Mental Models For Wall Street By JB Marwood. All Rights Reserved. Copyright © JB Marwood.

This course, ebook and information contains copyrighted material, trademarks, and other proprietary
information. You may not modify, publish, transmit, participate in the transfer or sale of, create derivative
works of, on in any way exploit, in whole or in part, any Proprietary or other Material.
JBMarwood.com
Mental Models For
Wall Street

JB Marwood
Hello and welcome to Mental Models For Wall Street.

On this course we are going to investigate a number of mental models and specifically
how they relate to investing, trading and business.

Introduction

But what is a mental model?

Well, a mental model, in it’s simplest form is an idea that helps us understand how the
world works.

Having a large array of these models at our fingertips gives us great tools we can use to
solve problems and navigate life.

I first learnt about mental models from reading about Charlie Munger, who is Warren
Buffett’s business partner, and who Bill Gates called “the broadest thinker he’s ever
encountered.”

According to Charlie Munger, it’s important to have a ‘latticework of mental models’

with which to hang your ideas and experience.

The world is complicated so you can’t rely on just remembering facts, you need to have
multiple models from all different disciplines in your head.

Our Mentors

We’re going to be talking a lot about Charlie Munger on this course since he’s regarded
as the guy who popularised the use of mental models.

And we’re going to be talking about some other great thinkers as well.

Daniel Kahnemann features heavily - as a result of his work in psychology and

behavioural finance, alongside Amos Tversky.

And we will also be referring to figures such as Richard Feynman the Physicist, Warren
Buffett the legendary investor and his early mentor Benjamin Graham.
Their insights will help us to understand the most important mental models and how we
can apply them to the business world, especially in the realm of trading and investing.

Finally, I’d like to also give a shout out to the Farnam Street Blog and also Peter Bevlin’s
book Seeking Wisdom which both helped in the making of this course.

The focus

Ask any of these experts and I’m sure they would say that the acquisition of knowledge
is an essential component to success.

It’s said, for example, that Warren Buffett used to read upwards of 600 pages a day.

But even though there is so much to learn, there are shortcuts we can take.

By studying the big ideas from the big disciplines. Disciplines like psychology,
economics, maths, physics and engineering we can go a long way in a short amount of
time.

And that’s the whole concept behind Mental Models.

To be sure, there are at least 90 models out there and learning them all would take a
very long time.

On this course, we will look at the most important mental models as related to financial
trading and we will learn some useful information along the way.

So let’s begin.
The Scientific Method

Better knowledge can and does change the world but what is the best way to find truth?

The best answer we have is the scientific method, which refers to a process of thought
based on integrating previous knowledge, observing, measuring, and logical reasoning.

Physicist Richard Feynman says that we need to be scientific in our research.

He also said that it is not unscientific to take a guess. The key is to run experiments to
prove whether your guess is right or wrong.

Implications For Trading And Investing:

So what are the implications for trading and investing?

Well, by being scientific - by running statistical tests and experiments - we can challenge
our guesses so that we are not clutching at straws and not basing our investment
decisions on unknowns.

We've all read books and articles that make interesting and sometimes outrageous
claims.

'Do this and you'll make a 20% return. This strategy works 70% of the time.'

But we can never know if these claims are true without running experiments and finding
out for ourselves.

Conducting historical analysis, running back-tests and keeping a decision journal, where
you collate data as you go along, are useful ways to do this.
Availability Bias

The next mental model we are going to talk about is called the availability bias.

This is a bias that stems from our inability to remember historical events accurately, it
says that:

1. We often misjudge the frequency and magnitude of events that have happened
more recently.
2. This happens, in part, because of our limitations on memory.
3. We remember things better when they arrive in a vivid narrative.

Example

For example, a person whose home has fallen in value and is struggling to find a job is
less likely to see or feel an economic recovery even when the data show signs that a
recovery is taking place.

Conversely, someone who just landed a great job with an impressive salary, they are
going to be more inclined to see that as proof the economy is recovering.

This concept is also a great example of what Danny Kahnemann calls “What You See Is
All There Is.”

This is the notion that we quickly form impressions and judgments based on the
information that is available to us. For instance, we form impressions about people
within a few seconds of meeting them.

Overall, the availability bias tells us that it takes a lot more mental effort to remember
things that do not come with a vivid story attached and this has huge implications to
financial trading and investing.

For example:

● A vivid memory of a financial crash or bubble might cause you to overestimate

the probability of another one happening in the near future.
 ● Excessive media coverage and sensationalist journalism might cause you to
assign the wrong probabilities to future events.
● Only remembering your winning trades might cause you to overestimate your
own trading ability.
● Only remembering your last few trades might cause you to misjudge the true
performance of your trading strategy. (This might cause you to discard or
embrace a trading strategy too early).

A form of the bias can also occur any time you look at a stock chart where you might
make a quick knee-jerk judgement based on flimsy chart patterns.

Here are some potential solutions to overcoming the availability bias:

- First Savvy investors must understand the limitations on memory and see the
difference between research and reaction.
- It is often better to choose unpopular vs. popular methods since popular methods
will be based on common mistakes and biases.
- Historical analysis and keeping a trading journal will give you the statistics
related to your own trading and investing. Studying this information will give you
real insights and this will allow you to trade scientifically without being
influenced by availability bias.

For example, if you have the data available for all of your trades, you will be in a better
position to analyse which trades are working and whether your newly adopted strategy
is really any better than your old one.
Misconceptions Of Chance

Similar to the availability bias, Daniel Kahnemann termed the phrase 'misconceptions of
chance' to describe our inability to assign correct probabilities to independent events.

According to Peter Bevlin, the author of Seeking Wisdom:

“We tend to believe that the probability of an independent event is lowered when it has
happened recently or that the probability is increased when it hasn’t happened
recently.”

This thinking can cause errors. In fact, the problem with this view is that nature doesn’t
have any sense of fairness or memory.

If we believe that independent events influence or have predictive power to future

events we are simply fooling ourselves.

Chance events, when combined with positive or negative reinforcement can be even
more dangerous because we can become over confident as a result of chance events that
went our way and overly pessimistic or risk-averse when chance events go bad.

It is easy to see this problem in financial trading:

For example, Have you ever thought to yourself or heard anyone say something like:

● Stocks have gone up for 10 straight days now, they will surely go down tomorrow.

This, could easily be a problem of miscalculating probabilities.

Essentially, this is similar to playing roulette. After hitting red 10 times in a row your
instinct says that black should be round the corner. But the probabilities are no different
than if we’d just seen 5 reds and 5 blacks.

And what’s more, if we were able to correctly predict such an event, we would likely
experience positive reinforcement and become over-confident in our ability.

Implication:
The implication is that it is crucial to understand if you are dealing with an independent
or dependent event.

If you cannot work out how to lose in a situation, then you are likely dealing with a
chance, independent event. And that's going to be hard to beat.

Historical research and keeping an investment journal will give you statistics related to
your trading.

Studying this information will give you real insights into the influence of randomness
and luck. Don’t make the mistake of playing a game you can’t possibly win.
Law Of Small Numbers

The law of small numbers relates to the impact randomness can have on individual
experiments and small samples of data.

As a sample size grows, the mean gets closer to the average of the whole population and
it reveals that:

1. Small data sets are more vulnerable to randomness and can be misleading.
2. Larger data sets more accurately reflect the truth.

For example, let’s imagine you poll 10 people on the street and 8 out of 10 said that pizza
was their favourite food. From this analysis, you might extrapolate that 80% of people
have pizza as their favourite food.

However, if you polled many more people, 1000 people for example, you will probably
find a much smaller percentage, perhaps only 2% or 5% or 10%.

This concept is also pertinent in the finance world.

For example, a fund manager might become a celebrated figure after recording five
winning years in a row for his investors.

However, five years may not be enough time to distinguish whether the success is due
to luck or talent. Particularly if the fund manager had only made a small number of
investments.

Furthermore, in an industry of thousands of financial managers, it's highly likely that at

least one will record a sequence of five winning years.

We tend to forget about all the fund managers who performed poorly and only
remember the ones who have performed well, a form of survivorship-bias.

Other Examples In Trading Include:

 ● A trading system that has a 90% win rate. The system looks great on paper but
those results are based on a sample of only 10 trades. Over 1000 trades, the
trading system might be a loser overall.

Solution:

Scientific analysis can give you the statistics related to your trading and the more data
you have the more accurate your findings and analysis will be.

Let's say you backtest a trading system that returns 20% per annum but only trades two
or three times a year. In this case you have a small sample size and you have to be
careful that the results do not suffer from the problem of small numbers.

The more data points you have available the more accurately you will be able to define
probabilities and come to conclusions.
The Black Swan

The law of small numbers states that the more data you have, the more accurate your
analysis will be. This is because you reduce the impact of aberrations and anomalies/
large outsiders in your results.

However, in parallel to the law of small numbers we also need to remember the black
swan idea from Nassim Taleb and specifically, the case of the Christmas turkey.

The black swan idea proposes that randomness cannot always be quantified or
accounted for. It is often only seen in hindsight.

The case of the Christmas turkey shows how large data samples are not everything and
that proper risk management must try to consider the possibility of unforeseen events.

As Nassim Taleb wrote in his book The Black Swan:

“Consider a turkey that is fed every day for 1000 days. Every single feeding will firm up
the bird’s belief that it is the general rule of life to be fed every day by friendly members
of the human race looking out for its best interests. On the afternoon of the Wednesday
before Thanksgiving, something ​unexpected will happen to the turkey. It will incur a
revision of belief."

Solution:

The Black Swan presents a dangerous problem for risk management because it suggests
many risky events are not predictable. Even if you have very large data sets you will
occasionally get a black swan event.

And here have been many examples of the Black Swan on Wall Street such as the 2010
flash crash, the 1987 crash, or the blow up of the hedge fund Long Term Capital
Management.

The solution to the black swan problem is to run experiments to analyse worst-case
scenarios and to actually try and take advantage of the black swan.
For example, by profiting from increases in tail risk. By making money from increases in
volatility, instead of the other way around.
Hindsight Bias

Hindsight bias occurs when we look back in time and see events as more predictable
than they were at the time a decision was made.

This is an obvious bias that has particular relevance to financial trading where
predictions are made on a regular basis.

In the short-term, hindsight bias can be comforting because it allows us to believe that
our judgement is better than it really is.

This could be why the bias exists in the first place.

We pretend that something was surely knowable and that helps us form criticisms about
decisions made by others. And It allows us to form a better narrative about the world.

However, that narrative is often flawed by the hindsight bias itself, since hindsight bias
causes us to see things through a distorted lens.

We become less accountable to our own actions, anchored to certain beliefs and
over-confident in our own abilities.

Here are some Examples In Trading And Finance:

● I knew the stock market was going to crash. The way the markets were acting last
week it was obvious.
● I should have bought that stock. I knew it was going up.
● I knew the Federal Reserve would screw up the economy. They should never have
raised rates.

Solution:

The best way to guard against hindsight bias is to first know that it exists, in all of us.
And that we need to be aware of it whenever making a prediction.

As a practical way of overcoming hindsight bias it’s important to have the discipline to
make explicit predictions which can then be reviewed at a later date.
By using a decision journal to record predictions and forecasts you can look back later to
see what factors affected your decision making.

By documenting the reasons you made a forecast you become better able to see what you
got right and what factors led you astray in your prediction. And then you can work to
overcome your weaknesses.

Perhaps you didn’t lean enough about the topic, or the history involved, or maybe you
got all your information from one source.

Whatever it is, documenting your process helps you to examine the causes and effects of
hindsight bias.

This process ties in well with scientific prediction methods and Bayes Theorem (which
we will talk about later and is a crucial part of better forecasting).
Bayes Theorem

Bayes Theorem was developed by 18th century mathematician and Minister Thomas
Bayes and describes the way we learn about the world; by studying and refining our
beliefs and behaviours as we gain more information.

This is a useful mental model that we can use to make better predictions and to improve
our processes. It’s a popular approach in science that can cater for both the simple and
the complex.

The Bayesian approach can be applied to probability like so: take the odds of something
happening, then adjust for new information.

This is most useful in the cases where you have strong prior knowledge.

If your initial probability is a long way off, the Bayesian approach is much less helpful.

One way you might start is to ask yourself the following question: What needs to happen
for my prediction to come true?

By asking this question, you can gather the most important information that you need to
make a prediction and then ignore less relevant information.

You can start by coming up with a plausible probability range or base rate.

For example, you might say something like “based on the information I have available I
am 95% confident that the probability is between 20-40 per cent”.

Or you might say “well, the betting markets suggest a probability of 30% so I will use
that as my base rate for now”.

You can use these probability values as your base and then use Bayes Theorem to
further improve your accuracy.

Here are some Examples Of how you might apply Bayes Theorem In
Trading:
 ● The probability of the Federal Reserve raising interest rates this month is shown
in the bond markets as 50%. Janet Yellen just said that inflation has increased
more than expected. The probability of a rate hike must now be slightly higher so
you can adjust your odds accordingly.
● The recent data shows that my trading strategy performs better on small cap
stocks and this is from a large enough sample size. Now I have that information I
can adapt my strategy to focus on smaller sized companies.
● A new poll shows that Donald Trump in the lead to be President. I must change
my odds to reflect that new information.

Solutions:

Analysing statistics and keeping abreast of new developments can give you the data you
need to implement Bayes Theorem.

Start by asking what must happen for something to be true and consider relevant base
rates.

Come up with a probability that enriches the base rate and which you believe best
reflects the information you have available. Then use new information to continually
adjust your odds.

Finally, keep track of your predictions so that you can assess whether your Bayesian
process is having the right effect. If it is not, you may have to look at the way you are
constructing your arguments.

Lastly, why not take a Bayesian approach to investing process too? As you gain more
information on what is working you can incorporate that into your approach.
Anchoring

Psychologists have found that when people make quantitative predictions, their
predictions are often heavily influenced by previous values that they may have seen or
may remember.

In one famous example, Danny Kahnemann and his colleague Amos Tversky asked
people to estimate how many African countries were part of the United Nations, but
before they did so, they spun a wheel of fortune.

The wheel was painted with numbers from 0 to 100, but rigged to always land on 10 or
65. When the arrow stopped, they asked the person in the experiment to say if they
believed the percentage of countries was higher or lower than the number on the wheel.

Then, they asked people to estimate what they thought was the actual percentage.

They found that people who landed on 10 in the first half of the experiment guessed that
around 25 percent of Africa was part of the U.N. Those who landed on 65 said around 45
percent.

The subjects had been locked in place by a psychological phenomenon known as

anchoring. Their decisions had been affected by the spinning wheel.

The trick here is that no one really knew the true answer so they had to guess.

The wheel was just a random number generator, but it produced a concrete value with
which to work from. When they adjusted their estimates, they couldn’t avoid the anchor.

Interestingly, the anchoring effect has been shown to apply to experts just as much as to
non-experts and as shown it can cause a quite drastic over-reliance on irrelevant
information.

One reason given for the anchoring effect is that, given a difficult question, the human
brain likes to latch onto any information that is available in order to lighten it's cognitive
load. The brain has limited capacity thus it seeks out easier solutions before complex
ones.
The problem, is that available information is not always relevant to the task at hand and
can often be misleading. As we saw in the experiment.

The anchoring effect is also quite applicable to financial markets whereby financial
traders often anchor their predictions about an investment based on where it has traded
in the past.

And a very good example of this is when a stock investor becomes anchored to the price
that they bought in at.

An anchored investor might say something like:

● I need this stock to come back to my purchase price before I will think about
selling.
● This stock is cheap. It used to be worth $50 and now it's only $10.
● This stock loves the $25 level. It will surely go back there at some point.
● “A report last year said this stock is worth $100, it must be worth something like
that amount now.”

So How To Overcome Anchoring? Here are some solutions:

Firstly, absolute, historical values are, in general, not very useful for trading, and your
purchase price should have no bearing on your decision to sell.

You should be focussed on more important considerations instead.

However, some anchors can be helpful if they allow traders to deal with complexity and
information overload.

If a large number of market participants are anchored on a certain level that can
sometimes be used to implement a trading strategy.

However, this should be balanced by the fact that some traders (such as insiders, value
investors or news traders) may pay little attention to historical values.

Overall, traders can benefit most from the anchoring bias by identifying when an anchor
exists, why it might exist, and how to take advantage of it.
Regression To The Mean

Regression to the mean refers to a concept where extreme outcomes are often followed
by moderate ones. This can occur in any series of complex phenomena where chance is
involved.

This idea was first worked out by Sir Francis Galton and it continues to be applied and
explored to date, and it’s observable in various fields such as sports and financial
trading.

Peter Bevlin who wrote a book called Seeking Wisdom explains that”

“The concept is not necessarily a natural law. Instead, it is a statistical tendency and it
may take a long while before the reversion plays out.”

A number of other variables come into play, and a lot of the factors that we assume
remain controlled can actually be more random.

Because of that, taking regression to the mean into account when it comes to tracking
metrics or improving performance is an important concept to get your head around.

For instance, Daniel Kahneman shared in his book ​Thinking Fast and Slow how an
Israeli Air Force officer had the experience of observing worse flying performance after
giving praise to his pilots and he noticed improvements to performance after giving
negative feedback.

The implication was that negative feedback made the pilots perform better while
positive feedback made the pilots complacent.

However, Kahneman found that this is simply a fallacy based on statistical tendencies.

The change in performance typically occurs naturally as a result of mean regression,

whether or not there's feedback involved or not.

In other words, the pilots who performed badly at first were more likely to improve
while the pilots who performed well were more likely to see their performance levels
decline.
And the tendency to revert back to the average occurs in all sorts of areas.

The hot hand phenomenon in basketball, for example, where a player goes on a hot
streak of scoring baskets, was shown to be nothing more than a misreading of
randomness.

Kahneman goes further to state that whenever the correlation between two scores is
imperfect, there will be some regression to the mean.

Correlation reveals how one variable affects another, with the coefficient measured
between -1 to +1 to indicate the strength of the negative or positive correlation.

In other words, when these variables don't seem to be strongly related to one another,
the best-performers tend to get worse over time while the worst-performers seem to get
better.

In line with this definition, it can be challenging to determine whether any changes in
performance are due to regression to the mean or other factors.

Examples In Trading:

Regression to the mean is a particularly challenging concept for investors.

On one hand, a market that is heavily extended is liable to pull back towards its average
over time. However, it may not do so if the move is a result of other underlying factors.

Also, in another example, a trader could be forgiven for thinking a series of winning
trades is down to his improved skill. But it could also be due to luck and his results may
soon fall back towards the average.

Likewise, traders may find a strategy that is shown to outperform the market over
several years. But again, those results may be due to chance.

Often, that particular strategy goes on to significantly underperform in the years ahead,
a clear case of regression to the mean.

Solutions:
For scientists, a control group can serve as a benchmark for measuring performance to
gauge which changes are producing results.

For investors, a trading journal or spreadsheet that keeps track of your key statistics can
serve as a reliable control group or benchmark in the same way.

Regression to the mean in the context of trading performance reminds of the

importance of longevity instead of focusing too much on one-time big wins or
short-term losses.

There’s another implication too.

Regression to the mean suggests that the amazing strategy you just found in a back-test
may go and significantly underperform in the years ahead. So, it may even be better to
bet against winning strategies rather than follow them.

There is not clear cut answer. If a market is at an extreme, like a 30-year low for
example, it may surely be a good time to take the other side, so long as there are no
major, underlying factors that could cause the market to keep trending.

The essential problem is knowing when the mean regression is likely to start. That
makes this is a complex concept that takes some deep thinking.
Aversion To Losses

Loss aversion is yet another theory credited to the prolific Daniel Kahneman and Amos
Tversky and it refers to people's preference for avoiding losses over acquiring equivalent
gains.

For example, it feels worse to lose $200 out of your wallet than it feels good to find
$200 on the street.

Some studies suggest that losses are twice as powerful, psychologically, as gains. If that
is the case, then the feeling of losing $200 is negated only by gaining double that
amount i.e $400.

It's possible too, that humans are hardwired to experience loss aversion as a survival
mechanism.

For example, for a human living near the edge of starvation, a loss of a day's food could
be disastrous and amount to their death. Whereas, for a human who is adequately food,
the acquisition of one extra day's food would only lead to extra comfort and is therefore
not as valuable.

Examples In Trading:

There are many examples of loss aversion in society and of course, it's also highly visible
in financial trading.

In finance, traders often go to great lengths to avoid having a losing trade or indeed
having a losing day or losing month.

And, losing $1000 on a stock trade always feel a lot worse than the joy of winning $1000
on a stock trade.

The problem is that this emotional response is rarely conducive to professional,

business-like investing.

Because investors hate losses so much they often end up making mistakes like holding
their losers for too long hoping that they will recover.
Likewise, investors often take their profits too early for fear of the position turning into
a loss at a later point.

In other words, they do the opposite of what is required. They cut their winners early
and they hold on to their losers.

Aversion to losses also has another negative side effect as it often leads to
chasing losses​, where traders try to win back the money they lost in order to make
their emotional self feel whole again.

This can be a particularly damaging thing to do and is a symptom of problem gambling.

The Solution

The solution to loss aversion is to recognise that losses are an inevitable part of the
investment game and to treat them the same way as you would gains, since there is no
real difference, psychologically, between losing $100 and gaining $100.

If you feel the affects of loss aversion, or the urge to chase losses, it's important to try
and disengage your emotional brain. Take a step back and start to think more rationally.
Endowment Effect

The ​endowment effect is another model that we can talk about that is particularly
relevant to investing and has close lies to the concept of loss aversion.

This theory comes straight out of psychology textbooks and behavioral economics and it
can be simply described in the following sentence:

“People ascribe more value to things merely because they own them”.

This has been illustrated in a number of social experiments where it’s been shown that
people, when given a good are reluctant to trade it for another good of similar value.

In one example, participants first given a Swiss chocolate bar were generally unwilling
to trade it for a coffee mug, whereas participants first given the coffee mug were
generally unwilling to trade it for the chocolate bar.

In another study by Kahneman, Knetsch and Thaler, it was found that participants
typically require compensation of twice the value of the thing they own before they will
consider swapping it.

According to Kahneman and his colleagues, this endowment effect occurs, at least in
part, because once a person owns an item, foregoing it feels like a loss and humans are
averse to losses.

That is, they would rather not lose something than gain something of equivalent value.

Examples In Trading:

There are clear examples of the endowment effect taking place in the stock market.

For example, it’s very common to become emotionally tied to a stock that you own,
perhaps owning it longer than you should.

This is especially true if you’ve held the stock for a very long time or if it’s been a winner
for you in the past.
The solution to this, as so often, is to take a more business-like approach to investing.

Ask yourself if you really want to hang on to this investment or would your capital be
better deployed somewhere else.

Can you calculate a more accurate value of your investment and rid yourself of the
endowment bias?
Cognitive Dissonance

Cognitive dissonance is the state of having inconsistent thoughts, beliefs, or attitudes.

These inconsistent beliefs can cause stress and lead to poor decision making.

According to one expert in cognitive dissonance, Leon Festinger:

“We hold many cognitions about the world and ourselves; when they clash, a
discrepancy is evoked, resulting in a state of tension known as cognitive dissonance. As
the experience of dissonance is unpleasant, we are motivated to reduce or eliminate it,
and achieve consonance (or agreement).”

We are said to try and reduce cognitive dissonance in three main ways:

First​, we might change our behaviour or our beliefs in order to balance out the
dissonance in our life.

For example, by taking up a new religion or or by giving up a bad habit.

Second​, we might seek out new information that contradicts the dissonant
beliefs. This can sometimes lead to a type of unhealthy rationalising.

For example, someone who drinks a lot of alcohol will face dissonance by a claim
that alcohol causes illness. Thus, the dissonant person may search out reports
that claim alcohol is good for you, or that illness claims are lacking in evidence.
They seek to ignore any information that does not support their views even if the
information is available and truthful.

Third​, we might reduce the importance of the dissonant beliefs, thus making
them not so much of a big deal in the first place.

For example, someone who smokes cigarettes may face dissonance by the fact
smoking can shorten life expectancy. The smoker might then diminish the
importance of a long life and claim it's better to anyway live a short life full of
pleasure than a long life devoid of any joy.
Cognitive dissonance can occur in all walks of life but it also has a psychological effect in
financial trading partly because there is money involved.

Whenever there is cognitive dissonance, there is bound to be indecision.

Here are some Examples In Trading:

● I know I should hold on to this stock but what if it turns into a loss?
● I know I’m supposed to wait for the perfect trade opportunity but I'm bored of
watching the screens and I’m itching to trade. Plus, I need to pay the bills with
my winnings.
● I've lost a lot of money in the markets and it’s painful, but I've learnt a lot along
the way too so maybe it was worth it.
● I know people say it’s impossible to win day trading currencies but I really want
to win and I think I can if I keep trying
● I know I have a passion for trading but what does it do for society? Is it
worthwhile pursuing?

Solution:

Cognitive dissonance can cause indecision and is the root of the psychological problems
that affect good trading.

The solution to tackling cognitive dissonance is to be very clear about your own personal
beliefs and ethics and to realise when they are being undermined.

Cognitive dissonance can easily manifest itself in self sabotage behaviour or gambling
impulses so it’s important to stay on top of your psychological self.

Knowledge, mental models and scientific experiments are the best tools to find the truth
which can then be used to resolve your dissonant beliefs or behaviours.
First Principles Thinking

First principles thinking is a way of looking at problems through a different lens. It's
about dissecting problems to their core so you can better analyse how to solve them
from the ground up.

Entrepreneur Elon Musk is a big proponent of first principles thinking and describes it
as follows:

“First principles is kind of a physics way of looking at the world. You boil things
down to the most fundamental truths and say,

“What are we sure is true?” … and then reason up from there.

Somebody could say, “Battery packs are really expensive and that’s just the way
they will always be… Historically, it has cost $600 per kilowatt hour. It’s not
going to be much better than that in the future.”

With first principles, you say, “What are the material constituents of the
batteries? What is the stock market value of the material constituents?”

It’s got cobalt, nickel, aluminum, carbon, some polymers for separation and a seal
can. Break that down on a material basis and say, “If we bought that on the
London Metal Exchange what would each of those things cost?”
It’s like $80 per kilowatt hour. So clearly you just need to think of clever ways to
take those materials and combine them into the shape of a battery cell and you
can have batteries that are much, much cheaper than anyone realizes.”

First principles thinking can be used to alter your decision making process and come to
more truthful or fundamental conclusions.

In finance, a good example might relate to company valuation.

For example, you might read a report that claims a company is worth $300 million.

To apply first principles thinking you would first ask what do you know is fundamentally
true?
You might know, for example, that the company has assets worth $100 million.

And then you might know the company has $50 million in cash. Now you have already
accounted for half of the company's reported value with just two bits of information.

Working up from these two obvious truths allows a real estimate of the valuation to
come through.

How To Apply First Principles Thinking

To apply first principles thinking it's important to first understand fundamental truths
and then reason up from there.

For investors, useful questions might include 'what do I know about a business that is
definitely true?' 'what needs to happen for my predictions to be right/wrong?' and 'what
do I need to do to achieve my financial goals?'
Margin Of Safety

First of all, this is what Warren Buffett, the world’s greatest investor has to say about
Margin of Safety:

“We believe this margin-of-safety principle, so strongly emphasized by Ben

Graham, to be the cornerstone of investment success."

Margin of safety is a term that you may have come across already in financial circles but
it actually has it's roots in engineering and quality control.

Essentially, it's a method used to reduce the chance of a process or system failing.

The best way to see margin of safety in action is with the concept of a bridge.

Imagine you’re asked to build a bridge and you calculate that the weight that it needs to
support (based on estimated traffic levels) is 10,000 tons of vehicle at any one time.

You could feasibly design a bridge that supports 10,001 tons or even 11,000 tons.

That should hold when traffic is flowing over.

But, what if the estimates are wrong? And what if something unexpected happens to the
materials or to the traffic or the bridge itself?

It's for this reason that engineers use a safety factor.

So instead of designing a bridge that supports 10,000 tons you’re going to design a
bridge that supports 30,000 or 40,000 tons.

That bridge is going to be much harder to break and for a long time will be much safer to
drive across.

Examples In Trading And Investing:

Margin of safety is also important in stock investing. So much so, that Warren Buffett
calls margin of safety the 'cornerstone of investment success'.
The idea is to work out what you think a stock may be worth and only invest if the
purchase price is significantly lower than your calculation of value.

This gives you a cushion to allow for human error, bad luck, or unpredictable volatility.

For example, it makes no sense to buy a stock for $60 that you think is only worth $62.
That only gives a very small margin of safety ( and consequently a large margin for error.

Much better to find a stock where the margin of safety is 30%, 50% or even more.

For another example, let’s say you like Apple and you calculate that Apple stock is worth
around $130 a share. And let’s say that the current market price is $111.

To achieve a 30% margin of safety, you need the stock to drop to $91 before you can
think about buying it.

For a 50% margin, you need the stock to drop to $65 a share.

So, as you can see. Even though you think the stock is currently trading below its true
intrinsic value, you’re not going to buy it until it’s on offer at a much bigger bargain.

If you can learn to apply the concept of margin of safety to all of your investment
decisions you’re going to be limiting your potential downside, limiting your risk and
giving yourself much more room for upside.
Supply And Demand

The law of supply and demand is one of the most basic economic laws thus it's a crucial
theory for traders and investors to learn about.

The premise is that the availability of a particular product and the desire (demand) for
that product affects its price.

Typically, low supply and high demand increases price while high supply and low
demand causes price to fall.

It's very easy to see this in action in the modern economy because nearly everything
around us is priced at a level intended to maximise profits.

For example, if a movie theatre cannot meet the demand for its showings it will either
put on more shows or increase the price of tickets, or both.

Likewise, you will have witnessed how a shop lowers prices on it's less desirable
products to attract more buyers.

In economics, supply and demand can get complicated because there are so many
contributing factors to take into account but a great example can be seen in the case of
crude oil.

The Case Of Oil:

Around the middle of 2014 the price of one barrel of crude oil was trading at around
$120 but by January 2016 the price had fallen to less than $40 a barrel, a fall of over
65%.

According to analysts the fall in oil was driven by a major shift in supply and demand
forces and we can summarise the main points as follows:

1. Slowing global economic growth. (This saw reduced demand).

2. Rising global oil production as a result of several years of high oil prices. (This
increased supply).
 3. Unexpected resumption of oil production in Libya, Nigeria, South Sudan and
Iraq. (Increased supply).
4. Increasing energy efficiency in terms of oil production techniques. (Increased
supply).
5. Record oil output from Russia. (Increased supply).
6. The resumption of nuclear power stations in Japan. (Reduced demand).
7. Natural gas and renewable energy sources eating away oil’s market share.
(Reduced demand).

You can see from these main points how the price of oil came to reflect supply and
demand dynamics and find a new price equilibrium at a much lower level.

Another key takeaway, though, is how prices feed back into the supply and demand
dynamic causing a cycle.

High prices generate greater profits which leads to more competitors coming in which
then leads to greater supply. Meanwhile, low prices means lower profits which leads to
fewer competitors and lower supply.

In the case of oil, it was high prices over several years that generated the increased
interest in oil and gas in remote locations such as the Arctic and East Africa.

As well, high prices allowed businesses to invest more in technology which allowed them
to become more efficient in oil production.

As the supply of oil increased and the demand for oil decreased we saw a double
whammy that caused the oil price to fall more than 60%.

The implication for investors, therefore, is to learn the supply and demand dynamic and
carefully analyse where a business or market might sit in the cycle.

Doing so can help to pick the market turns and decide where an investment strategy
should be focussed.

Of course, it’s also wise to remember the hindsight bias here as major market moves are
always more explainable when they are in the past.
Feedback Loops

Feedback loops fit nicely with some of the other models described here such as
regression to the mean, Bayes theorem and the complex adaptive system.

They occur when reactions affect themselves, and there are two types; positive feedback
loops and negative feedback loops.

A negative feedback loop is one that tends to cause a reduction or reversal often to
maintain a status quo. Meanwhile, a positive feedback loop is one that feeds on itself
and tends to enlarge or amplify changes.

A good example of a negative feedback loop is temperature regulation in the human

body.

When our core body temperature rises above a certain level, around 98.6° Fahrenheit,
sensors on our skin detect it and send signals to the brain to induce perspiration in
order to cool us down.

Conversely, when the body is too cold, we experience reduced blood flow and shivering,
in order to generate heat and raise our core temperature.

Stock market bubbles on the other hand can be thought of as positive feedback loops,
where high prices feed optimism which then feeds higher prices.

This loop doesn't last forever but it can last a long time.

A good example is the dotcom bubble where investors kept buying technology stocks
even though they were vastly over-valued.

And of course, the reverse can happen in stock market crashes where lower prices feed
into a cycle of fear and pessimism.

According to Sanjay Bakshi:

“You’re on the right track when you visualize a positive feedback loop as a
mechanism which is nested inside a negative feedback loop. To illustrate, why do
 bear markets follow bull markets? Because over the long run, markets operate
inside a negative feedback loop with built-in corrective mechanisms. When prices
run too far away from underlying values, there are forces that pull them back."

That’s certainly a good way of looking at the markets even if it does require a great deal
of skill to time trades perfectly.

Implications For Traders And Investors:

For traders and investors, it's important to recognise the two types of feedback loops. A
negative feedback loop, by design, is more associated with market reversals or
pullbacks.

And so it has great similarities to mean regression.

Whereas a positive feedback loop is associated with trends and bubbles.

The implication is to recognise which market state you are in but get ready to switch
course when the regime changes.

Importantly, another way to use feedback loops is for improving your own productivity
and performance.

For example, by keeping a decision journal, you can revisit what you did wrong and
what you did right.

Analysing your performance helps to improve your techniques and confidence and thus
helps to create your very own positive feedback loop.
Occam's Razor

Occam's razor is a mental model that can be used in many walks of life and it's
attributed to a 14th-century English philosopher and logician, William of Ockham.

The basic premise of Occam's razor is as follows:

When faced with two equally good hypotheses, always choose the simpler.

By doing so, it's possible to eliminate complexity and get rid of unnecessary elements
without compromising on functionality.

Consider the following scenario as an example:

You wake up one day to find that two big trees have been blown down in the night.

You’re offered two possible explanations:

1. The trees were blown down by a strong wind.

2. An alien spaceship came down in the night, knocked both trees down in the same
direction then left without leaving any other trace.

Clearly, scenario one is the most likely explanation here and that’s because it requires us
to make the least number of assumptions.

Scenario 1 is a fairly common event when compared to scenario 2, which requires a great
deal of imagination.

Although Occam's razor is a useful guide for many situations it does have it's limitations
and has been criticised by some for reducing complexity and therefore ignoring
important elements.

So it's important to note that Occam's razor does not imply that simpler is necessarily
always better. It is, just, simpler.

Examples In Trading:
The idea of Occam's razor is very useful for system traders especially. Or even those who
are wishing to choose a fund manager or investment vehicle.

For example, consider two trading strategies that are both shown to return an average of
10% per year with a similar level of risk and drawdown.

The first trading system is complex and made up of many moving parts, such as moving
average indicators, filters and timing signals. While the second trading system is simple
and only has a couple of key elements.

Occam's razor would suggest going with the second system. Since the second system is
less complex and probably less likely to fail. In essence, why add complexity when there
is no need to?
Complex Adaptive Systems

The idea of the complex adaptive system stems from the belief that the universe is not
linear but full of systems that are complex and constantly adapting to their
environment. Systems such as weather systems, immune systems, social systems and as
we will talk about in a second, financial markets.

A good example of a complex adaptive system is car traffic. A car by itself is not
necessarily an adaptive system, but if you put hundreds of them together on the same
road and watch them navigate towards their destinations, you can clearly see a complex
adaptive system in action.

In heavy traffic, with cars moving to different destinations at different speeds, every
driver has to continuously adapt their behaviour to other driver's actions.

This is what creates the complex, continuously adapting system.

Examples In Trading:

The stock market is another prime example of a complex adaptive system. (As are all
financial markets such as forex markets, bond markets and futures markets).

Since the stock market is made up of so many different participants, determining where
a stock might go in the short-term is not just a question of where ​you think that stock
might go. It’s also a question of where others think that stock will go, who are, of course,
thinking the same thing as you are.

So you have a system where individuals are constantly interacting with one another,
predicting and adapting their behaviour to others behaviour.

The famous British economist John Maynard Keynes said it best when he compared the
market to a type of beauty contest, here’s his quote:

“Professional investment may be likened to those newspaper competitions in

which the competitors have to pick out the six prettiest faces from a hundred
photographs, the prize being awarded to the competitor whose choice most
nearly corresponds to the average preferences of the competitors as a whole; so
 that each competitor has to pick, not those faces which he himself finds prettiest,
but those which he thinks likeliest to catch the fancy of the other competitors, all
of whom are looking at the problem from the same point of view. It is not a case
of choosing those which, to the best of one’s judgment, are really the prettiest,
nor even those which average opinion genuinely thinks the prettiest. We have
reached the third degree where we devote our intelligences to anticipating what
average opinion expects the average opinion to be. And there are some, I believe,
who practice the fourth, fifth and higher degrees."

And if you’re intrigued by this explanation make sure you also take a look at the Guess
the Number Game that the Financial Times ran in 1997.

In this game, you have to guess a number between 1 and 100 with the goal of making
your guess as close as possible to two-thirds of the average guess of all those
participating in the contest.

This game provides a very clear example of the type of higher level thinking that may be
required to win in the stock market.

The implication when faced with making financial decisions is to try and work out what
level other participants are working and how they might react to certain events.

It’s a difficult task, for sure, but it might just be the best way to make investment
decisions.
Circle Of Competence

Circle of competence is another idea that is frequently referred to by billionaire investor

Warren Buffett and it's a simple concept that says you should concentrate on areas you
know a lot about, since it is impossible to be an expert in everything.

As an example, Buffett is well known for avoiding certain sectors such as technology. He
knows what works for him and he sticks within those circles.

Buffett says this:

“You don’t have to be an expert on every company, or even many. You only have
to be able to evaluate companies within your circle of competence. The size of
that circle is not very important; knowing its boundaries, however, is vital.”

How To Stay Within Your Circle Of Competence

In investing it's very easy to stray outside of your circle of competence and get distracted
by news stories about hot stocks and industries, but you must always ask yourself, are
you working within your circle of competence?

Some businesses are easier to understand than others. For instance, a small coffee shop
business will have fewer moving parts than a large biotech company.

It's important to work out where your expertise lies and focus on those areas.

If you have a lot of experience in a certain industry then use that to your advantage and
analyse companies in that field.

Decide what your skills are and what you’re good at doing.

Above all, learn where the boundaries are and don’t get distracted by the noise and
excitement happening elsewhere.
Mr Market

Continuing with Warren Buffett and his mentor Benjamin Graham we can also now talk
briefly about Mr Market. Because Mr Market provides a very useful metaphor for
looking at the stock market as a whole.

So just who is this mysterious figure Mr Market.

It all comes from Ben Graham who said that you should view the market as a kind of
manic-depressive business partner which he called Mr Market.

Mr. Market appears daily and names a price at which you can either buy, sell, or in fact,
do neither. But according to Graham Mr Market unfortunately, has ​incurable
emotional issues.

As Warren Buffett wrote in one of his shareholder letters:

"At times Mr Market is euphoric and can only see the favourable factors affecting
a business. When in that mood, he names a very high price because he fears that
you will snap up his interest and rob him of imminent gains.

At other times he is depressed and can see nothing but trouble ahead for both the
business and the world. On these occasions he will name a very low price, since
he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored.
If his quotation is uninteresting to you today, he will be back with a new one
tomorrow."

In other words, Mr Market has different moods. Sometimes he is up and sometimes he

is down. And you get to choose when to do business with him.

Here are some examples in trading:

• Mr Market is in a particularly bad mood today. The S&P 500 is down 6%.
• Mr Market is on top of things right now. Better to wait for some bad news and get in
the market when there's a wider margin of safety.
As you can see, by viewing the stock market in Mr Market terms, you can better judge
when the market is acting in your interests, try to remember that the market is there to
serve you, not the other way around.
Fear Of Missing Out (FOMO)

Fear of missing out (FOMO) is increasingly used to describe the angst associated with
using social networks and the effect of living in our connected age.

It's described in the Oxford English Dictionary as "Anxiety that an exciting or interesting
event may currently be happening elsewhere, often aroused by posts seen on social
media".

But FOMO also has implications for financial trading where anxiety can be aroused
through the missing out on financial profit and this feeling is often exacerbated by the
abundance of financial news coverage and commentary on the web.

For instance, here are some examples of FOMO in Trading:

● I missed my entry price in Apple stock and now it's gone up $10 already. I can't
believe I missed making that trade and losing that profit.
● Everyone is making money in biotech stocks and I'm losing money in energy. I
really wish I was trading biotech like them.

Solution:

The best solution to FOMO is to ask yourself whether the anxiety felt is an accurate
reflection of reality or whether it could be a result of the many other human biases and
distortions that we’ve discussed already.

For example, if you followed your trading plan correctly and you still feel that you
missed out, you're likely suffering from cognitive dissonance.

If you secretly wish you were trading a more exciting sector, one that you don’t know
much about, then you’re violating your circle of competence.

If you missed a trade that went on to make a profit, then you may want to re-check your
processes and also consider hindsight bias.

It’s not always easy to know which model applies to which situation as everyone is
different.
But it is important to realise that careful, scientific analysis is the most sure route to
finding success and that you are the only one responsible for implementing that.

You can only improve the things under your control so take a Bayesian, feedback-based
approach to improving your results and try to ignore all the noise that has no direct
influence on your own success.
Confirmation Bias

The confirmation bias is an important one because it reveals how we often seek out
information that is based on prior judgements or beliefs.

In short, we tend to interpret new evidence as confirmation of our existing beliefs or

theories.

Confirmation bias is also linked to many other biases such as anchoring, hindsight bias,
cognitive dissonance so it can have a big impact on overall decision making.

Examples of confirmation bias might include:

1. A reporter who is writing an article on climate change but only interviews the
experts who support her own world view.
2. A heavy drinker who supports his habit by only seeking out news stories that say
alcohol is good for you.
3. Conspiracy theorists who support their claims by only looking at evidence that
support their theories.

In Trading And Investing, confirmation bias is equally prevalent:

In fact Warren Buffett said that "the human being is best at interpreting all new
information so that their prior conclusions remain intact"

There are many examples of the confirmation bias in finance, partly because we always
come into the market with pre-conceived notions.

For example, consider the investor who buys a stock simply because he likes that
company's products, paying no consideration to the share price or other fundamentals.

Or the investor who likes a stock simply because it made him money in the past.

Or the trader who only gets his news reports from one source.

Or the company analyst who has spent many hours working on a company report.
The analyst may have a biased opinion of the stock simply because of the time spent
researching it. To avoid that bias, the analyst would have to also analyse all of it's
competitors, a long and arduous task.

In general, we have a tendency to disregard information that does not sit well with our
original opinion.

We might have pre-conceived ideas that one stock is riskier than another, or that a
certain sector is never worth investing in.

And often, just looking at a stock chart can give investors a preconceived opinion about
a company.

For example, if a stock chart has been trending steadily down for a long time, it's very
hard to believe that that company could be a good business.

Conversely, if the stock chart has been steadily rising, it's very easy to say that this must
be a well-run, profitable organisation.

The Solution To Confirmation Bias:

Confirmation bias is something that has troubled many great minds over the years.

Charles Darwin used to say that whenever he ran into something that contradicted a
conclusion he cherished, he was obliged to write the new finding down within 30
minutes. Otherwise his mind would work to reject the discordant information, much as
the body rejects transplants.

So, the best way to overcome confirmation bias is first to recognise it and then to
actively seek out the other side of the argument.

In stocks, never buy a share without first thinking about why someone wants to sell it to
you. Just like you have a reason for buying it, the other guy has a reason for selling it.

Charlie Munger also has something to say that relates to confirmation bias. He says that
‘he never allows himself to have an opinion on anything that he doesn't know the ​other
side's argument better than they do.’
So, keep an open and scientific mind. Run experiments and remember to look at all
sides.
Sources/Credits

Books

Thinking, Fast and Slow, 2013 by Daniel Kahneman

Choices, Values, and Frames, 2000 by Daniel Kahneman and Amos Tversky

Pleasure of Finding Things Out: The Best Short Works of Richard P. Feynman (Helix Books), 2005 by
Richard P. Feynman and Jeffrey Robbins

Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger (Abridged) 2005 by Charles T.
Munger and Peter D. Kaufman

Seeking Wisdom: From Darwin to Munger, 3rd Edition 2007 by Peter Bevelin

A Few Lessons for Investors and Managers from Warren E. Buffett 2012
by Peter Bevelin and Warren Buffett

The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: "On
Robustness and Fragility" (Incerto)May 11, 2010
by Nassim Nicholas Taleb

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Incerto) Aug 23, 2005 by
Nassim Nicholas Taleb

Misbehaving: The Making of Behavioral EconomicsJun 14, 2016 by Richard H. Thaler

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel 2006 by
Benjamin Graham and Jason Zweig

Berkshire Hathaway Letters to Shareholders 2016 by Warren Buffett and Max Olson

The Snowball: Warren Buffett and the Business of Life 2009 by Alice Schroeder

Elon Musk: Elon Musk’s Best Lessons for Life, Business, Success and Entrepreneurship 2016 by Andrew
Knight

Darwin: The Life of a Tormented Evolutionist, 1994 by Adrian Desmond and James Moore

A Theory of Cognitive Dissonance 1957 by Leon Festinger

Bayes Theorem Examples: The Beginner's Guide to Understanding Bayes Theorem and 2016 by Logan
Styles

Superforecasting: The Art and Science of Prediction 2016 by Philip E. Tetlock and Dan Gardner
Online

JB Marwood
Farnam Street
More Mental Models
James Clear

Additional Credits
Lorraine Yow - Illustrations
Buffettology
Time
Forbes
Innomind