This article is the third of this new weekly series called Latticework of Mental Models , which will be authored by my friend and partner in writing the Value Investing Almanack , Anshul Khare. Anshul will write on various mental models – big ideas from various disciplines – which can help you think more rationally while analyzing businesses and making your stock investment decisions.
What if I told you that the DCF (discounted cash flow) analysis and the principle of time value of money was first discovered in 600 B.C.? And the person who discovered it was neither an economist nor a mathematician. He was a storyteller called Aesop.
“You must be kidding,” you might say. Well, let’s find out.
In my personal experience, one of the most effective ways to make a conversation (written or verbal) interesting is to tell a story capturing your idea. In fact, I can safely claim that whenever I hear or read something that starts with “let me tell you a story,” it gets me hooked for at least few minutes. I am sure your experience won’t differ too much from mine.
Even most of the holy texts in different religions contain lot of stories. Questions is, why is it so?
Let’s try our multidisciplinary approach and look for possible explanations in the field of Biology. One of the big ideas from biology is the theory of evolution also known as ‘principle of natural selection’. It gives some clues to the question we are puzzling over.
Our brains have been wired by evolution in such a manner that remembering a story is far easier than remembering isolated bits of information. Stringing together events and facts into a believable and satisfying narrative is brain’s way to conserve energy.
It may seem an oddity but this characteristic of brain is used by prodigious memory champions also. When presented with random pieces of information, they take a story template and inject those random pieces in the story. It’s surprising that you can very easily recall that information (in the same order) even after weeks. Isn’t that awesome?
For the second vantage point, let’s turn to the field of literature. Remember, we’re trying to find answers in multiple disciplines. Literature tells us that humans love stories. Stories are one of the most powerful and emotive ways that we communicate with one another. We heard stories from our parents and grandparents and we tell them to our children. In fact, the oral tradition of storytelling goes back to thousands of years, much before humans could write.
Storytelling – A Powerful Tool
Storytelling is a tremendously useful tool to increase the longevity of your message in audience’s mind. So it’s no surprise that being a master story teller is one of essential traits required for effective communication.
So no prizes for guessing as to why Charlie Munger often quotes from Aesop’s fables . If you haven’t heard about Aesop’s fables, it’s very similar to Panchatantra fables which most of us in India have grown up hearing.
These fables deliver wisdom of ages wrapped up in short and funny stories. They feature talking animals, and children especially love these short tales. The elements of surprise and/or suspense make these fables very interesting.
Now coming back to our earlier question about Aesop being inventor of DCF analysis, while there is no way to prove my hypothesis but following saying from Aesop is particularly interesting –
A bird in hand is worth two in the bush.
And DCF in simple words is – a rupee (bird) received today (in hand) is worth more than a rupee received tomorrow (in bush). Can you come up with a better way to explain the concept of time value of money?
Please pardon my poor attempt at humour but, as adults, we usually question the relevance of these old fables in modern world. However, if you look at them again with the lens of mental models, you can find that they are as relevant today as they were in ancient times.
Stories are like those silver bullets. They are small, they hit hard and the effect stays for a long time.
Let’s revisit some of those stories and see if we can discover some mental models in them.
Story 1: The Lion, the Panther and the Fox Who Went Hunting
One day the lion, the panther and the fox went hunting together, and it was agreed that whatever they caught would be shared between them. After lulling a large stag, they decided to have a hearty meal. The lion asked the panther to divide the spoils, and after the panther made 3 equal parts, he told his friends to take their pick, whereupon the lion, in great indignation seized the panther and tore him to pieces. He then told the fox to divide the spoils, and the fox gathered everything into one great pile except for a tiny portion that he reserved for himself.
“Ah, friend,” asked the lion, “Who taught you to divide things so equally?”
“I needed no other lesson,” replied the fox, “than the panther’s fate.”
- Lesson – Better to learn from the mistakes of others than commit your own
- Mental Model – Vicarious Learning
According to Charlie Munger, reading is one of the most reliable way for vicarious learning –
Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day. In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.
When it comes to investing in stock market, it’s as important to learn about bad businesses as it is to know about good businesses. Good businesses give you a clue about what succeeds and bad businesses warn you about what fails.
Story 2: The Fox and the Grapes
A famished fox crept into a vineyard where ripe, luscious grapes were draped high upon arbors in a most tempting display. In his effort to win a juicy prize, the fox jumped and sprang many times but failed to reach the bunch of grapes in spite of all his attempts. When he finally had to admit defeat, he retreated reluctantly and to console himself, muttered – “Well, what does it matter anyway? The grapes are sour!”
- Lesson – It is easy to despise what you cannot get
- Mental Model – Cognitive Dissonance
Human beings are good at rationalizing the things that they can’t understand or accept. This behavioural bias is called Cognitive Dissonance.
Consider what Nobel Laureate and popular physicist Richard Feynman has to say about this –
Above all, never fool yourself, and remember that you are the easiest person to fool.
Charlie Munger warns –
Recognize reality even when you don’t like it – especially when you don’t like it.
So next time when you fail to get something, ask yourself if you are holding any false beliefs or assumptions. May be your overconfidence about your false ideas may be hurting your performance in investing.
Story 3: The Man and the Lion
Once, while a man and a lion were traveling together, they began arguing about who was the braver and the stronger of the two. Just as their tempers started to flare they happened to pass a statue carved in stone depicting a lion being strangled by a man.
“Look at that!” exclaimed the man. “What more undeniable proof of our superiority can you have than this ?”
“That’s your version of the story,” responded the lion. “If we were the sculptors, there would be twenty men under the paw of a single lion.”
- Lesson – History is written by the victors
- Mental Models – Survivorship Bias, Alternate Histories
We are blind to the outcomes which are hidden from us. When we look at the events we don’t realize that the event could have turned out in hundred other possible ways. For a human mind, the arrow of causality mostly seem to go in one direction.
One trick that I recently read about which is employed by fund houses to lure the gullible investors, runs like this – every now and then they float a new fund with different name with different mix of stocks. With so many funds running in parallel, some are bound to do very well and these are the ones which are shown in the prospectus by the fund marketing team. But nobody talks about the other funds which faded away in obscurity of sub-optimal returns, or even ended up with permanent loss of capital!
Story 4: The Donkey, the Cock, and the Lion
A donkey and a cock lived together in a farmyard. One day a hungry lion passed by and saw the donkey in such good condition that he decided to make a meal out of him. Now, they say that nothing irritates a lion so much as the crowing of a cock, and at that moment the cock happened to crow. So, the lion ran away as fast as he could.
Greatly amused to think that a lion would be frightened by a mere bird, the donkey plucked up courage, galloped after him, and felt proud that he was driving the king of beasts out of the farmyard. He had not gone very far, however, when the lion turned around sharply and made mincemeat out of him within seconds.
- Lesson – Presumption begins in ignorance and ends in ruin
- Mental Models – Overconfidence Bias, Skill Vs Luck
Many amateur investors, influenced by profits generated in a rising market, start living under the illusion that they have extraordinary stock picking skills. So, greatly amused to think that it’s easy to make money in the markets, they pluck up courage and start galloping with bigger money at stake. And before they go any far, the Lionish-market turns sharply and makes a mincemeat out of the overconfident investor.
As Warren Buffett says –
Only when the tide goes down, it’s revealed who were swimming naked.
Are you swimming naked and hoping that the tide will never go down?
The purpose of this post is not to amuse ourselves by finding mental models in some obscure fictional stories. My attempt is to highlight the importance of having storytelling in your mental model toolbox. It’s to illustrate how fables can prove to be a crucial vehicle for effective communication.
I hope this series on mental models is helpful in both understanding and improving your thinking. The search for wisdom is a long journey and no matter how much we learn the destination may still seem elusive. That’s because we are still going to make misjudgements. The key is to know our limitations and keep improving.
Sherlock Holmes said –
I confess that I have been as blind as a mole, but it is better to learn wisdom late than never to learn it at all.
This is what the Farnam Street blog says about mental models –
Mental models are tools for the mind….The more models you have from outside your discipline and the more you iterate through them when faced with a challenge in a checklist sort of fashion, the better you’ll be able to solve problems.
Models are additive. Like LEGO. The more you have the more things you can build, the more connections you can make between them and the more likely you are to be able to determine the relevant variables that govern the situation.
And when you learn these models you need to ask yourself under what conditions will this tool fail? That way you’re not only looking for situations where the tool is useful but also situations where something interesting is happening that might warrant further attention.
Here is an action item for you – share the ideas with at least one of your friends. Today. Teaching is the most effective form of learning. When you are teaching to somebody else, it reveals the gaps in your own understanding. So my ulterior motive here is that by sharing my thoughts and ideas with you, I too learn a lot.
Keep the curious child inside you alive. Learn as if you are going to live forever. And thanks for your gift of attention.