Latest / The Dutch Investors / #33 | 5 Mental models for investors

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#33 | 5 Mental models for investors · The Dutch Investors

0:00
SPEAKER_00: In life and business, the person with the fewest blind spots usually wins.
0:05
SPEAKER_00: And I don't mean winning in a billionaire kind of way, I mean making better choices, avoiding big regrets, and understanding the world just a little bit more clearly than yesterday.
0:18
SPEAKER_00: Now, we all have blind spots, I do, you do, but the good news is that we can train ourselves to see more clearly.
0:28
SPEAKER_00: That's where mental models come in.
0:31
SPEAKER_00: Now, before you run for the hills thinking this sounds too academic or technical, hold up for a second.
0:38
SPEAKER_00: Because mental models are simply tools in a toolbox, or lenses, ways to see the world that help us make better decisions.
0:47
SPEAKER_00: I truly believe you'll gain some value from this episode because this episode will be relevant today, tomorrow, and 200 years from now.
0:57
SPEAKER_00: They're timeless, time-tested ideas.
1:00
SPEAKER_00: Let's jump into the episode.
1:12
SPEAKER_00: Let's start with a little backstory.
1:16
SPEAKER_00: The wise Charlie Munger, Warren Buffett's lifelong partner once said, and I quote, You've got to have models in your head, and you've got to array your experience, both vicarious and direct, onto this latticework of mental models.
1:33
SPEAKER_00: When I first heard that, I was like, Lattice what now?
1:38
SPEAKER_00: Munger was basically saying something really simple.
1:42
SPEAKER_00: We need frameworks to make sense of the world, and these frameworks, mental models, are like tools in a toolbox.
1:50
SPEAKER_00: The more you collect, the better you are at navigating life complexities.
1:56
SPEAKER_00: Whether it's investing, decision making, in personal life or whatever.
2:01
SPEAKER_00: Just figuring out how things work.
2:04
SPEAKER_00: Every time you make a decision, you're using a model.
2:08
SPEAKER_00: Most of us are just doing it unconsciously.
2:10
SPEAKER_00: To the man with the hammer, every problem is a nail.
2:14
SPEAKER_00: It's something I truly stand by and believe in, especially as an educator.
2:20
SPEAKER_00: It's about learning and knowing chunks of knowledge from different disciplines that can be simplified and applied to better understand the dynamic world we live in today, but also a hundred or a thousand years from now.
2:35
SPEAKER_00: Richard Feynman said best, and I quote, You only think you know, as a matter of fact, and most of your actions are based on incomplete knowledge, and you really don't know what it is all about, or what the purpose of the world is, or know a great deal of other things.
2:54
SPEAKER_00: It is possible to live and not know.
2:58
SPEAKER_00: A mental model is simply your internal representation of how something works, whether it's the stock market, human behavior, or even your own emotions.
3:08
SPEAKER_00: The trick here is to build this toolkit, one that draws from physics, psychology, biology, math, and even history.
3:17
SPEAKER_00: And it sounds simple, but it's the kind of thing that takes time to build.
3:22
SPEAKER_00: You've got to live, listen, and learn, constantly adding layers to that mental lettuce work.
3:29
SPEAKER_00: So the question I kept asking myself is, how many of these mental models do I have in my own toolkit?
3:37
SPEAKER_00: And more importantly, how can I keep adding to it?
3:40
SPEAKER_00: Because I truly believe in the discipline of mastering the best and avoiding the worst.
3:45
SPEAKER_00: Because I truly believe in the discipline of mastering the best and avoiding the worst of what other people have already figured out.
3:53
SPEAKER_00: I don't want to try and reinvent the wheel, I want to use what's proven to work and avoid what hasn't.
4:00
SPEAKER_00: And this idea really stuck with me because it's not just about how smart you are or about how much you know, it's about how you use what you've learned, how you pull those different threads together to see the bigger picture.
4:17
SPEAKER_00: And trust me, that's something that applies in just about every part of life.
4:23
SPEAKER_00: You know what the hardest part is about learning from the real world?
4:27
SPEAKER_00: It's us.
4:28
SPEAKER_00: We all walk around with blind spots, things we don't even realize we're not seeing.
4:34
SPEAKER_00: It's really tough to understand a system when we're right in the middle of it, kind of trying to see your own eyeballs without a mirror.
4:42
SPEAKER_00: There's this brilliant story from David Foster Wallace that nails this idea.
4:48
SPEAKER_00: Two young fish are swimming along, and they pass an older fish who nods and says, Morning boys, how's the water?
4:56
SPEAKER_00: The two young fish keep going, and then one turns to the other and goes, What the hell is water?
5:04
SPEAKER_00: It's funny, but it's also exactly how many of us move through life.
5:10
SPEAKER_00: The most obvious things, the things that shape every part of our reality, are often the hardest to notice.
5:17
SPEAKER_00: And because of that, we often fail to learn from the very world we're swimming in.
5:23
SPEAKER_00: Okay, let's dive into some of these powerful mental models that the grades use.
5:29
SPEAKER_00: Now there are millions of mental models out there, some true, some false, but in this episode I will focus on the ones with the greatest utility.
5:38
SPEAKER_00: Let's start with number one, inversion.
5:41
SPEAKER_00: Charlie Munger used to love this one.
5:44
SPEAKER_00: He often talked about how in order to succeed, you shouldn't just ask, how do I get rich?
5:50
SPEAKER_00: Instead, ask, what would guarantee I stay poor?
5:54
SPEAKER_00: It's the reverse way of thinking.
5:56
SPEAKER_00: Inversion comes from a very practical and problem-solving mindset in engineering.
6:02
SPEAKER_00: Engineers are taught to think about how things can break, fail, or go wrong before figuring out how they'll succeed.
6:10
SPEAKER_00: It's about failure-proving designs, systems, and processes.
6:15
SPEAKER_00: One great example comes from the airline industry.
6:19
SPEAKER_00: After a series of deadly plane crashes in the early 20th century, engineers and designers started to think differently.
6:27
SPEAKER_00: How do we make an airplane that flies perfectly?
6:30
SPEAKER_00: Instead, they asked, What would cause this airplane to crash?
6:35
SPEAKER_00: And by approaching the problem the other way around, by focusing on all the things that could go wrong, they were able to identify weak points in the design, build safeguards into systems, and make planes much safer.
6:51
SPEAKER_00: And this inversion in action, how you figure out the worst case scenarios and then engineer solutions around it, that ensures they never happen.
7:03
SPEAKER_00: What are the mistakes that would derail your progress?
7:07
SPEAKER_00: Well, things like overtrading or using excessive leverage or ignoring risks would certainly ruin anyone.
7:15
SPEAKER_00: And the idea behind inversion is that we're often better at identifying what will fail rather than what will succeed.
7:24
SPEAKER_00: If you avoid the big mistakes, success becomes a lot easier to achieve.
7:30
SPEAKER_00: In inversion, the focus isn't on what works, it's on what could fail, and then building safeguards against those failures.
7:39
SPEAKER_00: The lesson here is avoid the worst case scenario, and everything else becomes a lot easier.
7:46
SPEAKER_00: Invert.
7:47
SPEAKER_00: Always invert.
7:49
SPEAKER_00: Okay, number two.
7:51
SPEAKER_00: Margin of safety.
7:53
SPEAKER_00: It's the mental model many of you probably already know of, but most might not be completely aware of what it actually means.
8:01
SPEAKER_00: The concept of a margin of safety actually has its roots in engineering as well, particularly in the design of structures and machinery.
8:11
SPEAKER_00: When engineers build something, be it a bridge or a building or even a car, they don't design it to withstand exactly what they expect.
8:21
SPEAKER_00: They build in an extra cushion, so to say, to account for the unforeseen stresses, errors, weather, or situations beyond the usual operating conditions.
8:33
SPEAKER_00: Imagine you're designing a bridge to support traffic.
8:38
SPEAKER_00: If you designed a bridge to hold exactly 10,000 pounds of weight, that would be very risky.
8:45
SPEAKER_00: What happens if there's a gust of wind or if a heavier load crosses than expected?
8:51
SPEAKER_00: The bridge might collapse.
8:53
SPEAKER_00: So instead of designing it to hold just 10,000 pounds, engineers will design it to hold, say, 15,000 pounds, providing a margin of safety.
9:04
SPEAKER_00: This extra cushion ensures that even if something unexpected happens, like a truck that's heavier than expected, or perhaps even a structural flaw that wasn't caught during testing, the bridge won't fail.
9:18
SPEAKER_00: It's the same concept as building a little wiggle room into your plans to prevent a disaster.
9:24
SPEAKER_00: This margin is key in engineering because it acknowledges that things don't always go according to plan.
9:32
SPEAKER_00: Just like in investing.
9:33
SPEAKER_00: There are so many variables in the real world that they can't be predicted.
9:38
SPEAKER_00: Engineers know that.
9:40
SPEAKER_00: They can't foresee every possible situation, so they ensure their designs are overbuilt to handle some level of unpredictability.
9:50
SPEAKER_00: Now, if we bring this concept back to investing, you can see how this connects.
9:55
SPEAKER_00: Just like the bridge, engineers built with extra strength into their designs, in investing you aim to buy stocks that are, well, undervalued, below their intrinsic worth.
10:08
SPEAKER_00: A margin of safety can be achieved by being more conservative than perhaps is needed.
10:13
SPEAKER_00: This undervaluation then gives you a cushion in case the investment doesn't entirely go as planned.
10:20
SPEAKER_00: So the lesson here is always plan with a buffer for the unexpected.
10:26
SPEAKER_00: Next up, feedback loops.
10:29
SPEAKER_00: They are everywhere.
10:31
SPEAKER_00: Whether we realize it or not, they describe systems where the output of a process gets fed back into the system and affects the next round of outputs.
10:42
SPEAKER_00: This can either amplify or balance the process.
10:46
SPEAKER_00: I'll explain it more in depth.
10:48
SPEAKER_00: There are two types, reinforcing loops and balancing loops.
10:52
SPEAKER_00: A reinforcing loop accelerates a process, while a balancing loop works to balance or stabilize it.
11:01
SPEAKER_00: Let's step away from investing for a moment and take a look at feedback loops in a completely different context.
11:08
SPEAKER_00: Our own bodies.
11:10
SPEAKER_00: This will help you understand the concept a lot better.
11:13
SPEAKER_00: Imagine you're working out in the gym.
11:16
SPEAKER_00: When you start lifting weights, your muscles experience tiny tears, and these micro tears trigger a process where your body sends nutrients to repair the muscles, making them stronger over time.
11:30
SPEAKER_00: This repair process doesn't just stop once, every time you work out, you cause these small tears again and again, and the cycle continues.
11:40
SPEAKER_00: This is a reinforcing feedback loop.
11:43
SPEAKER_00: It accelerates the process of building muscle because each workout leads to stronger muscles, which makes you capable of lifting even more weight.
11:52
SPEAKER_00: The stronger you get, the more you push your body, and so the loop continues, feeding itself.
11:59
SPEAKER_00: But let's switch to the balancing feedback loop to see the contrast.
12:04
SPEAKER_00: Imagine you're outside on a hot summer day, and your body's core temperature starts rising.
12:10
SPEAKER_00: To maintain a stable internal environment, what scientists call a homeostasis, your body kicks in a cooling mechanism, sweating.
12:20
SPEAKER_00: Sweat evaporates off your skin, cooling you down.
12:24
SPEAKER_00: If you get too cold, your body will start shivering to generate heat.
12:29
SPEAKER_00: Here's the balancing feedback loop.
12:32
SPEAKER_00: Works to keep your body temperature within a stable range.
12:36
SPEAKER_00: It's constantly adjusting to make sure things don't get too extreme.
12:41
SPEAKER_00: If you didn't have this loop, your body would either overheat or freeze, and that's dangerous.
12:48
SPEAKER_00: Now consider how feedback loops show up all around us, whether in nature, society, or even in our personal habits.
12:57
SPEAKER_00: In nature, the predator prey cycle is another example, where there are more rabbits, foxes have more to hunt.
13:05
SPEAKER_00: As the fox population increases, the rabbit population decreases, which in turn lowers the number of foxes, allowing the rabbit population to rise again.
13:16
SPEAKER_00: It's a dynamic balancing loop where each side keeps the other in check.
13:20
SPEAKER_00: In our personal lives, feedback loops show up when we establish habits.
13:25
SPEAKER_00: If you consistently eat healthy meals, your body will feel better, which encourages you to keep making those healthy choices.
13:33
SPEAKER_00: But if you start eating junk food, you might notice that you feel sluggish and that you could push you to make better choices the next day.
13:41
SPEAKER_00: This is a balancing loop in action.
13:44
SPEAKER_00: Your body gives your feedback about the choices you make, helping you steer towards a healthier behavior.
13:51
SPEAKER_00: Just like with the examples with muscle growth or market panic, reinforcing feedback loops in investing can accelerate a trend, whether that's a bull market, a successful company's growth, or even a stock price.
14:06
SPEAKER_00: For example, think about a company that releases a game-changing product.
14:13
SPEAKER_00: Initially, sales might be modest, but as more customers start using the product and sharing their experiences, demand grows.
14:22
SPEAKER_00: This growing demand leads to more sales, which further strengthens the company's reputation and increases its market share.
14:30
SPEAKER_00: In turn, the company can reinvest more in innovation, which accelerates growth even further.
14:37
SPEAKER_00: This is a classic reinforcing feedback loop.
14:41
SPEAKER_00: And perhaps the best example of this is, well, Nvidia.
14:46
SPEAKER_00: The same kind of loop can happen in markets.
14:48
SPEAKER_00: When stocks start rising and investors see others making money, they pile in, driving prices up even higher.
14:57
SPEAKER_00: This creates a cycle where the more people buy in, the more the prices rise, attracting even more investors.
15:04
SPEAKER_00: The loop feeds itself and the momentum keeps building.
15:08
SPEAKER_00: These loops can become dangerous if they go unchecked for too long.
15:13
SPEAKER_00: Just like in the stock market, if the price rise is based on hype rather than fundamentals, well, the bubble will eventually burst.
15:23
SPEAKER_00: On the flip side, balancing feedback loops in businesses and markets work to stabilize and regulate.
15:29
SPEAKER_00: They provide the necessary checks and balances to prevent things from getting out of hand, much like how your body regulates its temperature and how ecosystems balance predator prey populations.
15:41
SPEAKER_00: Take a company's financial performance, for example.
15:44
SPEAKER_00: Imagine a business that's growing too quickly, without a solid foundation.
15:50
SPEAKER_00: If it expands too rapidly, its operations will suffer.
15:55
SPEAKER_00: Customers could experience poor surface, quality could decline, or supply chains might break down.
16:02
SPEAKER_00: These negative consequences act as a feedback mechanism for the business.
16:08
SPEAKER_00: Management has to notice the issues, take corrective action, and slow down expansion or focus on quality control to restore that balance.
16:18
SPEAKER_00: Similarly, in investing, you may see a balancing loop when assets or sectors get overheated.
16:25
SPEAKER_00: If too many investors pile into one stock, the price might soar far above its intrinsic value.
16:32
SPEAKER_00: This causes the market to correct itself eventually, maybe with a sudden dip in price, ultimately forcing valuations back to more reasonable levels.
16:43
SPEAKER_00: This balancing act is essential to maintain a healthy market where prices reflect the actual fundamentals of a business rather than speculation.
16:55
SPEAKER_00: The lesson here: feedback loops are powerful and can either amplify or balance in either direction.
17:03
SPEAKER_00: Alright, that was a pretty long one, but I think it's important.
17:08
SPEAKER_00: Number 4, another mental model is regression to the mean.
17:12
SPEAKER_00: I like to call it the killer of hype.
17:15
SPEAKER_00: The origin of this idea goes all the way back to the early 19th century, specifically to Sir Francis Galton, a British scientist who noticed a fascinating pattern in statistics.
17:29
SPEAKER_00: He observed that extreme events tend to be followed by more moderate ones, and over time things tend to balance out.
17:39
SPEAKER_00: One of the most famous examples of regression to the mean in nature comes from Charles Darwin's observations of the Galapagos Islands during his voyage on the Beagle in the 1830s.
17:52
SPEAKER_00: There were these birds, and these birds, which live on the Galapagos Islands, come in different shapes and sizes, with variations in their beaks.
18:02
SPEAKER_00: The variation in beak size was actually linked to the availability of food on the islands, especially the type of seeds they ate.
18:13
SPEAKER_00: When Darwin first observed the finches, he noted that the birds with larger beaks were better equipped to handle tough, hard seeds, while birds with smaller beaks were better at eating softer seeds.
18:28
SPEAKER_00: This was an example of natural selection at work.
18:32
SPEAKER_00: Birds with beaks suited to their food sources were more likely to survive and reproduce.
18:38
SPEAKER_00: Makes sense, right?
18:40
SPEAKER_00: But here's where regression to the mean comes in.
18:43
SPEAKER_00: During times of drought, when food sources like seeds became scarcer, the birds with the largest beaks had a temporary advantage because they could crack open the tougher seeds.
18:57
SPEAKER_00: Over time, this led to a population of finches with larger beaks.
19:02
SPEAKER_00: However, after a few years, when the drought ended and rainfall returned to normal levels, the types of seeds available also changed, and the population of finches began to regress to the previous, more average beak size.
19:19
SPEAKER_00: The next generation of finches showed a more typical distribution of beak sizes as smaller beaked finches became better suited to the new types of seeds available.
19:30
SPEAKER_00: In this case, the extreme beak size, whether that's large or small, had given certain finches an advantage or disadvantage during specific conditions.
19:42
SPEAKER_00: When conditions returned to normal, the bird population as a whole began to regress towards the mean.
19:49
SPEAKER_00: This is an example of how nature, through evolution, tends to balance things out over time.
19:54
SPEAKER_00: But this pattern is everywhere in life, whether that's in the weather, moods, or even in success rates in businesses and projects.
20:04
SPEAKER_00: If you have an extraordinary streak, don't assume it will last forever.
20:09
SPEAKER_00: Eventually you'll come back to the average, whether you like it or not.
20:15
SPEAKER_00: The beauty of this mental model is in understanding how extremes, whether that's to the downside or to the upside, can be exciting, are often temporary.
20:25
SPEAKER_00: Warren Buffett often uses this model to remind investors that hot stocks don't stay hot forever.
20:32
SPEAKER_00: If a stock has been consistently outperforming the market, there is a huge chance that it will eventually fall back down.
20:41
SPEAKER_00: It's just how the world works.
20:44
SPEAKER_00: The outliers are fascinating, but they're rarely sustainable.
20:49
SPEAKER_00: The lesson here is extremes rarely last, things tend to return to the average.
20:56
SPEAKER_00: Alright, the last mental model for today is the well-known Circle of Competence.
21:02
SPEAKER_00: Many of you probably know this one either through Books or Warren Buffett, but the concept of knowing your limits is much more ancient.
21:11
SPEAKER_00: It actually stems back from Greek mythology.
21:15
SPEAKER_00: Take the story of Odysseus and Homer's Odyssey.
21:19
SPEAKER_00: When Odysseus and his men approach the island of the sirens, they are warned about the dangers of their seductive song.
21:26
SPEAKER_00: The sirens lure sailors into dangerous waters, leading to shipwrecks.
21:33
SPEAKER_00: So, what does Odysseus do?
21:35
SPEAKER_00: He knows he can't resist their call.
21:38
SPEAKER_00: So he has his crew block their ears with beewax.
21:42
SPEAKER_00: And he himself, bound to the mast of the ship, gives the order to keep going, no matter how tempting the song becomes.
21:51
SPEAKER_00: In this myth or story, whatever you want to call it, Odyssey's circle of competence wasn't about defeating the sirens, it was about recognizing that he couldn't outsmart their allure and choosing to safeguard himself in a way that allowed him to proceed without falling victim.
22:09
SPEAKER_00: He worked within his limitations.
22:12
SPEAKER_00: This is one of Warren Buffett's golden rules, and he says, and I quote, the key to investing is to know what you know, and more importantly, know what you don't know.
22:23
SPEAKER_00: This is his version of a mental model called the, well you guessed it, circle of competence.
22:31
SPEAKER_00: And the idea is very simple.
22:33
SPEAKER_00: Invest only in businesses you can understand deeply.
22:38
SPEAKER_00: If you don't know how a business works or you can't explain why it will be profitable in the long run, don't invest in it.
22:46
SPEAKER_00: This doesn't mean you have to know everything.
22:49
SPEAKER_00: It means knowing what's outside your expertise and avoiding it.
22:54
SPEAKER_00: In life, the circle of competence is about acknowledging your strengths and weaknesses.
23:00
SPEAKER_00: And that's difficult.
23:02
SPEAKER_00: Whether you're tackling a project, learning a new skill, or making decisions in, I don't know, relationships, knowing where your competence lies keeps you grounded.
23:14
SPEAKER_00: It prevents overconfidence from leading to poor decisions and reminds you that sometimes the best move is to ask for help or lean on experts.
23:25
SPEAKER_00: Just as Odysseus didn't pretend he could defeat the sirens, we can all benefit from stepping back when the situation calls for expertise beyond our reach.
23:36
SPEAKER_00: It's not a sign of weakness, it's a sign of wisdom.
23:40
SPEAKER_00: The beauty of this model is that it keeps you focused and helps you avoid costly mistakes.
23:46
SPEAKER_00: Buffett is famous for sticking to industries and businesses he knows inside and out, whether that's insurance, consumer products or railroads.
23:57
SPEAKER_00: By staying within his circle, he's been able to make a fortune.
24:02
SPEAKER_00: The lesson here is recognize your limits and know what you don't know.
24:07
SPEAKER_00: These models are so much more than abstract concepts.
24:12
SPEAKER_00: Whether we're talking about investing, personal decisions or even broader societal trends, by understanding these models, we can make better, more informed choices.
24:23
SPEAKER_00: They help us see things more clearly, avoid unnecessary risks, and ultimately make smarter decisions.
24:32
SPEAKER_00: Mental models won't make you perfect, they won't make me perfect, they won't give you the next hot company, but they'll help you avoid the dumb mistakes.
24:41
SPEAKER_00: And investing, not losing, is half the battle.
24:45
SPEAKER_00: Don't try to be the smartest in the room, try to be the most prepared.
24:50
SPEAKER_00: And to end on a simple note, I like to call triple R read, reflect, and revisit your mistakes.
24:58
SPEAKER_00: That's it for today.
24:59
SPEAKER_00: Until next time, stay curious, keep learning, and happy investing.