My boss was explaining to me about mental models. He was saying that we use heuristics to form judgements or make decisions. Heuristics are rules of thumb used to short cut the thinking process. He quoted the example of a kid, whom you pointed out to him what a car looks like. Overtime, based on observation, he would form certain rules like ‘4 wheels’, ‘windows’, etc to conclude that an object is a car, even though it is of different shape, make and color. We form such mental models in every area of our lives to aid us in making conclusion faster. If not, we have to spend a lot of time understanding a subject or an object from zero.
Ladder of Inference
Start from the bottom of this ladder. We pick up certain data that we think are important to aid our decision making. Thereafter we add meaning to the data and make assumptions. After we draw enough conclusions, we form beliefs. We will always act according to our beliefs. And once we get results, we select the results that we seek, to reinforce our belief.
I would use my colleague’s example. He has a belief, “all women are bad drivers.”
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Probably when he started driving, he encountered a few bad drivers. He peered into the driver’s seat and notice most of them were women. So he assume and draw conclusions that female driver is a factor for bad driving. Overtime, it becomes his belief that this is the truth. Every time he encountered a bad driver, he will peer into the driver seat, and reinforce his belief when it is a female driver while subconsciously choose to ignore the data when it is a male driver.
Hendra was also sharing about perceptual biases during the mentor session. He said that, “we see what we want to see” and “we hear what we want to hear”.
Are you forming mental models your investment?
As we first learn about the market, we have no experience or any rule to guide us make our investment decisions. We are trying to grapple with the movement of prices and even the mechanism of making an order. A seasoned investor would have certain rules to guide him how to invest. The rules are derived from his belief what makes an a good investment. For example, based on his observation (selected data), a low P/E ratio is one of the important factors for a value buy. He will actively look out for stocks that have low P/E ratios. The stocks that earn money reinforce his belief while stocks that lose money will be considered as unlucky. Likewise for a technical trader, he will only choose to see a particular chart pattern work and ignore when it failed.
While mental models are good as they help us shortcut our thinking process, they can handicap us if we adopt wrong beliefs. It will be worse if society embrace a wrong mental model. The deeper and more widespread the mental model, the more vulnerable it is. In my view (maybe I am a culprit of my own mental model), everyone believes that the safest asset in the world is US bonds, and it will be disaster when it comes a day US defaults.