Practical Wisdom: Two More Mental Models for Investing

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“Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.

“You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.”

– Charlie Munger, Vice Chairman of Berkshire Hathaway

Few things are as powerful as the idea of “practical wisdom.”

It’s where you apply theory to practice. It’s where “street smarts” meet “book smarts.” It’s where the rubber meets the road.

As Charlie Munger – Warren Buffett’s longtime investment partner – points out, making better decisions isn’t a single skill.

What distinguishes consistently good decision makers from poor ones is having a toolbox of diverse mental frameworks and tools.

We call these different frameworks “mental models.”

The Wonderful World of Mental Models

You may have heard the expression “To a man with a hammer, every problem looks like a nail.”

We all make decisions based on the models that we have in our heads. Investors are like this as well.

If you are a fan of John Bogle (a “Boglehead”), no matter what the investment question, the answer is always “index funds.”

If you are a value investor, the answer is always “cheap companies.”

If you are a Silicon Valley venture capitalist, the answer is always “invest in the next Google.”

Such narrow thinking has always bugged me. The world is much too complex to reduce it to a single model.

Sure, a hammer can help you get a job done. But it does you little good if you’re trying to repair a watch or perform open-heart surgery.

In both investing and in life, you need different tools for different tasks.

Over the years, I’ve collected and summarized dozens of mental models that I’ve found the most useful. I shared some of them last week. Below are two more, as they apply to investing.

No. 1: The Network Effect

A network tends to become more valuable as more nodes are added to it. To understand this best, contrast an electrical grid with a telephone system.

J.P. Morgan’s brownstone mansion was the first home to get electricity in New York City. Although it thereby gained immense value, it did not matter to Morgan whether his neighbors had electricity or not.

In contrast, when the same mansion had its first telephone installed, it was virtually worthless – until Morgan’s neighbors had telephones as well.

Only with additional telephones – nodes – on the network was the phone network able to generate any value.

In today’s interconnected world, the network effect is more important than ever. It’s the source of massive value for both companies and investors.

The lesson for investing? Much of many companies’ value stems from the network effect.

Yet I’ve never seen a value placed on a network in any textbook approach to valuing an investment.

Remember the importance of networks the next time you’re thinking of investing in a Facebook (Nasdaq: FB) or Visa (NYSE: V).

No. 2: The Pareto Principle

The Italian economist Vilfredo Pareto was the first to observe that 20% of the population in Italy owned 80% of the land. As he dug deeper, he found that this skewed distribution applied to a wide range of things.

Thus emerged the Pareto principle: that 80% of your results come from 20% of your efforts.

Twenty percent of your customers account for 80% of your profits. Twenty percent of your activities account for 80% of your happiness.

The Pareto principle is well-known among business consultants. It has become a staple of management curricula at leading business schools.

Yet it’s ironic that the Nobel Prize-winning finance professors down the hall have yet to integrate the Pareto principle into their investment models.

So how does it apply to your investing?

Take a look at your portfolio. Chances are 20% of your investments account for 80% of your profits. By focusing – and increasing – the size of your bets on the 20% of your best investments, you can make an enormous difference in your investment returns.

To sum up…

The purpose of mental models is to make better decisions. It’s why I love the exchange-traded funds (ETFs) I recommend in Oxford Wealth Accelerator. ETFs offer the broadest possible range of answers to the widest range of investment questions.

But understand that building your latticework of mental models is a lifelong project. Stick with it, and you’ll find that your ability to make good decisions – in both investing and in life – will improve consistently.

Good investing,

Nicholas