A mental model is an explanation of a thought process about how something works in the real world. Mental models help shape our behaviour and define our approach to solving problems (akin to a personal algorithm) and carrying out tasks. Mental models have been studied by cognitive scientists as part of efforts to understand how humans know, perceive, make decisions, and construct behavior in a variety of environments. Charles Munger provides a concept of “Elementary, Worldly Wisdom” which consists of a set of mental models framed as a solving problems of business, finance and investing. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.
Common Biases and anomalies
1. The phenomenon called survivorship bias
“Suppose we invest $250 in each of four stocks. The first stock earns 50 percent, the second stock earns 20 percent, the third stock earns 10 percent, and the fourth stock goes bankrupt mid-year. We end the year with $950 ($375 + $300 + $275 + $0), or a loss of 5 percent on our $1,000 investment. Survivorship bias occurs when one calculates the returns on this group of investments using only the survivors at the end of the year, which in this case are the first three stocks. The survivors returned over 26 percent, much more impressive than a five percent loss. Survivorship bias is a virus that can infect indexes and the composition of mutual fund peer groups, but not just that.”
– Source: plansponsor.com
It has been observed that racetrack bettors tend to shift their bets to riskier prospects as “these bettors really prefer ongshots because a small longshot bet can gererate a large enough profit to cover their earlier losses, enabling them to break even”. What the “the-end-of-the-day-effect” (tells us is that people use reference points in decisions that they make under uncertainty which goes against the expected utility theory (that assumes that people make rational choices).
Articles on Behavioral Economics as a Mental Model for Investing
Behavioral Economics Nuggets on Sportgamma
“Prospect Theory: An Analysis of Decision under Risk” by Daniel Kahneman and Amos Tversky, Econometrica, Vol. 47, No. 2. (Mar., 1979), pp. 263-292.
“Hidden Flaws in Strategy” by Charles Roxburgh, The McKinsey Quarterly, 2003, number 2
“Consumer behavioural biases in competition: A survey” by Steffen Huck and Jidong Zhou (2011) Munich Personal RePEc Archive
“Prospect theory and Asset Prices” by Nicholas Barberis and Ming Huang (2001)
“Choice Architecture” by Richard Thaler, Cass R. Sustein and John P. Balz (2010)