Your mental model will affect your investing

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  • Shaping your portfolio: mental models will influence where you put your money

    Shaping your portfolio: mental models will influence where you put your money

If the events of recent weeks (or years) have you asking yourself, “What is wrong with these people?” — the answer is: not very much. They simply suffer from a small but crucial error in the way their brains create models of the world around them.

That is the conclusion of The Unpersuadables: Adventures with the Enemies of Science, a 2014 book I reread this weekend. The insights of author Will Storr are applicable not only to the current political mayhem but to traders and investors.

Indeed, anyone who makes important decisions based on their subjective understandings of the universe stands to learn something about themselves and their decision-making processes.

Storr interviews, and occasionally embeds himself with, people many of us might describe as rather eccentric if not disturbed. UFO abductees, Holocaust deniers, new earth creationists, western medicine eschewing homeopaths, meditation gurus, extreme yogis, “skeptiks” and past-life regression therapists are among those whose world views are closely examined.

What is so striking about all of the people embracing unorthodox views isn’t that they are insane, but rather that they seem so normal. They are high-functioning individuals, who for reasons that within the book are only hinted at, have a deep flaw in their psychological understanding of how the world works.

Indeed, what is wrong with these people? They are deeply tribal; they construct storylines to help make sense of the world; when evidence is presented in direct conflict to that narrative, they find ways to dismiss it or ignore it.

Their compulsion for emotional narratives overwhelms any sense of data or evidence-based analysis. They are homo sapiens operating the way homo sapiens wetware has operated for hundreds of thousands of years. What is so shocking is not that these people are so awful or believe in awful things, but that they are otherwise rational and sane people.

As Storr writes: “Stories change us first, and then they change the world.”

All of our models are imperfect, which is a polite way to say wrong. But the mental images we create of the world we live in don’t have to be perfect; they need only be good enough to allow us to find food and water, avoid becoming someone else’s lunch, locate shelter and generally survive long enough to procreate and perpetuate the species. Good enough is all we need for those purposes.

That, of course, isn’t good enough for deciding where and how to risk money in the capital markets.

And yet this may be counterintuitive: having a complete and accurate 360-degree view of the world, a model with perfect comprehension of the objective universe, wouldn’t aid the purpose of sustaining human life. That sort of mental model would be a huge burden to create and maintain in terms of sensory perceptions and energy consumption.

The human brain weighs three pounds, or about 2 per cent of body weight, yet it is responsible for using 20 per cent of our daily caloric intake.

From an evolutionary perspective, having a perfect model of the world wouldn’t help survival of the species; it might even make perpetuation less likely during times of limited resources or environmental stress.

Storr quotes Jonathan Haidt, the New York University professor of ethical leadership, who notes that the world is “not really one made of rocks, trees, and physical objects; it is a world of insults, opportunities, status symbols, betrayals, saints and sinners.”

In other words, beliefs.

You can see this in the investing debates that take place every day. It is how people rationalise their current holdings. They “talk their book” because portfolios reflect their mental models.

Whether you are a value investor or an active trader, you believe you have an understanding of how markets and economies function, and deploy your capital accordingly. You can explain your positioning with a quick story, one that is a product of your world view. But you probably are unaware of how much your subjective inner narrative drives your rationalised views.

Regardless of where you fall in the Federal Reserve debate, or if you think stocks are cheap or expensive, or if this market is too old or has room to run, your mental models are at work. Be aware of how their imperfections might be driving your investing decisions.

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy

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Published Aug 26, 2017 at 8:00 am (Updated Aug 25, 2017 at 7:45 pm)

Your mental model will affect your investing

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