A Crash Course in Building Your Latticework of Mental Models

Note: This is a review of Robert Hagstrom’s book Latticework – The New Investing [1]. This review first appeared in February 2015 issue of our premium newsletter, Value Investing Almanack.

As a school kid, when I was taught to solve a mathematical problem in a certain way, nobody encouraged me further to attempt the same problem in another way. You know why? Because in our traditional education system we have been trained to think in a limited way.

Charlie Munger, the inimitable vice chairman of Berkshire Hathaway, calls this a-man-with-a-hammer syndrome – To a man with hammer, every problem looks like a nail. So how do you overcome this handicap? The answer lies in developing a sound thinking process and that’s where multidisciplinary learning comes into picture.

Hagstrom’s book, unlike most other investment books, is about Munger’s way of learning – multidisciplinary education. So I won’t advise you to read this book if all you are looking for is magic formulas or readymade rules of sound investing.

This is a powerful book arguing for the importance of a multidisciplinary approach to investing. So if you are one amongst the many investors who have been searching out companies to invest in for a number of years and all you have learned is to plug basic financial information into excel models, this book will give you some new mental tools to assist your analysis.

The term latticework is attributed to Charlie Munger. He views a latticework of mental models [2] as an interlocking structure of ideas that is clearly multidisciplinary in nature. Drawing from this transdisciplinary focus, Hagstrom takes us through some key principles or laws from a number of disciplines such as psychology, physics, biology, and philosophy, among others. He then applies these theories to investing and the stock market.

Hagstrom argues that a successful stock picker must be ready to shift models and look at the markets from different vantage points with the passage of time. Instead of working like an analyst – using just factual information to plug into excel models – investors need to regard the insights or models from other disciplines too.

The task of the investor, Hagstrom explains, is to be well-read and always be on lookout for new perspective of understanding the world around us.

Anyways, before talking about this book, let me share with you a quote from Charlie Munger –

You must know the big ideas in the big disciplines, and use them routinely…if the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience – both vicarious and direct – on this latticework of models.

But the sheer amount of knowledge available in different subject areas is scary. Where do you start? Well, you could start with Latticework.

If you want to know the history of development of some of the challenging ideas from different disciplines and their applicability to the field of investing, then Latticework is the book you should read next.

What is Latticework?

The word Latticework is a metaphor to describe an interlocking structure of big ideas (Mental Models) from different disciplines.

And the first step to effective learning is to develop the habit of discovering the connections that exist between different bodies of knowledge –

“… inventors were led to a discovery by first observing the similarities that existed between a previous invention (source) and that which the inventor wished to build (target)”

For example, the idea of carburettor in automobiles came from perfume sprayer. The electric pistol initially created to test the purity of air eventually became the spark plug for automobile engines. Similarly automobile gears are direct descendants of water wheel.

But before you can start thinking about connections between different disciplines, you need to learn the important ideas from these disciplines.

The book outlines few important concepts from the fields of Physics, Biology, Social Science, Psychology, Philosophy and Literature. Let’s delve into these ideas one by one.

Big Ideas from Physics

The first great insight from this book is about the myth that most of the big ideas originate like a flash in a human mind. On the contrary these ideas build with one thought at a time involving multiple people.

For example, some of the important discoveries made by Isaac Newton in the field of Physics were inspired by prior ideas developed by Kepler, Galileo and Descartes. Newton himself says – “If I have seen further it is by standing on the shoulders of giants”

The second important big idea from physics that you should know is – Equilibrium.

… equilibrium is not only the backbone for classical economics but it also serves as the foundation for modern portfolio theory.

A weighing scale with equal weights on both sides is at static equilibrium but earth circling around sun is in state of dynamic equilibrium. The theory of “supply and demand” in economics draws its inspiration from the concept of equilibrium.

When the stock prices rise beyond what the business fundamentals can support (because of extreme greed), a dis-equilibrium sets in the market. A temporary market correction may bring back the balance or a crash can send the market to other extreme (bear markets).

But Physics alone cannot explain everything. Let’s jump boundaries and turn to the subject of Biology for another perspective.

Biology of Capital Markets

One of the big idea to learn from biology is the “Theory of Evolution” or “Natural Selection”, which was first proposed by Charles Darwin. According to this theory, the species which is most adaptive to environmental change, survives.

“The common trait found in financial systems, just as in biological systems, is evolution – adaptation.”

Both biological ecosystems and capital markets behave as complex adaptive systems. Any small change can produce large (non-linear) results and vice versa.

“Complex systems must be studied as a whole, not in individual parts, because the behaviour of the system is greater than the sum of the parts.”

However, the biological interpretation of economy and stock markets still has several missing pieces.

“…innovation in financial markets is rapid, compared to the slow random-variation process in biological systems.”

So lets explore other disciplines and see if we can find some insights there.

Big Ideas from Social Sciences

Some may agree that one of the most uninteresting subject during school education was social studies, and ironically it was relatively easy to get good grades in it. But it’s also the origin of many mental models which are immensely relevant in stock market investing.

Social science is the study of how people behave in a society. What better place to apply this study, than stock market. Markets being a group of people need to be understood using concepts from social science. One such idea is the theory of “Self-organization” –

“The concept of self-organization can be explained with an example of a growing city in which the population tends to segregate itself based on people’s ethnicity, language, race, culture etc.”

Markets and economies also display this behaviour [3] –

“…equity and debt markets have no central controller, and both are excellent examples of self-organizing, self-reinforcing systems.”

Another idea from this discipline is the “Theory of Emergence”. Robert has explained this beautifully with the example of ant colonies.

If you think about it, Benjamin Graham’s mental model of Mr. Market is nothing but the personification of collective behaviour of all the participants in market (or society).

Psychology is powerful

How important is knowledge of psychology in stock market investing? Well, without a basic understanding of human behavioural biases, according to Charlie Munger, you are like a one-legged man in an ass kicking contest.

Because of evolutionary changes human mind is wired in such a way that it’s prone to certain irrational behaviour in a predictable manner. These are also known as behavioural biases, such as mental accounting, loss aversion, overconfidence bias etc.

“Benjamin Graham recognized the link between investing and psychology when he first pointed out the difference between investing and speculating using the metaphor of Mr. Market. Individuals when associate with a crowd, their behaviour can get affected by crowd psychology.”

The discussion on “noise vs signal” and why people fall for forecasting is something which you shouldn’t miss in this section of the book.

Philosophy is a thinking tool

This is one subject where you won’t find any pre-packaged theoretical concepts or absolute answers. The purpose of Philosophy is to learn “how to think”.

There are various branches of Philosophy and all of them teach you how to question the conventional wisdom. In “Metaphysics” you learn to think about abstract ideas like God and afterlife. “Ethics” deals with the question of morality. Politics is the investigation of the idea of right and wrong at the societal level.

Another big idea from philosophy is of Pragmatism which states that truth changes with circumstance and as new discoveries are made.

In investing, when your initial assumptions are proven wrong, it’s important that you accept your mistake and take the loss instead of denying the new reality. The famous British economist John Maynard Keynes said – “When the facts change, I change my mind. What do you do, sir?”

Literature : Read for thought

How many times you find a book that you have read before but can’t even write a four line review for the book? The culprit is our shallow reading habit. When we read a book we allow the book contents to flow over us like a warm water bath.

The big idea from literature is that you become a better thinker by learning to read critically and thoughtfully. What is critical reading?

Don’t just read a book passively. Own the book. Use a marker to highlight the text which you liked, use a pencil to write down your own thoughts on the page margins. Question the author, try to refute his arguments, act as if you are debating with him face to face.

One of my favourite author Nassim Taleb says –

“Any book worth reading, is worth reading twice.”

Conclusion

As you would have realized by now that “Latticework” isn’t a book on “how to pick stocks or manage your portfolio”. However, it gives you a new way to think about investing.

In the end I want to leave you with this thought – Purpose of reading is to assist you in independent thinking and no amount of reading can be a substitute for your own thoughtful reflection. So read some, think some and then think some more.

And when you go back to what you had read, I can guarantee that you will find some refreshing insights.

Please note that this book was later republished with a new title – Investing: The Last Liberal Art [4]