynamics help you understand how energy flows, how entropy increases, and how systems tend towards equilibrium. Don’t ignore the constraints imposed by nature; respect the laws that govern the universe.
Laws of Motion: A set of physical laws that describe how objects move when subjected to forces. The laws of motion help you understand how inertia, acceleration, momentum, and gravity affect motion. Don’t overlook the forces that shape movement; appreciate the dynamics that govern change.
Emergence: The phenomenon whereby larger entities arise from smaller entities through interactions among them. Emergence helps you understand how complex systems and patterns can arise from simple rules and interactions. Don’t assume that complexity requires complicated design; recognize that simplicity can generate complexity.
Evolution / Natural Selection: The process whereby organisms better adapted to their environment tend to survive and produce more offspring. Evolution / natural selection helps you understand how adaptation, variation, and competition shape the diversity and survival of life. Don’t resist change or ignore feedback; embrace evolution and learn from your environment.
Equilibrium / Homeostasis: The state of balance or stability within a system or between systems. Equilibrium / homeostasis helps you understand how systems self-regulate and maintain their optimal conditions. Don’t disturb the balance or push the limits; respect the equilibrium and adjust accordingly.
Principle of Least Effort: The tendency to prefer the path of least resistance or the course of action that requires the least work. The principle of least effort helps you understand how humans and animals optimize their behavior and conserve their energy. Don’t work harder than necessary or waste your resources; seek efficiency and simplicity.
Leverage: The ability to influence a system or environment in a way that multiplies the outcome of one’s efforts. Leverage helps you achieve more with less by using various tools, techniques, or strategies. Don’t rely on brute force or linear thinking; use leverage to amplify your impact.
Multiplying by Zero: The phenomenon whereby one single factor can nullify the effect of many other factors in a system or equation. Multiplying by zero helps you identify the critical elements or risks that can ruin your plans or goals. Don’t ignore the weakest link or the biggest threat; avoid multiplying by zero.
Incentives: The motives or rewards that influence one’s behavior or actions. Incentives help you understand what drives human behavior and decision-making. Don’t assume that people act rationally or altruistically; consider the incentives that shape their choices.
Externalities: The costs or benefits that affect a third party who did not choose to incur them. Externalities help you understand the unintended consequences of economic activities and social interactions. Don’t overlook the impact of your actions on others or the environment; account for the externalities.
Game Theory: The study of strategic interactions among rational agents who have conflicting or cooperative interests. Game theory helps you understand how people and organizations make decisions in situations where their outcomes depend on the actions of others. Don’t assume that everyone has the same goals or preferences; anticipate the possible moves and responses of other players.
Entropy: The measure of disorder or randomness in a system. Entropy helps you understand how systems tend to move from order to disorder over time, and how energy becomes less useful as it is dispersed or dissipated. Don’t expect things to stay the same or improve by themselves; recognize that entropy increases unless work is done to reverse it.
Activation Energy: The minimum amount of energy required to initiate a chemical reaction or a change of state. Activation energy helps you understand how catalysts can lower the energy barrier and speed up reactions, and how temperature can affect the rate of reactions. Don’t assume that reactions happen spontaneously or uniformly; consider the energy needed to overcome the initial resistance.
Critical Mass: The minimum amount of material or number of participants needed to start and sustain a chain reaction or a collective action. Critical mass helps you understand how nuclear fission, social movements, viral phenomena, and tipping points work. Don’t underestimate the power of small changes or contributions; recognize that critical mass can trigger exponential growth or change.
Network Effects: The phenomenon whereby the value or utility of a product or service increases as more people use it. Network effects help you understand how platforms, markets, and social networks create positive feedback loops that benefit their users and providers. Don’t ignore the impact of your network or connections; leverage the network effects to increase your value or utility.