Let’s start by understanding, what are mental models?

A mental model is a simple way of explaining how something works. Like a framework or a map to reach somewhere (a Goal).

Basically, Mental models are the thinking tools that help us to simplify complex problems into understandable chunks.

There is no single perfect mental model, they all have some flaws, like anything else in this world, but still, many of the mental models have allowed us to perform some incredible tasks, in the field of biology, chemistry, physics, economics, and Psychology.

And there are hundreds of mental models, but only a few dozens carry most of the freight.

I got to know about mental models after reading the book, Poor Charlie’s Almanac in which Charlie Munger, the vice-chairman of the world’s greatest compounding machine - Berkshire Hathaway, explains some of the most important mental models which he used to reach where he is now.

This is one of my favorite quotes from Charlie Munger -

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well.

Systematically you get ahead, but not necessarily in fast spurts. Nevertheless, you build discipline by preparing for fast spurts.

Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.”

In this article, we will be discussing a few of the most important mental models, which will help you to make better financial decisions.

In simple words, Inversion is a way to reach excellence, by avoiding stupidity!

Charlie Munger once said ~ “All I want to know is where I’m going to die, so I’ll never go there.”

Most people think that to achieve some goal you need to make some wise decisions, but according to Charlie Munger, it’s not about making the wisest decisions but avoiding the stupidest things.

Inverse thinking is basically Flipping a problem upside down so that you can get a better perspective of it.

It helps you to see the things which you wouldn’t normally focus on.

In simple words, Instead of asking how to do something, ask How not to do it!

And then avoid those pitfalls.

Say you want to become happier, then don’t ask yourself how to become happy, but the opposite, that, what will make you sad.

1. Bad Sleeping schedule.

2. Bad eating habits.

3. Toxic Relationships.

4. Doing something you don't enjoy.

5. Not doing any Physical Activity.

6. Worrying about the Future.

So, if you avoid doing these, you will automatically put yourself into a position where you will be happier.

In one of the shareholders’ meetings, Charlie talks about how inversion helped him become a better weather forecaster during world war 2 when he was serving in the US air corps.

So, he was assigned to make weather maps, but what he was actually doing was clearing pilots to take flights.

He used the Inversion technique, and asked himself, how can I kill these pilots? What would be the easiest way to do it?

So, that he could avoid those scenarios at all costs.

He figured out there were only two ways to do that:

1) Get the planes into cold temperatures that would cause them to ice up and crash, or

2) Get the pilot into an area where he would run out of fuel before he could safely land.

So, he made sure that pilots don’t end up in any of the above scenarios.

Now, you can use this mental model in any other area of your life, say you want to make profits as an investor, so ask yourself How you can make big losses in your investments?

1. Put all your money into a single stock/Don’t diversify.

2. Follow tips to make your investments.

3. Don’t do any research before making any investment.

4. Buy/sell based on your emotions.

5. Don’t follow your plan.

Now, you just have to avoid doing these things, and you will automatically get better results from your investments.

Similarly, if you want to become a Profitable trader, ask yourself what are the things that are likely to cause you big losses.

Some of those things are:

1. Hold your losers, cut your winners.

2. Average your losers.

3. Don't follow the plan.

4. Have an Ego.

5. Try to make money all the time.

6. Compare your profits to others.

7. Jump from one strategy to another.

8. Focus on the P&L.

9. Find shortcuts (Borrowed systems),

10. Risk too much on a single trade.

Now, once you know what can make you big losses, you just have to avoid doing these things.

And you will most likely become a profitable trader.

2. Circle of competence

In simple words, your circle of competence is your Edge in your field.

It’s basically about finding your area of expertise in whatever you do.

This is what Munger said at the 2020 daily journal meeting ~

“I think about things where I have an advantage over other people. I don’t play in a game where the other people are wise and I’m stupid. I look for a place where I’m wise and they’re stupid. You have to know the edge of your own competency. I’m very good at knowing when I can’t handle something.”

What he’s saying is that we would achieve better results in the longer term if we operate inside our circle of competence.

See, We can either become master at one thing, or we can become the jack of all trades, where we know a bit about everything but we don’t have an edge in anything.

Warren Buffet and Charlie Munger have built Berkshire Hathaway by only buying businesses they understand.

And doing this they have missed many big opportunities!

But, but! By operating inside their circle of competence, they have also saved themselves from making many big mistakes.

According to Charlie Munger ~

“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.”

Now, If you are a trader there are various trading styles and each style has its own strengths and limitations, So it’s not like one thing is better over another.

What most people do is that they try to do everything, they want to trade positionally, they want to do scalping, they also want to sell options, well this is the recipe for disaster!

Why? To know that we have to understand a bit more about what the circle of competence is.

A circle of competence is not something you can build in a day, it’s not something you can learn from others. If others can teach you something, it’s probably not an edge (circle of competence), Circle of competence is like the specific knowledge that you gain over a period of time, by making mistakes, learning things on your own, and finding what works for you.

That’s how you Build your Circle of competence.

Say your area of expertise is cash trading, but now the market is not favorable for your type of trading, and you see the options guys making a lot of money.

So, you say to yourself, Let’s try some options trading. If I can make money in cash, I can make money while trading options too, how hard can it be?

You try the same, and end up losing a good amount of money.

What’s the lesson here?

If you are playing outside your circle of competence, you are just gambling.

To become a successful trader, you need to have a deep understanding of one thing (i.e your circle of competence) and then you just have to stay within that circle to keep making money over the long term.

Now, you might have a question, how can we grow if we stop trying new things.

See, you have to understand that the Circle of competence is not static, it’s dynamic, it can expand or contract.

So, you have to slowly expand your circle of competence with time. Don't catapult yourself ten miles outside your circle, that is pure gambling, just keep learning a little bit every day, and with time your circle of competence will expand.

While staying inside your Circle of competence, you might feel like you are missing a lot of opportunities, but at the same time, you would also save yourself from making a lot of stupid mistakes.

This is one of my favorite quotes from Charlie Munger “ Risk comes from not knowing what you’re doing”

3. Second-order Consequences and long term thinking

Time is one of the most important yet least understood parts of our life.

Time is what makes all the difference, all the decisions you take in life are usually related to time, whether you succeed or fail in your business, work depends upon how you see time, as a friend or as an enemy.

Well, believe it or not, short-term thinking is one of the biggest reasons we fail to succeed in many areas of our life.

You wanna get fit, then you’ll have to avoid eating junk food, well that’s hard right, cause eating that food will give you a dopamine hit in the short term, whereas if you don’t eat it, you won’t see any difference in your health over the short term.

The same is the case when you have to follow the rules in trading, in the short term it’s really painful to cut your losses and see that profit turn into a loss just because you followed the plan, so in the short term breaking your rules seems like a good decision to you.

But! That’s the catch, whatever is making you feel good in the short term is likely to put you into a bad situation over the longer term.

Short term thinking is like “I want to have a better today at the cost of tomorrow”

Short-term thinking makes you impatient, and you end up making some bad decisions.

Like few of my Trading buddies have this problem, where they can’t sit out of the markets even for a day, they are impatient because they are running behind instant results.

If they understand that sometimes sitting out of the markets is necessary and it might feel like they are missing the action in the short term, they will save themselves from overtrading! Which is the biggest reason behind big losses in trading.

Sitting out is long-term thinking, trying to punch the orders daily just for the sake of taking a trade, is short-term thinking, for which you’ll have to pay in the longer term.

Well, the reason why most people don’t make wise decisions is that they don’t think about the second-order consequences of their actions.

Every action has its consequence and each consequence has its subsequent consequence, basically, a single decision can lead to a series of cause and effects, this is what we call the second-order consequences.

Most of the time when you make a decision, you focus upon the immediate consequences, like when you make the decision to not go to the gym, you are just focusing on the immediate consequences, which is that gym sucks, and you wanna take some rest, what’s the big deal right?

Well, you just focused upon the first-order consequences, now the second-order consequence of this decision will be that you’ll feel lazier in going to the gym next time, and that will create third-order consequences, which is that your health will be negatively affected in the long run.

This was just a basic example of how it works.

Second-order thinking helps you to think through time, before making any decision you ask yourself, “and then what”. How are these decisions going to affect me in 10 mins, days, and months? This is the only way you can really think in the long term and make better decisions.

TL;DR

1. Spend less time trying to be brilliant and more time trying to avoid stupidity.

2. Always operate inside your circle of competence, anything that you do outside your circle of competence is gambling.

3. You have to decide whether you want to have a better today at the cost of tomorrow or a better tomorrow at the cost of today.

4. Always think about the second-order consequences of your actions, that way you will be able to keep a long-term mindset.

So, that’s it for today from our side, I hope that you enjoyed reading this article, also do share this article with your friends over social media.

Thanks for reading :)