The Motley Fool

3 Mental Models Investors Should Adopt

Charlie Munger is Warren Buffett’s right-hand man, and though he may not be as well known as the Oracle of Omaha, he is a superb investor in his own right. In fact, Munger was the man who influenced Buffett to depart from strict “old-school” value investing principles espoused by Benjamin Graham (Buffett’s mentor), and to gravitate his style towards buying quality companies at a fair price.

Munger strongly believes that investors should be equipped with what he calls a “latticework of mental models” from different disciplines in order to obtain a holistic view of businesses. I shall be touching on a total of nine mental models which I think investors should adopt in a series of articles. I will cover three models in this article, and the remaining six in subsequent articles.

Mental model 1: Inversion

Inversion is actually a problem-solving technique and involves considering what we would want to avoid, rather than what we would like to obtain.

When applied to investing, inversion means actively avoiding stupidity rather than trying to seek brilliance. Munger likes to say “Invert, always invert” when he is faced with any problem. Inverting helps us as investors to understand a problem better, and also exposes us to potential mistakes in our logic we may have neglected to account for. It helps us avoid mistakes, and hence minimise losses. Recall that we need a good margin of safety when investing, therefore inversion can be a powerful mental model to make use of.

Mental model 2: Confirmation bias

Human beings have a natural tendency to look for evidence which conforms to our belief systems. This is known as confirmation bias and it can be a very powerful force which prevents people from seeking alternative or differing opinions.

In investing, confirmation bias can lead us into trouble if we consistently ignore evidence which suggest that our investment thesis is flawed. The way to defeat this bias is to actively seek out opposing views or opinions, even though these may be jarring for our minds.

Mental model 3: Circle of competence

The circle of competence is a concept first mentioned by both Buffett and Munger. It relates to sticking to what we know well from an investing standpoint, and not straying from that.

For example, we may have intimate knowledge on consumer and pharmaceutical businesses because of our previous work experience. So, we would be able to use our knowledge to invest successfully in these sectors. But, we should avoid a sector we know nothing about, say, semiconductors. Though reading and research can help to expand our circle of competence, it normally takes months, if not years, for an expansion of our knowledge-circle to happen.

There are more mental models on the way, so stay tuned! [Editor’s note: The second article in the series has been published and it can be found here.]

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.