3 Mental Models For Money Management

Shakira
Post : November 10, 2022

Mental models are thinking tools that help to improve your ability to think, make better decisions and even solve problems. Investing guru Charlie Munger was the first person to use the term 'mental models' in the year 1994. It was during a famous commencement speech at USC Business School. 

Mental models are how we reason things and how we understand the world. They not only shape what we think but also shape the opportunities we see. Since we cannot keep each and every detail of the world in our heads, models are used to simplify the most complex into a much more understandable one. 

Are mental models useful?

The majority of information is processed in your brain, and the decision-making usually occurs subconsciously, as it would be difficult for your brain to process everything in a conscious state. If it tried to, it would frequently crash. 

This system of decision-making and processing information, which are done subconsciously, may work well most of the time but also may leave you prone to cognitive errors. Mental models help to understand life and guide your behaviour and perception. 

Much of the success of Charlie Munger, partner at Berkshire Hathaway, is attributed to applying various mental models. Mental models allow individuals to stimulate the behaviour of systems mentally. Most often, they are based on analogies from experience. 

They help you make wise, long-term decisions without knowing everything about a certain situation, as they simplify even the most complex situations, helping you to reason through them easily. 

What are the types of mental models for thinking about your money?

There are hundreds of well-known mental models, but knowing even a handful of the fundamental ones can benefit you in many ways. 

“A few big ideas across multiple disciplines carry 95% of the freight” – Charlie Munger. 

In this post, we have put together four outstanding mental models with financial goals to obtain interesting outcomes.

1. Circle of Competence

The circle of Competence is quite simple. This subject area is one in which a person is thoroughly skilled or is an expert. Warren Buffet and Charlie Munger developed this mental model. The circle of competence describes limiting a person’s financial investments in areas where a person has less or no understanding and experience. 

It is all about focusing and emphasizing areas where an individual has more familiarity and aligning a subjective assessment to one's own competence. Warren Buffet summarized the concept of the Circle of Competence in the motto, 

"Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital."

Further expanded by Warren Buffet in his letter to Berkshire Hathaway in 1996:

"What an investor need is an ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence."

Remaining within one's own Circle of Competence has a great number of benefits that can help with good financial growth. 

2. Time value of money

Time is indeed a valuable asset. It is often true when we say that something done today is much more valuable than something done tomorrow. This same concept also lies in money, in the sense that a dollar today is worth more than a dollar received in the future. Money is worth more now than in the future because we can invest it and earn more. 

The time value of money is widely accepted as it is of great benefit in finance, and it is also one of the factors that are considered when weighing the opportunity costs of spending money rather than investing or saving. 

3. Opportunity Cost

Opportunity cost is a term referred to as 'trade-off'. Generally, whenever you are making a decision, it is important to consider the trade-off. 

Considering a trade-off means thinking about what you will have to give up in order to receive something. Opportunity Cost is a hypothetical question. Understanding it in simple terms: How could I have used my money if I hadn't used it on my choice? What did this choice cost me? 

Opportunity cost usually centres around the question 'what if' and yields great benefits when it comes to making financial decisions. As each action is traded for another, Opportunity cost is strongly connected to every decision that is made in your life. 

Conclusion 

An explanation of a person's thought process on how things work in the real world is what mental models are all about. They help to shape behaviour and also with problem-solving. Mental models are a representation of external reality which plays a major role in decision-making and reasoning. 

In psychology, mental models are sometimes referred to as mental stimulation or mental representations in general. Human reasoning, in one view, depends on mental models. Learning new mental models gives you an opportunity to see the world in a new way. Mental models are the best way to make intelligent decisions. Are you looking at Islamic home loans from such a perspective? 

 

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