Psychology of Money

Mental models beat financial models

  • Financial models = ways to represent a specific financial situation.
  • Mental models = ways of thinking about how something works.

Let’s pretend I’m new to investing. I come across a financial model that the stock market will return 8% per year on average. Based on that statistic, I decide to buy the S&P 500 index.

Then a recession happens and my portfolio craters. I freak out, decide I suck at stocks, and sell my holdings for a loss.

Don’t use a financial model without a good mental model

In the above example, my financial model failed me because it didn’t pass the stress test of reality.

Assuming 8% annual returns led me to think of the stock market as static, rather than dynamic.

Having the wrong mental model can ruin an otherwise good financial decision.

Conversely, here’s an upgraded mental model: think of buying the stock market (S&P 500) as a way to bet on America’s long-term growth. With this perspective, I’m more likely to…

  • Be more at peace with the ups and downs of the market
  • Take a longer term view of my investments
  • Avoid unnecessary losses

Instead of asking “Why’s my portfolio down 20%?” perhaps I’d ask: “Is America on discount right now?”

That’s the power of a mental model.

But one model is not enough. It’s useful to diversify our thinking and apply different mental models for different situations.

“To the man with only a hammer, every problem looks like a nail.”

What’s your favorite mental model for money? Would you like to read more of this? Let me know 👇🏽

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