How to think clearly in investing
Most of the investors think too little but calculate too much and their lies the big problem for them. Investing in the business, where we have to think a lot and do fewer calculations. Most investors develop the habit of calculating precisely to three decimals points or even longer. Great investors are great thinkers. They spend a lot of their time and energy in thinking a lot about future business prospects and fundamental aspects of the business. Investors have to be an independent thinker in making investments decision. So, we understand that, thinking is very important for our investment success and now the questions arise, how to think clearly? or what is a good thinking process? The answer lies in Mental Models.
Real world situations are very complex in nature. All the business works in this complex world only. There are many variables that are reacting with each other making it very difficult to accurately calculate the future outcomes.
Mental models provide a way through which we can smoothly navigate through the uncertain complex environment. Our quality of decisions and thinking depends upon the quality of our mental models.
Mental models are the broad frameworks of ideas through which we can think and make conclusions.
Many investors cannot think properly because most of the information they consume are not properly stored in their head. In order to deduce any useful information from thinking, we must arrange the data in our head in such a way that, they are highly correlated to each other.
For example, consider you have two bookshelves. In the first shelf, you have 1000 books arranged in the random order and in the second shelf, the 1000 books are properly arranged in order of their sections, racks, authors, etc. if we want to search a book in both the self then, in which shelf do we think that the searching process will be easy. Obviously the second self. But why so? The reason is simple, on the second shelf, we have arranged our books properly.
Likewise, for investors, it is necessary to arrange their own data in their head in such a way that, they produce good information. And one way of arranging the data into our head is through mental models. These mental models can be considered as a shortcut way of mental trick used for thinking very clearly and properly.
Occam Razor mental model says that, in order to think clearly and make conclusions, we have to think in very simple terms with very few assumptions.
For example, we decide to invest in some automobile company that grows at 5% for the next 3-5 years.
And our thesis for our investments are
- The company will grow at 5% because the automobile industry itself is going to grow at 5% for the next 3-5 years.
- The company is going to grow at 5% because it will be releasing new electric car model in next month and the pre-booking has started a few days earlier and the company’s management has given guidelines that, they will be reducing unwanted expenses that the company faces to grow at 5% for next 3-5 years.
Now as the investors, if we want to choose one of the two theses for our investments, we should choose the first thesis because it has only one assumption (i.e., industry growth rate of 5% for next 3-5 years) but the second thesis consists of many assumptions. Investors should avoid any thesis which consists of many assumptions because, to the thesis to work, all of the assumptions must come true. So, it is wise to select the thesis having fewer assumptions.
Investors while thinking about investments thesis should make fewer assumptions. The thumb rule is, avoid the investments which have got too many assumptions in it.
Investments thesis having fewer assumptions and very simple to understand must be considered for investments.
Power of small numbers
Let us understand this mental model through a simple example.
In a small village, there lived an old man of age 102. He would smoke all day and eat unhealthy food three times a day. But also, he remained very healthy and happy doing his day to day work.
What do we conclude from this story?
Many people may conclude that smoking and eating unhealthy food is no harm because the old man did unhealthy things all his life and was living happily at the age of 102.
But the story is still incomplete. If we deduce that, if we also smoke and drink all day, we may also live up to the age of 102, we are dead wrong in our analysis because our sample size is very small for any useful conclusion.
So, the right way for the analysis is an analysis of the sample of 1000 old men. Divide them into a group of smokers and non-smokers. Now analyze, who are living very healthy and happy.
I bet that the non-smokers group are far healthier than the smokers group.
Investors have the habit of extrapolating things. If one company in certain industries makes a huge profit, then they deduce that other companies in the same industry will also make a huge profit. But this is a wrong way of thinking. There is no guarantee that other companies will also make a huge profit in the future.
Likewise, most investors measure the profit growth of the company for the last 3-5 years and conclude whether the company is growing profit or not.
But this again is wrong thinking because our sample space of 3-5 years is a small time frame. Investors must calculate the growth of the company for the larger time frame that is 10-15 years.
Law of small numbers says that
We cannot conclude ant useful information just by seeing a small sample space and if we try to deduce any meaning information, we have to extend our analysis to a larger sample space.
Having too many mental models is not a good idea but rather having a few quality mental models in our head would be a great idea. We have discussed two mental models in this post and we will be exploring more such quality mental models in our next post.