These models can make you self-aware of where you are going wrong
16-Nov-2022 •Ravi Banagere
Charlie Munger, one of the most successful investors ever, is said to have the best 30-second mind in the world. He sees the essence of everything before you can even finish the sentence.
How does he do it? By observing reality and running it against his mental models. These models have helped him make better decisions in business, life, and the stock markets.
Before we proceed further, let's understand what mental models are. In simple words, mental models enable our brains to make sense of the world by reducing its complexity. But our brains can subconsciously react to an event in a way that may not have the best outcome. Hence, we need to recognise these biases to improve our decision-making process.
So, let's look at some mental models we tend to overlook when making our investment decision.
# 1 Doubt and avoidance tendency
Let's imagine the markets have turned red, and there are talks of recession. What would be a natural human reaction? Pure panic.
In such moments, our rationality takes a backseat. Neither do we check the quality of our investment nor try to understand the reasons for the market downfall. Instead, we take the easiest route possible, dumping our investment as quickly as possible, sometimes at a loss.
This reaction is called the doubt and avoidance tendency.
In such times, we cannot handle the pressure, causing us to make ill-informed choices - no matter how good these investments are or can be in the long run.
This is why Charlie Munger, the vice president of Berkshire Hathaway, uses his mental models to recognise these biases.
Over the years, these models have helped him immensely - and how.
For instance, his company has held shares of Coca Cola and American Express for more than three decades, which have witnessed several recessions and market falls. But he didn't react to such events, and since he was sure of the quality of stocks, he simply let the storm pass over.
Here's what he says about handling such situations, "I don't pay much attention to macroeconomic trends. Like the weather, I just ignore the weather. All these people that are blabbering on television don't think the way that I do."
What you should do
Like Munger, stay calm and let your investments do their 'kaam' (work).
In times of trouble, take a step back, recollect your thoughts, do a little research, assess your investment's quality and then come to a decision.
Well, this is another mental bias, and it's called the over-optimism tendency. In such cases, we jump in without calculating the risks.
The same goes for investors who have employed their hard-earned money in crypto assets.
Munger has been particularly dismissive of such over-optimism, saying that cryptocurrencies like Bitcoin were simply "created out of thin air" and that it is "stupid and evil".
What you should do
There's a thin line between gambling and investing. So, calculate the risks of an investment; don't go with the crowd and keep your optimism in check. You are investing your hard-earned money at the end of the day.
#3 Deprival-super reaction tendency
We ordinarily react to losses more intensely than when we win. This is why we hold on to our investments when it is up by five per cent, but we like to discard them if it falls by even three per cent.
Similarly, we sell our investment or stop our SIPs at the slightest threat of a loss.
This reaction is called the deprival-super reaction tendency, or loss aversion. We would rather avoid losing something than gain something.
Munger blames it on our temperament.
"A lot of people with high IQs are terrible investors because they have got terrible temperaments," is a timeless Munger quote that beautifully sums up our irrationality.
What you should do
Don't react to the smallest of losses. Just like us, our investments may need time and space to breathe to perform well.
To sum up, these mental biases are common, and we all have similar reactions to a given situation. However, Munger's mental models can help us be more aware of our weaknesses. This can only increase the quality of our investment decisions in the long run.