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Investor Mental Models

What are Mental Models?

Mental models are key ideas from each discipline (e.g. Mathematics, Physics, Accounting etc). It’s a framework or worldview you have in your mind to help you understand how the world works.

Traditionally in school, we study subjects in isolation. Information about each subject is compartmentalised into distinct folders in our brain – Math, Science, Arts etc. Often there is a lack of synthesis between subjects.

However, this learning style does not mirror the complexity of the real world. Our outcomes are shaped by forces from various fields, coming at different magnitudes.

By integrating information from various disciplines, we can see the many forces at play. This allows us to problem-solve effectively. Charlie Munger calls the interaction a Latticework of Mental Models”.

Why are Mental Models important?

The stock market is more than just numbers and equations. Fundamentally, the market is driven by human beings, who are subjected to an entire range of emotions. Thus, to take a purely quantitative approach and ignoring human nature would not allow us to succeed as investors.

Building up your repertoire of mental models helps you think critically. When making decisions in investing and life, avoid human biases and common psychological pitfalls.

As Charlie Munger said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Here is a non-exhaustive list of mental models I have compiled:

Collection of Mental Models

Investing: Circle of Competence, Margin of Safety, Time value of money

Accounting: Basic Accounting Equation, Free Cash Flow, Depreciation, Maintenance CAPEX, Growth CAPEX

Mathematics: Compound Interest, Decision Trees, Law of Large Numbers, Probability theory

Microeconomics: Asymmetric Information, Comparative advantage, Creative Disruption, Diminishing ultility, Supply and Demand

Physics: Activation Energy, Friction, Relativity, Inversion, Leverage

Psychology: Availability Bias, Anchoring, Confirmation Bias, Dunning-Kruger, Mere exposure effect, Survivorship Bias

Do note that memorising these mental models alone is not enough. To become a truly great thinker, you will have to connect them together into a latticework and see how they interact with one another.

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