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Three Mental Models for Personal Finance

The following is a guest post from The Master Dukes of Dollars. The two bloggers held court frequently, delving into lifestyle and personal finance discussions as they searched for ways to live an optimal life, eventually deciding to invite a global audience into their mindsets by establishing their own blog together. They believe anyone can build their financial kingdom – start building today!

In our adventure through life, we are constantly making decisions. In fact – a study was done that left me flabbergasted. I mean, who would have thought on an average day, adults make an estimated 35,000 decisions every day!!

Make Independent Decisions Through Rational Thinking

Now many of these decisions are on things that have little consequence, where our habits take over and only a small amount of energy is expended when making them. It’s easy for me to decide whether or not my coffee mug will be within reach during breakfast each day – it always is!

But life isn’t always so easy, and with the short-cuts we’ve developed as humans to tackle the onslaught of decisions each day, it is in our best interest to take big decisions heavily! That’s where rational thinking comes in. Rational thinking is our ability to draw unbiased conclusions by using logic, rules, and data to justify them.

By utilizing this process, you are able to handle life’s tough decisions and we sincerely believe that there’s power in doing so. Why? Because we have subconscious biases that go into every decision made. Add a few mental models all happening at once – generalization fallacies, headline nostalgia or emotional responses – you have a lollapalooza effect leading to actions (or beliefs) that may not be beneficial to you!

Want a few examples of news being emotionally charged? Check out Joshua Kennon’s article on statistics.

With rational thinking in mind, a new concept can be introduced to help how we make better decisions – Mental Models!

What are Mental Models?

Mental Models are your toolbox for making decisions! Here’s a quick video to give a quick overview.

To summarize mental models:

  • Big ideas from cross-disciplinary sources (psychology, engineering, etc.)
  • Applied in various disciplines to help understand the world
  • When many 4-5 of these mental models all affect one situation, we call it a lollapalooza!

Where Did Mental Models Come From?

Mental models were made famous by Warren Buffet’s partner in crime, Charlie Munger. He gave a speech on cognitive biases and how they can influence decision making, even on those who are experts on leadership or physics.

Further, he mentions them throughout a talk he gave to graduates of USC. Charlie believes understanding the world from this broad perspective gives you opportunity to make fast, smart, and reliable decisions – sometimes even finding answers quicker than those who specialize in their field. Which of course can be a very dangerous tool, in other words, use your rational thinking wisely.

Charlie has said because of these mental models and the latticework of them entangled within his brain, he has been awarded with great success in investing and business. He says one can never underestimate the power of incentives, ignore the potential second order effects of decisions or forget the self-bias (story below) each one of us tangles with in our daily decisions.

Learning new mental models is a life-long journey; but that shouldn’t cause any stress, because those who are successful also happen to be life-long learners!

A Mental Model Story…

Account for self-serving bias of others, and use it in persuasion – quote from Charlie Munger’s Speech to UCC Graduates in 2007:

“I watched the brilliant Harvard Law School trained general counsel of Salomon lose his career, and what he did was when the CEO became aware that some underling had done something wrong, the general counsel said, “Gee, we don’t have any legal duty to report this but I think it’s what we should do it’s our moral duty.”

Of course, the general counsel was totally correct but of course it didn’t work; it was a very unpleasant thing for the CEO to do and he put it off and put it off and of course everything eroded into a major scandal and down went the CEO and the general counsel with him.

The correct answer in situations like that was given by Ben Franklin, he said, “If you want to persuade, appeal to interest not to reason.” The self-serving bias is so extreme. If the general counsel had said, “Look this is going to erupt, it’s something that will destroy you, take away your money, take away your status…it’s a perfect disaster,” it would have worked!

This story shows the power of using mental models in your life, because sometimes it can be detrimental to your career if you don’t!”

Three Mental Models to Heed in Personal Finance

1. Compounding: Amount = (Principle)(interest^(rate of interest*time in years)

  • Ideas, money, relationships can grow exponentially through compounding!
  • Using the mental model of compound interest in your investments can lead to huge retirement results, the most important factory? Time! Start early!

2. Confirmation Bias: Reading, researching, and reflecting only on information that confirms pre-existing beliefs or ideas

  • If you only reading articles or evidence that go with your thinking such as investing in index funds, you lose the opportunity in other options that may come up in the future!
  • Learn from the various ideas and situations in personal finance, which then help you solidify or change your own beliefs!

3. Association: Humans associate feelings to intangible objects

  • When diamond rings are mentioned, one thinks of expensive and long lasting, flawless gems, marriage, and love. This was purposely done by the diamond industry marketing campaigns to drive sales.
  • Consumerism in the USA has associated spending with happiness, and as others in the community know – this just isn’t the case. Keep this in mind the next time you’re on Amazon or taking a trip to Target!

These three are just the tip of the mental model iceberg. The more you learn, the better they can be utilized as you accelerate your path to freedom.

Concluding Thoughts

Personal finance and rational thinking go hand in hand. Mental models help you drive better decisions in your career and life, which lead to compounding results (see what I did there?)! Saving high percentages of income is much easier when your level of income continuously increases! Bosses and businesses love rational thinking, and by taking advantage of mental models – you can become the employee they love because of it!

First time hearing about mental models? That’s quite alright. Start conquering them today!

If you are interested in reading more about mental models, we recommend two resources:

 

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