Mental Models

The Most Powerful Mental Model for Identifying Stocks

“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” ~ W. Somerset Maugham – English dramatist & novelist (1874-1965)

As I’ve seen in the past 20+ years of investing in the stock market, Maugham’s thought holds a great relevance when it comes to picking up businesses for investment.

Pick up a business with good economics and with good margin of safety, and the probability of making money in the long run is high. Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high.

Understanding a business also adds significantly to your margin of safety, which is a great tool to protect yourself against losing a lot of money.

[Read more…]

Latticework of Mental Models: The Rashomon Effect

The parable of six blind men and an elephant, goes like this —

When a group of blind men, who had never come across an elephant before, encounter the tusker for the first time, they try to conceptualize the animal by touching it. Each blind man feels a different part of the elephant’s body, but only one body part, such as the tail or the trunk. Then they discuss their understanding about the elephant.

The man who had touched the elephant’s side says, “It’s very much like a wall.”

The one who held the elephant’s tusk declares, “No! it’s like a smooth spear.”

“Not really. It’s like a python.” Claims the man who grabbed the trunk.

“You’re all mistaken.” shouts the man who got the elephant’s tail. “It’s like a thick rope.”

“I know we’re all blind but have you guys lost your mind also?” The fifth man who touched the animal’s ears says, “It’s like a big fan.”

“Come on, folks! What’s wrong with all of you?” Argues the sixth man who was leaning against the elephant’s knee, “It’s definitely like a tree.” [Read more…] about Latticework of Mental Models: The Rashomon Effect

Latticework of Mental Models: Lollapalooza Effect

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Why were Warren Buffett and his creation, Berkshire Hathaway, so unusually successful?

In 2007 Wesco Annual Meeting, someone asked the above question from Charlie Munger. He replied –

If that success in investment isn’t the best in the history of the investment world, it’s certainly in the top five. It’s a lollapalooza.

Lollapalooza in the conventional sense means something outstanding of its kind. A person, a thing or an event that is particularly impressive, or extraordinarily attractive. But being multidisciplinary learners, we shouldn’t be satisfied with the conventional definitions, should we? Moreover, Charlie Munger doesn’t use lollapalooza just for its dictionary meaning.

Here’s the definition of Lollapalooza taken from the book Poor Charlie’s Almanack –

Lollapalooza is, as personified by Charles Munger, the critical mass obtained via a combination of concentration, curiosity, perseverance, and self-criticism, applied through a prism of multidisciplinary mental models.

When Charlie Munger uses the word lollapalooza, he often attaches the word “effects” (as in “lollapalooza effects”) which means that multiple factors are acting together in ways that are feeding back on each other. [Read more…] about Latticework of Mental Models: Lollapalooza Effect

The Paradox of Knowledge

Tourist: This is a dangerously steep road with a sharp bend. Why isn’t there a hazard sign for motorists to slow down?

Guide: We had a warning sign untill yesterday. But since accidents were rare, officials concluded that the spot isn’t that dangerous after all. So they removed the sign.

Tourist: Don’t you think the rarity of the accidents was precisely because of the warning sign?

Guide: Ugh..

Amused at the stupidity of the officials? That’s because it’s easy to spot the cause and effect relationship between ‘presence of warning sign’ and ‘frequency of accidents.’ You can test the hypothesis. Remove the warning sign and if too many cars start plunging down the valley, there we have it – a clear correlation between an action and its consequences.

Latticework of Mental Models: Benford’s Law

On 25 November 2003, Kevin Lawrence was sentenced to 20 years in prison for pulling off possibly the biggest financial fraud in Washington State’s history. Here’s the backstory.

Kevin Lawrence graduated from high school in 1984. After a brief stint with a brokerage firm Lawrence bought a bowling alley and converted it into a fitness gym. He equipped the gym with modern exercise equipment, computers and hired chiropractors, masseuses and a nutritionist for the facility. But that was just the beginning of his entrepreneurship dreams. Soon he started working on an ambitious business plan to create a chain of high tech health clubs. He pitched the idea to a lot of investors.

Lawrence claimed that his startup would be an industry innovator that integrated fitness and health care into one business model, i.e., consumers could do fitness workouts and obtain health care within the same facility. His proposition also included offerings for design, manufacturing, and marketing of fitness equipments. Plus, he planned to build software to analyze the club member’s physical performance.

Lawrence must have been a good storyteller for he was able to convince more than two thousand investors and raise close to $100 million.

Latticework of Mental Models: Thinking From First Principles

First principles thinking is one of the most effective mental tools for solving problems, especially the hard ones. And no one embodies this philosophy of first principles thinking better than Elon Musk, founder of PayPal, SpaceX, Tesla Motors and SolarCity.

Musk, in one of his interviews, said –

It’s most important to reason from first principles rather than by analogy. The normal way we conduct our lives is we reason by analogy. We’re doing this because it’s like something else which was done or it’s like other people are doing. It’s mentally easy to reason by analogy rather than by first principles. First principles is the Physics-way of looking at the world. What that really means is that you boil things down to the most fundamental truths and then reason up from there. That takes a lot more mental energy.

For example, somebody could say that battery packs are really expensive and that’s just the way they’ll always be because that’s the way they’ve always been in the past. No! That’s pretty dumb. If you apply that reasoning (analogy) to anything new then you won’t be able to get to that new thing.

For batteries people say, historically it has cost $600 per kilowatt hour and it’s not going to be much better than that in the future. First principles thinking would say, what is the market price of the basic constituents of the battery? It’s got Carbon, Nickel, Aluminium, and some polymers for separation. So breakdown on the material basis and ask, “If we bought that in London metal exchange, what each of those things cost?” Oh! It’s like $80 per kilowatt hour. Clearly, you need clever ways to take those material and combine them into the shape of a battery cell and you can have batteries much much cheaper than anyone realized.

Latticework of Mental Models: Hot Hand Fallacy

One of the most embarrassing moments of my childhood was the day when my class teacher asked me something about Sachin Tendulkar. I replied, “Who is Sachin Tendulkar?”

I was in 6th standard. The entire class, including the teacher, burst into laughter. That was the day when I started taking an active interest in cricket. Of course, the motivation was to avoid looking like a fool in a cricket crazy nation.

“Dravid is not in form these days.” Claimed one of my friends.

“I hope he comes back in form soon else they will drop him from the national team.” Argued other friend.

I nodded in agreement. I was faking because one thing that still baffled me was the idea of a player being “in-form” or “out-of-form.”

“What’s this in-form and out-of-form business?” I asked my best friend. Typically, looking-like-a-fool fear goes away when you’re with your best buddies, right? He was the only one who I didn’t feel the need to impress with my cricket knowledge.

Well, if a player plays consistently well for many innings, we say he is in good form. Otherwise, he is considered out of form, he explained, “An in-form player is always in demand because he’s expected to continue playing well.”

Why does an in-form player play well? If it’s the past performance that determines the present form then how does it ensure the future performance? Isn’t this form business based on circular logic?

Latticework of Mental Models: Domain Dependence

Imagine this. You are escorted into a room. On one corner there’s a table with three items on it: a box of board-pins, a matchbox, and a candle. Your task is to attach the candle to the wall, so the wax doesn’t drip onto the table.

A psychologist named Karl Duncker first designed this experiment in 1945.

About seventy-five percent of the participants who take part in this experiment try following solutions.

First, they try to pin the candle onto the wall. It doesn’t work. Then they try to light the candle and use the dripping wax to attach it to the wall, but that’s usually not strong enough to hold the candle. So that doesn’t work either.

What about you? How would you solve this? Take a moment and think about it.

Very few people see the solution at once. Some people find it after only a minute or two of thought. Others see it after stumbling through several unsuccessful attempts. Most fail to solve it without some outside help.

Latticework of Mental Models: Manufactured Memories

Yesterday when I logged into my Facebook account, it showed a picture I had posted six years back. In the frame, I was having lunch with an old school friend.

It brought a smile on my face.

Interestingly, I had completely forgotten about the lunch. I just couldn’t remember being present when that picture was taken. My brain had conveniently erased that incident from memory.

I am sure it happens to others too. Also, Facebook knows it, so they introduced this feature. Bringing back those lost memories creates a pleasant experience which isn’t much different from the one when you find money in your old pant pockets.

How would it be if we never forgot anything? Why does our brain choose to remember something and spaces out on others? Is there an evolutionary reason behind this behavioural quirk? Let’s explore these questions today.

Latticework of Mental Models: Fundamental Attribution Error

The first impression is the last impression. I am sure you’ve heard this advice numerous times especially from the communication skill experts. But the more I studied psychology, stronger became my belief that there’s quite a bit of truth in this saying. However, if you’re into the business of working with people, it’s the first impression you shouldn’t trust.

Had I gone with my first impressions about some of the strangers I met in my life, I wouldn’t have found my best friends. If you look back in your life and trace the history of your relationships with your best buddies, you would tend to agree with me on this. In fact, go ahead and ask your old friends about how they thought of you (in the first meeting) as a prospective candidate for a long-term friendship.

Whenever we meet someone for the first time, we have a natural tendency to attribute his behaviour to his personality. If that stranger’s behaviour is cold and unresponsive, we jump to the conclusion that he is either shy or introvert or perhaps arrogant. Whereas an individual who seems warm and lively makes you believe that the guy is an extrovert.

Sometimes you may be right, but often you are falling for what is known as the Fundamental Attribution Error. This error is the result of people’s tendency to place an overemphasis on internal characteristics (personality) to explain someone else’s behaviour in a given situation rather than considering the external factors guiding that situation.