Throughout the last years, working in financial markets, I sometimes struggled with the amount of information raining down on me. Due to the constant news flow and wave of quotes, making sense of markets and execute your strategy can be difficult.
Searching for ways to be more focused and consistent, I discovered the concept of mental models. Through their application, I’m able to process information more efficiently and see through the fog of war. In essence, Mental models describe general thinking principles of how the world around us is working. They are used in almost any domain, be it economics, physics, or biology. Mental models are deeply rooted in the evolutionary tendency of our brains to generalize from information. They help us make sense of the world and guide us to make better and more consistent decisions. They reduce complexity which in return frees up brain capacity.
Due to my curiosity regarding a wide range of different subjects, I intend to acquire as many mental models as possible. Ideally, one can combine the various models from different disciplines (e.g. physics, biology, and economics) and weave a multidimensional network of principles. The more mental models you acquire, the more you can make sense of the things going on around you. This effect also can be seen in the collaboration of multidisciplinary teams. People with different backgrounds bring different mental models to the table which can increase overall decision-making quality.
One vivid example of the value of combining different mental models is the application of evolutionary theory to financial markets. There is a variety of different market participants using different investment strategies. In the course of time, profitable investors survive while unsuccessful ones lose their capital and get extinct. Markets behave with respect to the current ecosystem of participants and investment strategies.
A recent resemblance of this phenomenon is the investment strategy of volatility selling which was used heavily in equities over the past few years. Market participants would generate a steady income stream by selling options or combinations thereof and only would lose money if a significant rise in volatility would occur. The extensive utilization of this strategy led to a low volatility market environment, which in turn was perceived as confirmation of success. In February of 2018 short vol strategies were put to a test, when volatility markets blew up, a number of market participants were wiped out, and markets switched to an overall more volatile regimen. After trending down again for more than two years, COVID-19 send volatility skyrocketing and bankrupted even more investors employing short vol strategies, changing the market ecosystem permanently.
Following this short example of how you can apply and combine mental models, I will share some models which I assess as the most valuable. This list can be extended by any number of examples. Please refer to the links provided at the end of the article for additional resources.
The mental model of “first principles thinking” describes how one deconstructs problems into their basic components. These components are then used to build up a solution for the problem at hand. First-principles thinking is contrary to thinking by analogy, which is used most in our society. By reasoning from first principles, one can come up with far more innovative solutions to a problem because established paradigms are ignored. A brilliant example of first principles thinking is given by Elon Musk in this short interview.
One of the most important first principles of finance is “there is no free lunch”. To earn a return on your investment you have to assume some kind of risk. When analyzing an investment ask yourself: What are the risks regarding this investment? Am I compensated well for assuming the risks, especially with respect to opportunity costs?
When there is no intelligent answer to this kind of question, the odds are high that you won’t earn the expected return, or even worse, the investment will blow up in your face.
In my opinion, this is one of the most important mental models, if you aspire to improve your decision-making process. When applying probabilistic thinking, one tries to assign reasonable probabilities to a set of future outcomes corresponding to all possible sets of actions. To deduct reliable probabilities you have to consider the base rates of the respective problem at hand. For example ask yourself: How did similar situations, regarding the conditions and opportunity set, play out in the past? Based on this, what is the most likely outcome going forward? Base your assessment only on facts and separate them from underlying narratives!
It is extremely hard if not impossible to assign fixed probabilities to specific outcomes. Therefore I try to tilt the odds in my favor. When someone asks me if stocks or interest rates will move higher or lower in the future, I will answer “I don’t know! But based on the opportunity set at hand and historical base rates I assume x is more likely than y and therefore I’ll position my portfolio according to it”
If you are keen to learn more about probabilistic thinking, you will be delighted to watch the conversation with poker champion Annie Duke on making smart bets.
The laws of thermodynamics provide numerous possibilities of connection to business and financial markets. The most practical one is the first law of thermodynamics which in its essence states, that the energy of an isolated system is constant and can neither be destroyed nor created.
This can be wonderfully transferred to investing, as Corey Hoffstein of Newfound Research put it ” Risk can not be destroyed only transformed”! For example, when you try to avoid a particular risk ( by hedging it) you introduce a new one (losing capital due to paying an option premium). This metaphor is particularly useful when evaluating risk/return tradeoffs. What kind of risk am I taking or avoiding at what cost? What am I losing or gaining in return?
You will gain more insights into the transformation of risk by listening to the conversation between Meb Faber and Corey Hoffstein.
Anyone in the financial community is familiar with the concept of leverage, nevertheless, I’d like to add this mental model to my list. A lever can be thought of as a device that increases the force applied to an object. To put it in more general terms, a point of high leverage can be found, when small actions can make a huge difference in outcomes. One should focus on the problems where the inputs lead to the greatest results.
With respect to financial markets, leverage can increase good outcomes but reduces room for error when things go bad. It can make or break one’s existence and should be applied with caution. Leverage can be used explicitly via debt or implicitly via investment structure or derivatives. When evaluating investment strategies, it is crucial to understand the sources and uses of leverage.
Warren Buffett brilliantly describes the effects of leverage in this interview.
The mental model of regression to the mean can be found in nearly every aspect of our daily lives and its importance can not be overstated. In brief, the concept describes the occurrence of extreme outcomes which are followed by less extreme ones. For the effect to materialize, there need to be imperfect correlations between two objects which causes the true value of observations to oscillate around the mean. The higher the skew in the distribution of observations, the more pronounced is the regression to the mean after certain observations.
This concept is especially useful when analyzing market behavior or assessing the drivers of the success of investment strategies. Often we tend to assign outcomes to dedicated events when actually regression to the mean is at work. Take for example the evaluation of an asset manager’s performance during a due diligence process. Focusing to much on past performance, instead of the investment process, leaves you wide open for bad surprises, when returns regress towards their long-term expected values. The period of regression can be so long that it is hard to identify cause and effect relationships. Therefore you have to ask yourself: “Is the current observation caused by a comprehensible action or is it due to regression to the long-term mean?”
Watch this short explanation of the effect of regression to the mean in investing!
Mental models can be a usefull tool to aid your decision-making process, reduce complexity, and help you think more clearly. The broader the repertoire of models you acquire, the higher the number of opportunities you can create by connecting them. When using these models, it is critical to constantly question the underlying assumptions and examine whether they are applicable in the specific case.
They always only can be seen as guiding posts! It is not the intention to blindly adhere to them.