A mental model is nothing more than a heuristic rule of thumb. It’s a pattern or framework to understand the world better and to understand people better.

In this article, I’ll recap what our host, Rob Berger, talks about and go a little further. First, we’ll start with the key characteristics that mental models have, then we’ll cover the 11 mental models Rob has identified.

Characteristics of the Best Mental Models

1. They help us make better decisions

If mental models don’t help us do something, they might be interesting, but nothing more. So the best mental models are ones that actually help us in life. One way is to help us make better decisions.

To be more specific, good mental models help us make better decisions, faster. In the podcast, Rob uses the example of the “grandmaster.” If you’re in a chess duel against the “grandmaster,” you might be lucky enough to come up with the right move. But speed matters.

This is the same move that would be found instantly or very quickly by the “grandmaster” because they have a pattern they recognize.

Someone without a mental model that would help make faster decisions would have to struggle through and rule out other options to come to the right choice. This would take a significant amount of calculation.

While this is a chess-related example, it shows that mental models can help us make decisions faster. They become incredibly valuable if they can help us make decisions with more confidence, too. That’s particularly true in investing.

As Rob says, confidence (not misplaced confidence) in what we’re doing is incredibly valuable when it comes to investing. This is especially true in times like these when markets aren’t doing so well.

2. They help us filter out the noise

A good mental model can help you determine what’s essential and what’s not essential. This is critical as we’re flooded with information regularly. Think about the amount of data that’s thrown at us even just related to investing. It’s a lot.

So it’s important to know how and when to filter out the noise. If you invest in individual stocks, for instance, you can access the company’s annual report, which is filed with the SEC and contains a significant amount of information that can help you determine if an investment is good or bad.

But most investors will not only review documents like that, but they’ll also read news articles and use analyst opinions to sway their decisions. Yes, some of this information is valuable, but using an excellent mental model can help you determine what you actually need to focus on to make a decision, and what is just “bonus information” or even completely unnecessary information.

3. They help us eliminate bad decisions

A good mental model can help you remove bad choices right away. This can reduce decision fatigue and help you focus only on the options that matter. Rob uses the example of taking a standardized test, such as the LSAT.

One of the strategies when taking a test like this is to eliminate choices that are clearly wrong. Your goal is still to get the right answer, but this strategy will help you remove the wrong answers.

Say for example you had four multiple choice questions and eliminated two of them.
If your mental model was correct and you got rid of two wrong answers, your probability of success just doubled. So getting rid of clearly suboptimal choices can go a long way in helping us make the right decision. And a mental model can help you do this.

4. They can help us see non-obvious connections between things

The best example of this is the “latte factor,” which we talk about a lot on Dough Roller. Most of you know what the “latte factor” is, but for those that don’t, you can read about it here.

One of the great things this concept does is connect the seemingly small everyday decisions we make with our money to long-term wealth. It’s a connection. If you haven’t spent a lot of time thinking about your finances, you don’t always equate the small daily purchases with having enough money to retire on or achieving financial freedom at a younger age. Like Rob says, the mental model, which is really what the latte factor is, helps us see that connection.

5. They’re personal to you

Everyone is going to have different mental models. What might work for me may not work for you. For example, one of the mental models I use comes into play whenever I make a big purchase. I always ask myself if buying that item would add to my quality of life. If I think it does, I will still sleep on it before making the purchase.

This may not work for you, though. You may have a different framework. Rob talks about waiting weeks to make a purchase, for instance. Below we’ll talk about 11 different mental models, but just remember that everyone is unique and you may have to tailor and adjust these to work for you.

The 11 Mental Models

1. Second-order thinking

Second-order thinking is really walking through “what-if” scenarios to play out what may or may not happen when you make a particular decision. To draw this out in a financial way, let’s recap the car example discussed in the podcast.

Say you want to get rid of your car payment to save some money. Typical thinking would have you consider the fact that you need a car to get to work, so that’s not really a possibility. But second-order thinking takes it a little further.

Using second-order thinking, you might consider if you got rid of your car, you might have to move closer to work or take public transportation. The reasoning could become endless–which is the “what if” side of this. After thinking through the possibilities, you may end up deciding to sell or not to sell your car–but you’ve at least given it a second “layer” of thinking.

This can be particularly helpful when emotion comes into play. This often happens when we’re investing. You may have an emotional connection to a stock and want to keep it or sell it for some reason, but by employing second-order thinking, you can play out a few scenarios of what might happen if you take a specific action.

This, in theory, should help us make better decisions overall.

2. Things that are random don’t appear random

Have you ever noticed that when the stock market is up or down, and you’re looking at a financial site they always tell you why the market is up or down. For example, the stock market is down because of a trade dispute between China and the U.S. Or maybe it’s down because the Fed chairman made a comment about raising rates. Or perhaps the market is up because of an earnings release from Apple or Alphabet.

They could be right–those could be the reasons why the market is up or down. But then again, they could be completely wrong. Yes, it may be true that the Fed chairman made a comment about interest rates. And it may even be true that following that comment, the market went down. But that may not necessarily be the primary reason why the market was affected.

The reality is, a lot of things affect the market. This type of commentary that you see on financial sites may be correct to some extent, but it may also be very incorrect. We can get ourselves into trouble when we assign a cause and effect too quickly to something.

Sometimes cause does create an effect. But it’s not always the case. We need to recognize that far more in the world is either random or the actual cause and effect is unknown. If we’re too quick to associate these causes and effects, it can result in financial decisions that aren’t the best for us.

So to recap the second mental model, don’t always associate cause and effect too quickly. Many things happen at random, and we need to find the logical sense in events instead of creating stories or taking others’ stories as fact.

3. Compound interest

The third mental model is the idea of compound interest. We talk a lot about the latte factor on Dough Roller, and I think you can lump that into this mental model. It seems like a reasonably well-understood concept, but the idea of compound interest can change your financial outlook exponentially.

Here’s an example. Assume you’re a recent college graduate, making $50,000 a year right out of school. To make it even more difficult, let’s assume you’re never going to get a raise. Depending on where you live, $50,000 out of school is a pretty good salary, but throughout a career, not getting a raise would be pretty sad.

Next, we’ll assume you work from age 22 until age 67, which is the full retirement age for many people. So that’s 45 years. Even with never getting a raise, it’s still possible to become a millionaire.

If you socked away just 8% of your salary consistently for those 45 years, you’d end up with just over $1 million at retirement, assuming a modest 7% average annual return on investment.

So it’s possible. The idea of compound interest, then, should be one of your vital mental models to live your financial life by.

4. Business cycles

The notion of business cycles as a mental model is relatively simple. First, you have to identify a well-run company with a good brand and a management team that’s doing smart things with the money. This means things like not making stupid acquisitions or overpaying executives.

The company also shouldn’t be, to use Rob’s quote, giving away stock like candy at Christmas. They could possibly be paying reasonable dividends or buying back stock when it makes sense. The company is investing in itself when it makes sense. It’s a well-run company, but because of different business cycles, there are times the company doesn’t do very well, at least relative to the good years.

In the podcast, we use the example of John Deere. They had a couple of years where their stock was walloped because commodity prices were down (i.e., corn and wheat). Since the prices for these commodities were down, farmers weren’t buying equipment.

So the impact of the stock price was due to a specific business cycle. There are ups and downs in business, depending on what industry the company is in. And if you recognize that and you study it, you can make some pretty smart investing decisions.

5. The myth of sacrifice

The myth of sacrifice is when you can’t imagine giving something up, as it might be too big of a sacrifice. In the podcast, Rob uses his famous example of the mocha latte. Rob would always go to Starbucks to work, and he always had to have his mocha latte. To use his words, the thought of not having it was a considerable sacrifice.

Then one day, he decided to go cold turkey and just stop drinking the mocha latte. And the reason for it wasn’t the money, it was for health. A mocha latte isn’t exactly the healthiest drink for you. To Rob, it was painful. For a few weeks, he really missed his mocha latte. It’s all he could think about. Then after a few weeks, he just didn’t miss it.

I had the same experience about seven years ago when I went vegetarian. The first two weeks without meat was torture. It’s all I wanted. But then after a couple weeks, I not only didn’t eat meat, I had absolutely no desire for it. It didn’t appeal to me anymore. It didn’t make me hungry.

So this myth of sacrifice is almost like an addiction. We think not doing something or not having something will be painful. And maybe it is for a short period, but after a while, it will go away.

When it comes to money, this can mean not thinking you can part ways with $50 or $100 a paycheck. It might seem impossible. And once you do it, it might hurt for a few weeks. But after a while, you adjust your spending and make it work. And it’s like that money was never there.

So this idea doesn’t mean you can’t have things you want. The goal here is to create a mental model that helps you think beyond this myth of sacrifice. Odds are, you can do without whatever is you feel like you can’t give up. It’ll just take a little sacrifice.

6. Myth of happiness

This mental model is almost the opposite of the myth of sacrifice–we call it the myth of happiness.  We think certain things are going to make us happy. For example, a remodeled kitchen with a perfect stainless steel refrigerator. Or buying a new car. Whatever it is for you that you think makes you happy, many times it’s just a myth.

It’s not that these things are wrong or that you shouldn’t do them, though. But we can sometimes build them up in our minds as more essential and contributing more to our happiness than they really will.

Let’s use the new car as an example. When you get a new car, it’s new. That means it has the fresh car smell, new gadgets, and it’s spotless inside. It’s perfect.

But after a while, it loses its luster, doesn’t it? It becomes a mode of transportation. A car to get you to and from work. And that’s precisely what it is.

But you didn’t think that way when you bought it, right? Now, this doesn’t mean it was a bad purchase. It doesn’t mean you should go out and sell it. But if we see ourselves getting too excited about a purchase, we should think about this mental model and at least take a breath and think about it.

Again, it doesn’t mean we shouldn’t buy it. This happened to me a few years ago when I wanted a new car. I had an old car that I drove into the ground. I had just paid off my debt, and I was excited about a new vehicle. I felt like I deserved a really nice one.

I looked at some pretty cool cars, ones that were way out of my price range. But then I paused and recognized what I really needed. Which was a car to get me to and from work. I also knew I didn’t want a massive car payment or one that would last forever.

So I ended up buying the cheapest new car I could find–a Honda Fit. I still drive (and love) that car. It gets excellent gas mileage, and it works for what I need right now. No, it’s not the sexiest vehicle, but it gets me to and from work, which is what any other car would have become after a while anyway.

This is the idea of the myth of happiness. Pause and think before you buy.

7. Inversion

Charlie Munger, business manager for Warren Buffett, talks a lot about this. One of the best examples of this goes back to the LSAT example–taking a standardized test. As I talked about before, we know the goal of each question is to get the right answer. But sometimes “inverting” it can help us. So rather than looking for the correct answer, we eliminate the wrong answers. Almost looking at the problem in reverse.

A related concept is one that Stephen Covey talks about in his book, The Seven Habits of Highly Effective People. He says to begin with the end in mind. When it comes to money, this is brilliant. Think about what your goal is, then you work backward.

So this “inversion” can help us a lot. Especially when you’re thinking about investing for retirement. How can we eliminate bad options–whether they’re individual investments or overall strategies–to look at the situation differently?

8. Small gains, small wins

The mental model of small gains and small wins is sort of like Dave Ramsey’s justification for the debt snowball. With this method, he advises that we rank and pay off our debt in order of smallest to largest balance. Mathematically, this makes no sense. But psychologically, it does.

By eliminating a debt balance, we can become more motivated to pay off the next one and the next one. And so on and so forth. When you use a method like the debt avalanche, which has you pay off debts from highest to lowest interest rate (and makes sense mathematically), it may take you a while to get out of debt, depending on your interest rates. Studies have shown that those small wins work because you’re going to pay off the debt faster and that feels good.

It’s encouraging. You feel and see the progress. Now let’s not forget, you’re making progress either way when using those two methods mentioned above, but because you pay off a debt entirely it just feels like more progress.

For instance, if you get a credit card paid off, it feels good. And again, studies have shown that it encourages people and motivates them to stay the course and continue working on their debt.

So when you’re confronted with a big goal, think of ways you can break that goal up into small pieces. Break it up into modest gains. The key is to be consistently making measurable, well-defined progress. If you can do that, studies show that it will encourage you to keep going and keep you moving closer to your bigger goals.

If you want to take this concept a little further, you can do some reading. There’s a book that explores a similar idea and is called The Progress Principle. I highly recommend it.

9. Be aware of the signal-to-noise ratio to make stock market predictions

The signal-to-noise ratio helps you determine the information that’s important and useful to you, and filter out what’s cloudy useless information. So when you hear people start to predict the stock market, if you listen at all, view it as entertainment.

This doesn’t mean you shouldn’t take note of what’s happening and what’s being said. But being aware of this ratio can help you develop a mental model that will help you understand not only information that’s coming in from “experts” about where they think the stock market is going to go, but also it enables you to understand the movements of the market.

So the goal here is to use information at its face value. Develop a model so you can filter out the junk, and make decisions based on that.

10. The 10-year prediction

The 10-year prediction comes into play when you want to understand a company like Apple. We don’t know where Apple’s stock price is going to be in six months. And we certainly don’t know where the stock price is going to be in 12 months. But a better question to consider is where the company will be in 10 years. At first, you might think you can’t predict 10 years down the road, especially considering we can’t predict even six months ahead. But we’re anticipating something a little different.

We’re not predicting the stock market price of an index or in this case, an individual company like Apple. What we’re trying to predict is where we think the company will be 10 years from now–from a business standpoint.

Warren Buffett did this when he was talking about his investment in Coca-Cola. He can talk about the numbers if he wants, but when he made the investment years ago, he looked at it from a global perspective. He looked at things like the penetration Coca-Cola had in the world and compared it to things like population growth and how that penetration would correlate.

Apparently, there was more that went into that decision, but what he was doing was looking ahead to think about where Coca-Cola would be as a company down the road. Of course, none of this is guaranteed. But what you can do is look at an investment and think about where that company will be in 10 years.

Looking at a company like Apple, you might be pretty confident about where they’ll be in 10 years based on their products, brand, and leadership. Plus you might look at things like penetration, population, and the expected growth of Apple’s product line.

But many of us don’t invest in individual stocks, so maybe a better way of looking at this is thinking about where the markets will be in a decade, based on different economic and environmental factors. When it boils down, these are all just educated guesses, but in many ways, it provides you a more accurate lens into how you invest.

11. The obstacle is the way

The idea behind this is that sometimes the best course we can take is the hardest. We like easy things. Who wants barriers? Who wants challenges in the way? But the reality is, it’s when we work through the obstacles and the problems that we get the most growth in some way in some areas it’s relatively obvious.

Rob gives the conventional example of weightlifting. When you’re lifting weights, you have to really challenge yourself. You have to lift the weights that are uncomfortable. Now, you don’t want to hurt yourself, but within reason, you have to lift the weights that are hard to lift.

Otherwise, you don’t get stronger.

So the mental model here is to carry this concept over to money and investing. What’s difficult usually provides the most growth, and many times the most reward. We learn from our mistakes, and we learn from challenging situations. If you, for instance, choose only to use a robo advisor, you may reach financial independence. But you won’t really learn anything about investing–at least not as much as you would by analyzing and picking individual stocks.

The latter is more difficult and time-consuming. You are more prone to screwing up. Now, this isn’t to say index funds or robo advisors are bad–in fact I use both, and they’re great–but the idea remains that if we don’t push ourselves to learn or fail, we may never really grow.

Summary

Phew. That’s a lot. While these are just 11 of the mental models Rob figured out, I’m sure there are more that you have. Please share in the comments below what types of mental models you’ve come up with, and how they work for you.

Topics: Money and Life • Personal Finance • Podcast • wealth

The post DR Podcast 307: 11 Mental Models for Building Your Wealth appeared first on The Dough Roller.

via Finance Xpress