Buffett, along with his right hand adviser Charlie Munger, have made many great investment decisions. All the while, making very few mistakes.
Decisions for Buffett and Munger are put through a series of mental models or analytical frameworks developed from different fields. Through these frameworks they examine if the decision being made is rational or irrational.
In the book, Seeking Wisdom: From Darwin to Munger, 3rd Edition, author Peter Belevin reveals 28 mental models. In 14 of the 28, I saw a clear relationship between the mental model and reasons why people make bad financial choices.
By understanding these mental models, and therefore Warren Buffett’s investing strategy, you can begin to eliminate or minimize your mistakes.
This post explains the 14 mental models, and most importantly, shows you how to apply these mental models to copy Warren Buffett’s investing strategy.
(This post took me around 15 hours to write. I’ve never learned more, while researching a post. If you learned anything new, do you mind taking a second to tweet, stumble, or share this post on Facebook? Thanks!)
# 1 – Mere Association
Definition: “We automatically feel pleasure or pain when we connect with a stimulus – a thing situation or individual – with an experience we’ve had in the past or with value or preferences we are born with… We move towards stimuli we associate with pleasure and away from those we associate with pain”
How to apply it: If you’re looking to get rid of a behavior, such as overspending, associate that behavior with a negative emotion. One idea — every time you overspend, look at pictures of your dream house. Followed by, looking at pictures of houses you’ll have to live in if you continue your current habits.
Another idea is to write out your bucket list. A list of things you really want to accomplish in your lifetime. Next, imagine your closest friends and family doing what you’ve always wanted to do, while you sit at home.
If you do happen to take an action that gets you closer to your goals, imagine yourself living in your dream home or experiencing something on your bucket list. This will help to associate action, with pleasure.
# 2 – Reward and Punishment
Definition: “We do what is rewarding and avoid what we are punished for.”
How to apply it: Reward yourself for achieving your goals. Penalize yourself for bad behavior.
Say your goal was to save $500 last month, which you achieved. Take $50 or $100 and reward yourself. Go out to a nice dinner. Buy some decent seats for a concert. Play at the nice golf course. Hire someone to take care of your lawn, laundry, or clean your home.
In contrast, penalize yourself for poor behavior. It’s important that the penalty outweighs the potential reward. Therefore, if you set a goal to save $500 and were unable to do so, make sure the penalty is worse than the potential reward of a guilt free $100 spending spree…i.e. promise a friend that if you aren’t able to save $500 this month you’ll carry his golf bag for 18 holes or do his laundry for 30 days,
You’re more likely to take action, if your life will change for the worse if you fail.
# 3 – Self Interest and Incentives
Definition: “People do what they perceive is in their best interest and are biased by incentives.”
How to apply it: Hold yourself publicly accountable for your goals by sharing them with your family and friends.
- Tweet or share your goal updates on Facebook
- Set up a free blog on WordPress and send an email to your friends about the site
- Sign up for an account at Stickk
- Send an email out to a few close friends announcing your plans to change
The idea is to let your friends and family in on your dreams. No man enjoys the embarrassment of public failure.
Also, never trust anyone’s judgement who benefits from your decision. More times than not, they have their own self-interests in mind, not yours.
A great tip is to call a friend or family member, whose financial values you respect and want to model, before making a purchase that involves a commission (house, life insurance, investments).
# 4 – Self Serving Tendencies and Optimism
Definition: “We see ourselves as unique and special and we have an optimistic view of ourselves and our families.”
How to apply it: The majority of drivers, think they’re better than average. A recent study by AA Motor Insurance revealed that 86% of men between the ages of 17 and 24 think they’re excellent drivers.
The same can be said about investing. Most people believe they’re better than average, despite the evidence showing only a handful of people have achieved a better than market return, including taxes and expenses, over their entire investment careers.
In a study that ended in 2009, Dalbar Inc, found that the average stock investor earned 3,17% over the previous 20 years. During that time, the market returned 8.2%.
Ironically, by putting your money in a stock market index fund and doing nothing for 20 years, you’re above average.
When making financial decision, know the facts. Look for how many people actually beat the market by investing in individual stocks.
One last thing, humans tend to remember their successes more than their failures. Your friend is going to tell you about how he managed to invest in Apple just at the right time. What he will “forget” to mention is the 8 other stocks he bought that failed miserably.
# 5 – Self-Deception and Denial
Definition: “Distortion of reality to reduce pain or increase pleasure. Includes wishful thinking.”
How to apply it: Ask yourself is, “If I continue my current habits, how can I honestly expect my life to turn out.”
Next, find someone who knows your current habits and ask them how they honestly feel your life will turn out based on your past behavior.
The truth may hurt but it’s better than denial.
# 6 – Consistency
Definition: “Being consistent with our prior commitments and ideas even when acting against our best interest or in the face of disconfirming evidence.”
How to apply it: I was lucky enough to have a few shares of stock passed onto me from my Grandpa. At the time he passed, the stock was worth around $20. I sold it two months ago for $3 a share.
For three years, I watched the stock go down. Always attempting to convince myself that it would soon go back up.
One day, I finally asked, “Would I invest in this stock, today?” The answer, OF COURSE NOT!
I sold the stock that instant.
The decision to sell went against my beliefs of who I was.. After all, I’m a CERTIFIED FINANCIAL PLANNER®, I don’t make bad investments, I’m great with my money, right?
That’s why it was so hard to do, even though it was the right decision.
The best way to avoid this is by asking for advice. Seek someone who is knowledgeable and wasn’t committed to the earlier decision. Ask them what they would do if they were in your situation.
# 7 – Deprival Syndrome
Definition: “Strongly reacting (including desiring and valuing more) when something we like and have (or almost have) is (or threatens to be) taken away or “lost.”
How to apply it: Successful real estate agents will take you through each room engaging your imagination. They will talk about how your bed could go here, how you can host parties here, and your office can be there. All of a sudden, you feel ownership of that apartment or house.
Now come the negotiations. Unfortunately, you do what it takes to meet the asking price. The pain from losing what you believed was yours, is a lot less than meeting their asking price.
The question to ask yourself when you find yourself in any negotiation situation is, “Do I want this for emotional or rational reasons?”
# 8 – Status Quo and Do-Nothing Syndrome
Definition:”Keeping things the way they are. Includes minimizing effort and a preference for default options.”
How to apply it: Humans are lazy. We enjoy keeping things the same. Even though it may not be the right decision, we perceive it easier to stay with our average job rather than seeking out a better one. We prefer to buy and spend our time on the same stuff, rather than seeking something different that could be better.
Overall, we have a very short-term view of life.
This is a problem.
We eat the same foods, rather than change to a healthy diet. Twenty years from now, this choice can mean life or death. For now, it means an upset stomach.
The best way to avoid this is to listen. Listen to the advice and regrets of others.
I’m 26 years old and married with no kids. The often repeated regrets of people older than me are:
- I wish I started to save earlier
- I wish I traveled more before I had kids
- I wish I moved down to the city when I was your age (I’m from suburbs of Chicago but now plan to move to Chicago)
Next time you in conversation with someone older than you, ask them what regrets they have. Remember, the cost of doing nothing, is often greater than the cost of taking action.
# 9 – Impatience
Definition: “Valuing the present more highly than the future”
How to apply it: It’s hard to do what’s best for our future. This behavior repeated, makes our future a lot worse and our present only slightly better.
Not a great trade.
When making a decision, consider both short and long-term consequences. Compare the present good/bad against the future good/bad. More often than not, a small amount of short-term suffering, leads to a lot of long-term pleasure.
A very good trade.
# 10 – Envy and Jealousy
Definition: “We evaluate our situation by comparing what we have to what others have.”
How to apply it: I’m often asked, “How much should someone have saved by the time their 28?” Or, what should by net worth be at the age of 32?”
My answer to both, which always seems to frustrate whoever is asking, “A little bit more than last month.”
If you attempt to make each day, week, month, or year a little bit better than the last, that’s success. Success isn’t having a top 5% net worth of your age group.
The key to getting rid of envy of jealously is to stop comparing yourself to others. Instead, compare your past self to your present self.
# 11 – Contrast Comparison
Definition: “Judging and perceiving the absolute magnitude of something not by itself but based only on its different to something else presented closely in time or space to some earlier adaption level.”
How to apply it: After you buy a $600 suit, $150 shoes that match seem cheap. After you buying a $45,000 car, a $1,500 sound systems looks like a bargain.
When evaluating a purchase, make sure to break out the purchase into different categories.
Would you buy a $1,500 sound system for your car a month from now, if you paid separately? If the answer is no, then it makes no sense to spend the $1,500 today.
# 12 – Anchoring
Definition: “Overweighing certain initial information as a reference point for future decisions.”
How to apply it: Anchoring is another reason for my mistake of holding on to my stock. Since the price was $20 initially, I had in my mind that the stock would one day return to $20.
However, if I was looking for a stock to invest in today I wouldn’t put my money in this company.
It’s a good habit to look at some of your past financial decisions and ask yourself, “”If I had not made this decision, knowing what I now know, would I make it today?”
If not, it’s time to change course.
# 13 – Vividness and Recency
Definition: “Over-influence by vivid or the most recent information”
How to apply it: If you’re a long-term investor, don’t watch investment news. You’ll tend to make decisions of what you just saw.
The same goes for reading.
Knowing that you can trade all of your investments in less than two minutes, it’s extremely dangerous to surround yourself with negative news.
If you enjoy knowing what’s going on, stick to an unbiased source that presents facts and doesn’t state opinions.
# 14 – Reciprocation
Definition: “Repaying in kind what others have done for or to use like favors, concessions, information and attitudes.”
How to apply it: It’s natural for us to not want to feel in debt. Marketers understand this. They give you a free sample and then ask for an order. They throw in something for free at the last second. All this causes us to buy things we may not need or at too high of a price.
Be careful and conscious when you receive something for free.
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Photo by: Art Comments