June 30, 2024 • 1hr 23min

TIP641: Improve Decision Making with Mental Models w/ Clay Finck & Kyle Grieve

We Study Billionaires - The Investor’s Podcast Network

In this episode, Kyle Grieve and Clay Finck continue their discussion of Robert Hagstrom's book "Investing: The Last Liberal Art". They explore how concepts from philosophy, literature, mathematics and decision-making science can be applied to improve investment analysis and decision making. The hosts emphasize the importance of developing a multidisciplinary approach and flexible mindset when analyzing investments. They discuss various mental models and frameworks that can help investors think more clearly about businesses and avoid common cognitive pitfalls.

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Key Takeaways

Using the right description and comparison for a business is crucial for developing an accurate investment thesis. The example of Amazon being more comparable to Dell than Walmart in its early days illustrates this.
Narratives are powerful in investing, but are most effective when backed up by statistics and data. A good story alone is not enough - numbers are needed to support the narrative.
Bayesian analysis can be a useful tool for investors to update probabilities and position sizing as new information becomes available about an investment.
System 1 (intuitive) thinking often leads to errors in investing. System 2 (slow, deliberate) thinking is usually more reliable for making investment decisions.
Being a "fox" rather than a "hedgehog" in investing - having a flexible mindset and considering multiple perspectives - tends to lead to better outcomes.
High intelligence does not necessarily correlate with rational decision making. The concept of "dysrationalia" explains how smart people can still make irrational choices.
Actively learning about mental models and making their use a habit through journaling and deliberate practice can improve investment decision making over time.

Introduction

In this episode, Kyle Grieve and Clay Finck continue their discussion of Robert Hagstrom's book "Investing: The Last Liberal Art". They explore how concepts from philosophy, literature, mathematics and decision-making science can be applied to improve investment analysis and decision making.

The hosts emphasize the importance of developing a multidisciplinary approach and flexible mindset when analyzing investments. They discuss various mental models and frameworks that can help investors think more clearly about businesses and avoid common cognitive pitfalls.

Topics Discussed

Using Proper Descriptions in Analysis (3:34)

The hosts discuss the importance of using the right description and comparison when analyzing a business. They use the example of Amazon in its early days:

Bears compared Amazon to brick-and-mortar retailers like Barnes & Noble and Walmart, concluding it was overvalued
Bulls argued Amazon was more comparable to Dell's business model:
- Taking orders online
- Shipping from distribution centers
- Operating with negative working capital
Key point: Using the proper description and comparison is crucial for developing an accurate investment thesis

The Power of Narratives in Investing (12:02)

The hosts discuss the role of narratives in investing:

Narratives are powerful and can move stock prices, but are most effective when backed by statistics
A good investment thesis often requires both a compelling story and supporting data
"Stories without numbers are just fairy tales, and numbers without stories to back them up are exercises in financial modeling." - Aswath Damodaran
Investors should seek narratives backed by data to develop conviction in an investment thesis

Optimizing Reading for Learning (17:43)

The hosts discuss strategies for getting more out of reading, based on Mortimer Adler's "How to Read a Book":

Read for understanding, not just information gathering
Ask key questions while reading:
- What is the book about as a whole?
- What is being said in detail?
- Is the book true in whole or in part?
- What of it? (How can I apply this?)
Compare ideas to other authors and develop your own insights
Re-read impactful books to cement core ideas

Using Bayes Theorem in Investing (40:18)

The hosts explain how Bayesian analysis can be applied to investing:

Bayes theorem: When we update our initial belief with new information, we get a new and improved belief
Can be used to update probabilities of investment outcomes as new information becomes available
Helps investors adjust position sizing based on changing probabilities
Example: If bearish scenario becomes less likely, it may increase the attractiveness of an investment

Why Value and Prices Become Disconnected (45:45)

The hosts discuss why stock prices can deviate from intrinsic value:

Human psychology and behavior cause prices to oscillate around intrinsic value
Prices rarely stop exactly at intrinsic value - tend to overshoot in both directions
Over long periods, intrinsic value tends to be the dominant factor in returns
Market rarely delivers "average" returns in any given year due to these oscillations

Limitations of Intuition in Investing (50:20)

The hosts explain why relying on intuition (System 1 thinking) can be problematic in investing:

Daniel Kahneman's concept of System 1 (fast, intuitive) vs System 2 (slow, deliberate) thinking
Investing is a complex environment where intuitive skill is less likely to develop
System 1 often leads to errors in investing - System 2 is usually more reliable
Using checklists and thorough analysis can help engage System 2 thinking

Making Mental Models a Habit (1:09:22)

Kyle shares his approach for making mental model thinking a habit:

Actively learn about mental models through books, blogs, etc.
Journal about mental models and how they connect to investments or life
Set aside time to deliberately practice applying mental models
Over time, mental model thinking becomes more automatic

Recent Mental Models Learned from Guests (1:14:59)

Kyle shares some mental models he's learned from recent podcast guests:

Kill criteria (Annie Duke) - Creating clear criteria for when to exit an investment
Dichotomy of control (Vitaliy Katsenelson) - Focusing on what you can control in investing and ignoring what you can't

Conclusion

The hosts emphasize that developing a multidisciplinary approach to investing takes time and deliberate practice. By learning mental models from various fields and making their application a habit, investors can improve their decision-making processes over time. Key takeaways include the importance of using proper descriptions when analyzing businesses, combining narratives with data, updating beliefs with new information, and engaging in slow, deliberate thinking rather than relying on intuition for investment decisions.

The episode highlights that successful investing requires more than just intelligence - it demands rational thinking, flexibility, and the ability to view investments from multiple perspectives. By cultivating these skills and continuously expanding their mental toolkits, investors can enhance their ability to navigate the complexities of the financial markets.