Mental Models and The Stock Market


The lesser known one is the risk of ruin and the effort it takes to get back to even with a huge loss.

A mental model is a way of explaining how something works. It’s a concept, framework, or view that one has in solving problems or looking at the world. Applying mental models to investing was popularized by Charlie Munger. He suggests a latticework of about 100 mental models that he uses in investing.

If you’ve wondered why as a student of engineering or accounting you were required to study a subject on psychology, today you might find out why.You might even put it to good use. I’ll share some mental models relevant in investing.

Let’s start with mathematics. This one should be obvious. One has to be able to know the basics of arithmetic before investing. Within mathematics, there is of course compound interest. For most of us it tells us how much we can grow your money at a specific rate over a specific time.

The lesser known one is the risk of ruin and the effort it takes to get back to even with a huge loss. Say you invested P100,000 and you lost 50 percent. It puts your new capital to P50,000. Making 50 percent won’t make it back to P100,000. You’ll need 100 percent return just to get back to even. That’s why in trading or investing, rule number one is never lose money, or at least try not to lose too much when you’re wrong so it won’t be hard to bounce back. In short, principal protection is of utmost importance for long term success.

Another branch of mental model arising from mathematics is thinking in terms of probability. (You can finally use what you learned in statistics including combinations and permutations. Let’s just hope you still remember it.) Munger tells the story of horse betting and the parimutuel betting system. This system is used in horse racing where all bets are pooled together, taxes and house-take are deducted and pay off odds change depending on the bets. This is similar to the stock market when due to insistent speculator demand a hot stock goes higher or when due to fear a stock gets oversold. So payoffs constantly change. We know how to bet on the more likely winner but we should also look at the odds. Let’s say in a race the bad horse has only a 10 percent chance of winning. The good horse has a 50 percent chance of winning. But the odds is that the bad horse pays 100 to 1, while the good horse pays 3 for 2. Taking the odds into consideration, the bad horse is actually a better bet.

A decision tree could be helpful in making a good choice. By writing down the possible scenarios and placing the probabilities of each scenario, we also get to prepare for the worst. The main takeaway of this example is that you invest only when the odds are in your favor. This would mean not buying and selling every stock that moves. But making more infrequent but well thought of trades.

If it’s so simple, why aren’t more people making more money in the market? Because it’s not easy. According to Daniel Kahneman, our brain uses two different ways of forming thoughts. System 1 is fast, automatic and emotional. System 2 is slow, effortful, infrequent and logical. Given a situation, our biological psychological make up would naturally choose System 1. System 1 helps us avoid life threatening situations quickly and is relevant for our survival but is not very useful in the modern world of investing. Information and data are more available and convenient today more than ever before. But the behavior of investors have not changed much. We still like to buy what’s in and hot and follow the herd. To be successful, we have to be able to separate emotional fear and greed into our investing decision and being aware of is the first step.

In psychology there’s this experiment by Pavlov where a bell is always rung before feeding a dog. When done often, the mere bell ringing caused the dog to salivate. The dog learned to associate the bell ringing with food even though there’s really no connection. One way Pavlovian conditioning may be observed is when the stock index tanks and investors think there’s a problem with the economy. So, they also start selling all the other stocks. After losing an investment, you might think of having a nice massage to relieve your stress. Well, your mind might associate losing with a nice massage. So, maybe you should think twice before getting it.

The above are just some of the few mental models we can use to hopefully become better and wiser in tackling the markets. May the odds be ever in your favor.

Josefino Gomez is a Registered Financial Planner of RFP Philippines. He is also a certified public accountant, a certified real estate broker and a certified treasury professional.


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