Mental Models for Superior Investing Decisions

Discounted Cash Flow (DCF)

DCF estimates an asset's value by projecting its future cash flows and discounting them back to the present using a required rate of return. If the discounted value exceeds the current cost, the investment may be worthwhile.

Investors use DCF to find mispriced securities and to model how sensitive valuations are to growth or discount-rate assumptions.

Relative Valuation (Multiples)

Unlike DCF, relative valuation compares a company's value to similar firms using ratios such as P/E or EV/EBITDA. This market-based approach signals whether a stock is over- or under-valued relative to peers.

It is used to spot bargains and to calibrate DCF estimates.

Black–Scholes Option Pricing

The Black–Scholes–Merton model prices European options based on the strike price, stock price, time to expiration, risk-free rate and volatility.

Traders use it to value options and to hedge positions; awareness of its assumptions (constant volatility, no dividends, European exercise) helps avoid misuse.

Modern Portfolio Theory & Efficient Frontier

MPT is a mathematical framework for constructing portfolios that maximize expected return for a given level of risk. It emphasizes diversification and uses variance and correlation to evaluate portfolios.

The efficient frontier shows the set of portfolios with the highest return for each risk level. Portfolio managers use it to balance risk and return and to identify optimal allocations.

Capital Asset Pricing Model (CAPM) vs. Fama–French Five-Factor Model

CAPM relates expected return to systematic risk via the formula E(R) = Rf + β(E(Rm) – Rf); it uses beta, the risk-free rate and the market risk premium to decide if a stock is fairly valued.

The Fama–French five-factor model extends CAPM by adding size (SMB), value (HML), profitability (RMW) and investment (CMA) factors, providing a more comprehensive explanation of returns.

Credit Models

Bayesian Inference / Bayes' Theorem

Bayes' theorem updates the probability of an event given new evidence, providing a method to revise predictions with new information.

Investors use it to update risk assessments as market data changes.

Regression to the Mean

Extreme performances (positive or negative) tend to be followed by more average outcomes; this phenomenon occurs because luck or randomness often contributes to extremes.

Recognizing regression to the mean helps investors avoid overreacting to recent results or chasing past winners.

Power Laws & Fat Tails / Black Swans

Research by Mandelbrot and Fama shows that financial returns display fat-tailed distributions where extreme events occur more frequently than predicted by normal distributions.

"Black swans" are outlier events with huge impacts; investors use awareness of fat tails to adjust risk management and stress-test portfolios.

Correlation vs. Causation

Correlation means two variables move together, whereas causation means one variable produces change in another. Correlation doesn't imply causation because of confounding variables and directionality problems.

Investors must avoid mistaking spurious correlations for causal relationships when making decisions.

Monte Carlo Simulation

Monte Carlo simulation estimates the probability of various outcomes by assigning random values to uncertain variables and running thousands of trials. It is used in finance to forecast price movements, assess default risk and analyze derivatives.

The technique helps investors understand the range of possible results and evaluate the probability of ruin.

Supply & Demand Curves

The quantity of Supply increases with price, the quantity of demand decreases with price, and the equilibrium price and quantity occur where supply and demand curves intersect.

Investors analyze supply–demand imbalances to forecast commodity prices, product pricing and the impact of policy changes.

Business & Credit Cycles

The business cycle has stages—expansion, peak, recession, depression, trough and recovery—representing fluctuations in economic activity.

Credit cycles, which often last longer, involve periods of easy credit followed by contraction when lending standards tighten and interest rates rise. Understanding these cycles helps investors anticipate macro trends and manage leverage.

Opportunity Cost

Opportunity cost is the benefit forgone when choosing one alternative over another; evaluating decisions requires comparing the returns of all options.

Investors use opportunity cost to assess capital allocation—for example, selecting between two stocks or deciding whether to hold cash.

Nash Equilibrium (Game Theory)

Nash equilibrium occurs when each player's strategy is optimal given the strategies of others and no player can benefit by deviating unilaterally.

In markets, it helps analyze strategic interactions such as pricing wars, OPEC production decisions or bidding in auctions.

Gresham's Law

Gresham's law states that "bad money drives out good"; when a government debases currency, people hoard high-quality money and spend the debased currency. Historical examples include Elizabethan England and the disappearance of silver coins after 1965 in the U.S.

Investors use it to understand currency crises and to gauge trust in fiat currencies.

Prospect Theory & Loss Aversion

Prospect theory shows that people overweight potential losses relative to gains; given two identical outcomes, individuals prefer the one framed as a gain and fear losses more than they value equivalent gains.

Investors become risk-averse with large stakes and sometimes risk-seeking when stakes are small. Understanding loss aversion helps structure trades and avoid panic selling.

Confirmation Bias

Confirmation bias is the tendency to seek information that confirms existing beliefs while ignoring contradictory evidence.

It can lead investors to overestimate their thesis, hold onto losers or avoid diversification. To counter it, investors should deliberately seek disconfirming evidence.

Social Proof / Herding

Herding occurs when investors follow the crowd, assuming others have better information. This behaviour can create bubbles and crashes, as seen in the dot-com bubble.

Herding stems from fear of missing out and can cause investors to ignore their own analysis.

Availability Heuristic

People overestimate the likelihood of events that are easily recalled or have recently occurred; for instance, hearing about a shark attack may cause someone to avoid swimming even though attacks are rare.

In investing, recent market moves can distort expectations (e.g., "hot hand" fallacy), leading to overreaction or underestimation of risks.

Reflexivity (Soros)

George Soros's theory of reflexivity states that investors' perceptions influence economic fundamentals, which in turn alter perceptions, creating feedback loops. The process can drive prices away from fundamentals and cause booms and busts.

Recognizing reflexivity helps investors anticipate bubbles and reversals.

Network Effects

The network effect increases a product's value as more users join. Value can rise directly with the number of users (direct network effect) or indirectly through complementary innovations.

Tech platforms like social networks rely on network effects to build moats; investors watch for critical mass and potential congestion.

Economies of Scale

Economies of scale occur when increasing production lowers per-unit costs. Internal economies of scale come from within a firm (e.g., spreading fixed costs), while external economies stem from industry-wide factors.

Firms that achieve economies of scale can underprice competitors and expand margins.

Porter's Five Forces

Michael Porter's framework identifies five forces—competitive rivalry, threat of new entrants, bargaining power of suppliers, bargaining power of customers and threat of substitutes—that determine industry profitability.

Investors use it to evaluate an industry's attractiveness and a company's moat.

Red Queen Effect (Evolutionary Arms Race)

Derived from evolutionary biology, the Red Queen effect posits that organisms must continually adapt just to maintain their relative fitness. In business, companies must innovate constantly to maintain their competitive position amid rapid technological change and globalization.

Investors favor firms that can keep "running" faster than rivals.

Margin of Safety

Benjamin Graham advised buying securities at a substantial discount to their intrinsic value, providing a margin of safety in case the investment thesis is wrong.

By paying $0.50 for $1 of value, investors reduce downside risk while preserving upside potential.