Mental Models for trading

I’m a big fan of Farnam Street and its Knowledge Project. Shane has captured a lot of different mental models, which can be used to make better decisions. I think this can also be applied to improve your trading.

Within this article series, I will try to look into the most relevant mental models and describe how this applies to trading. Let us start with the basics, what are mental models?

Mental models are frameworks that help us understand complex systems or problems by breaking them down into simpler components (actually breaking down complex aspects into their core components is a mental model as well – first principles thinking). These models can support you in making sense of the world, identifying patterns, and helping you make better decisions in general. These concepts are highly relevant for trading. They are essentially a way of simplifying reality and can be used in any field. Examples of mental models are the already mentioned first principles thinking, evolution in biology, feedback loops in systems or supply and demand in microeconomics. I will select a number of these models and break them down to figure out how we can apply them every day.

Why are these models important? The more cross-disciplinary approaches you can combine when making sense of the world, the better the outcomes tend to be. We tend to over-specialise nowadays and have a very narrow view of the world. This applies to trading as well, people tend to focus on only one approach they are familiar with, ignoring everything else. Creating a latticework of mental models as recommended often by Charlie Munger is what eventually leads to overperformance in terms of the quality of your decision making. And making 2% better decisions than the rest of the population, catapults you into the famous top 1% of traders that actually make money consistently, for a long period of time. That’s the goal.

If you want me to cover a particular model first, let me know in the comments.