The Motley Fool

6 Mental Models Investors Should Adopt

This article carries on from Part 1 where I looked more closely at Charlie Munger’s latticework of mental models, and teased out 9 mental models in all which investors should adopt to make better sense of the world and also make better decisions. Let’s jump straight into the next three.

Mental model 4: Occam’s Razor

This was named after Friar William from Ockham, and is a type of heuristic (i.e. general rule of guidance or observation) which states that the simpler explanation is usually the correct one. This is not a rule which is cast in stone (as sometimes things really are complex by nature), but is a way to think about things which simplify them and eliminates unnecessary complexity.

In the realm of investing, this means that investors should rely on a simpler explanation at times instead of trying to come up with grandiose theories as to why something had occurred.

Mental model 5: Hanlon’s Razor

Hanlon’s Razor states that we should not attribute an event or condition to malice if it is more easily explained by stupidity. In simpler terms, this means that we should avoid complex theories which could make us paranoid or neurotic, as we live in a world which is affected by all sorts of random, unexplained events.

For investing, it simply means bad results may not always stem from someone trying to sabotage you (i.e. neurosis), but in fact may result simply from mistakes made in relation to the investor’s logic and analysis.

Mental model 6: Second-Order Thinking

Second-order thinking is a concept whereby in complex systems, there is often a second layer of effects which may dwarf the first layer, but which goes unnoticed as people only tend to notice the first (initial) layer of effects. In a nutshell, effects can send out ripples which cause other effects, and these further effects may have ramifications or consequences for the initial effects.

In investing, the clearest example of this is when people feel optimistic towards a company, they would pile in capital to finance its growth. The company then does well deploying the capital, which results in better earnings and even more optimism, in a kind of feedback loop. Understanding this is important for the investor to be able to grasp how complex systems work and how events may interact with one another.

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