Invert To Financial Independence
To make better financial decisions, have better financial planning mental models.
Traditional models act as sets of assumptions, concepts, and values that provide a framework for reality. Similar to a design for a new project, you can use mental models to upgrade the quality of your thinking.
The goal with mental models is to remove your initial emotional gut instinct from your response.
Some of the greatest CEO’s use mental models to make decisions.
Warren Buffet's business partner, Charlie Munger, falls into this camp. Munger uses these models as tools when investing to facilitate rational thinking
One mental model he uses is inversion, which considers a problem in reverse order.
In his 2007 speech to USC graduates, he discussed how to be successful in life.
Instead of asking the question straight on, he asked, “What will really fail in life? What do you want to avoid?”
He concluded sloth and unreliability. Do the work and be reliable. Simple enough.
Watch Charlie explain this concept below:
Charlie looks at what he wants to avoid as a framework when making decisions. You may not always be able to solve problems with this model but you’re less likely to get yourself in trouble. Shane Perrish says, “avoiding stupidity is easier than seeking brilliance.”
So how would we apply Charlie’s inversion mental model to personal finance?
Instead of asking, how do I create financial independence for myself? Ask, what will not create financial independence for myself? What do I want to avoid?
In evaluating this question, I see four common pitfalls:
Lack of savings
Ego investing
Buying without recognizing consequences
No vision or plan in place
Not having saved enough
Discipline is your key to freedom.
There are no shortcuts.
“Easy choices, hard life. Hard choices, easy life.”
Spend less than you make and invest the difference. Start at 10% minimum and increase until uncomfortable.
Investing with your ego
The ego wants to outperform the market and get rich quick.
Buying the next Amazon, Google, or Tesla that will 100x your return on investment.
These investors watch CNBC financial news networks, focus on every press release, news article, and earnings report. Searching for the next great investment. No news detail escapes them. Your brain is a pattern recognition machine - eventually, you will find something.
You need to justify your efforts.
As a result, you overvalue an article and gain confidence in the trajectory and potential of a company. Therefore, you double down on your position.
You know what’s next…
You want to beat the market, but can you?
The most educated and highly credentialed individuals work to beat the market. They spend billions trying to generate excess return or “alpha.”
S&P, a leading resource for benchmarks, paints a dismal picture for active managers. In 2016, looking at managers that did outperform, over the following 4-years, less than 1% continued this hot-streak.
Their sales tactics may be good but their performance is not. There is no magic crystal ball.
One of the biggest mistakes investors make is overvaluing information they shouldn’t, and undervaluing information they should.
That is, investing based on what stocks or markets are perceived to perform well versus holding an asset allocation of broadly & globally diversifying index funds.
This constant drive for more information is the basis for not understanding the problem.
More is not always better.
If you really understood the problem, you would be targeting the finer details not broad generalizations.
At the cocktail party, no one talks about the index fund they hold that generates consistent returns. Instead, they discuss the stock that has returned them 100x their investment.
It’s easy to get distracted. What drives growth isn’t always sexy or fun.
Ego investing is the enemy.
Buying without recognizing consequences
Traditional life decisions have financial consequences.
The path starts off with a college degree and $200,000 in student loan debt. A graduation present to yourself of a new car - $20,000 in debt. You marry your college sweetheart - $20,000 wedding. A new home because you need a place to live - $300,000 mortgage. Along the way, you eat out for dinner frequently, take vacations, and buy yourself various toys.
Next thing you know, you’re 40 years old and you have no money. This is the standard of a prosperous American middle-class life.
We unconsciously consume our way throughout life without thinking twice.
Wait to make your biggest financial decisions. Why rush?
Go to a 2-year community college then transfer to complete your remaining 2 years of college (I did this and saved $50,000). Buy a 10-year old used car and treat it like your dream car. (My car is 13 years old and 150,000 miles strong). Research on over 3,000 weddings shows no evidence to suggest expensive weddings correlate to wedding length. Life is long and divorce is expensive - choose wisely. Rent instead of buy - home equity is overrated.
Your present day sacrifice offers greater consumption in the future.
Don’t forget this.
Your decision to spend less than you make today isn’t a punishment - it’s a gift.
Not having a plan
“Failing to plan is planning to fail”
Planning integrates data-analysis with your goals and values. Between crunching numbers and your vision, you can create financial planning mental models to direct you to your destination.
See what I mean below:
Integration is key.
A model is only as valuable as the assumptions, concepts, and values put into it. Otherwise, the framework is not relevant. Your financial plan is no different.
Start at the end and work backwards.
Following a financial plan over the long run requires discipline. Mental models can act as a filtering mechanism that can support rapid decision-making in the face of an ever changing environment.
Nothing worthwhile in life is ever easy - embrace the process.
Today’s problems require long-term strategic planning and problem solving.
We’re humans and we aren’t always rational. Use the power of inversion to tune out your emotions and leverage higher-level cognitive thinking.
How could your finances improve if your emotions didn’t drive your decisions?