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So many people go through life with a very small collection of mental models to help them understand the world. This diminishes their ability to think.
“A man with a hammer sees every problem as a nail” – Charles Munger
You need many different mental models in your tool box so that you can choose the right tool when a problem or a decision comes along.
What do I mean by mental models?
Mental models are the thought processes, the psychological approach, used by people to understand the workings of the world. They are representations of real, hypothetical or imaginary situations. They are models of reality.
Investors can make use of the big ideas from the big disciplines.
Using a mental model from one discipline in another
A classic mental model is Darwin’s theory of evolution; the concepts of natural selection and survival of the fittest. Prior to that way of looking at the world there were alternative paradigms. Darwin remodelled our way of considering reality.
Once you understand this mental model you can apply it in other circumstances. For example, I find these ideas very useful as a way of explaining the “eco-system” of industries, with “creative destruction” (another mental model) and profitable “niches”.
You can take this further and think of industry disruption – such as internet based substitute ways of supplying customer need, say books, music or taxis – as similar to massive environmental change affecting animals and plants.
I meet so many managers who stick to the industry they know, simply because it is the only one they understand and can operate in. They carry on regardless of the world around them changing. They can’t understand why doing what they did successfully a few years ago now brings losses.
This is analogous to an animal that is adapted to perform well in only one set of circumstances. If those circumstances no longer apply then this species will die. Far better to develop adaptability, flexibility and a wider understanding of other environments that can be moved into.
This is where people like Warren Buffett come in. They can look from above at dozens of businesses in a variety of industries and make a judgement on suitability for the receipt of investment capital to grow. Those with poor ROCE prospects do not deserve more capital.
Just like nature destroys, then decomposes the basic resources (e.g. organic chemicals), and then allows new growth elsewhere (e.g. new species) using those components, so in business we see re-allocation of capital as a vitalising activity (so be proud of being an investor who allocates capital).
Failing to use mental models from other disciplines
A classic example of this is the training of economists in most universities. They learn economic models and they learn complex maths. They are given hammers. They then go around using those hammers to tackle every problem.
If any discipline needs to borrow from others it is economics. For example, the relationships between economic inputs and outputs is not like the inputs and outputs in physics. The main reason is that people are at the centre of economics. It is how they behave that determines economic outputs ranging from responses to low interest rates (higher spending/lower spending?), the minimum wage (higher/lower unemployment?) to the moods of the stock markets.
A glaringly obvious failure of economics was the experience of the sub-prime crisis, which seemed to total mystify the econometricians. The sale of securitised bonds, CDOs and other fancy instruments all looked great in the statistical modelling done by the greatest mathematical brains.
It’s a pity they only had hammers though. Anyone with half a brain could observe what was going in with the psychological of the players: house buyers with no income could still get a mortgage; mortgage broker’s psychology to pump out more deals; Wall Street sellers of securitised bonds psychology to get bonuses for passing-on financial instruments based on mortgages; over-confidence in statistical models that showed sub-prime securitised bonds did not default much, and that house prices NEVER EVER fell in all………..To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
