Book review - Psychology of Money
Timeless lessons on wealth, greed, and happiness - book by Morgan Housel
Our relation with money is a soft skill (and not hard science), where how you behave is more important than what you know. This soft skill, is called Psychology of Money - knowing what to do tells you nothing about what happens in your head when you try to do it.
Doing well with money has little to do with smartness and a lot to do with how you behave -
A genius who loses control of their emotions can be a financial disaster. The opposite is also true. Ordinary folks with no financial education can be wealthy if they have a handful of behavioral skills that have nothing to do with formal measures of intelligence.
Ronald James Read (1921 – 2014) was an American philanthropist, investor, janitor, and gas station attendant. He walked or hitchhiked 4 mi (6.4 km) daily to his high school and was the first high school graduate in his family. He enlisted in the United States Army during World War II, serving in Italy as a military policeman. Upon an honorable discharge from the military in 1945, Read returned to Brattleboro, Vermont, where he worked as a gas station attendant and mechanic for about 25 years. Read retired for one year and then took a part-time janitor job at J. C. Penney where he worked for 17 years, until 1997. Read died in 2014. He received media coverage in numerous newspapers and magazines after bequeathing US$1.2 million to Brooks Memorial Library and $4.8 million to Brattleboro Memorial Hospital. Read amassed a nearly $8 million fortune by investing in dividend-producing stocks, avoiding the stocks of companies he did not understand such as technology companies, living very frugally, and being a buy and hold investor in a diversified portfolio of stocks with a heavy concentration in blue chip companies.
Opposite to Ronald Read was Richard Fuscone, a Harvard-educated Merrill Lynch executive with an MBA, had a successful career in finance that he retired in his 40s to become philanthropist. In the mid-2000s Fuscone borrowed heavily to expand an 18,000 square foot home, which cost more than $90,000 a month to maintain. However 2008 financial crisis, turned Fuscone's into dust - high debt and illiquid assets left him bankrupt.
Ronald Read was patient; Richard Fuscone was greedy. That's all it took to eclipse the massive education and experience gap between the two - Welcome to the Psychology of Money - place where someone with no college degree, no training, no background, no formal experience, and no connections massively outperform someone with the best education, the best training, and the best connections.
To understand our relation with money, it is better through lenses of psychology and history, not finance. For example, to grasp why people bury themselves in debt you don't need to study interest rates; you need to study the history of greed, insecurity, and optimism.
What shape our behavior towards money
People from different generations, raised by different parents who earned different incomes and held different values, in different parts of the world, born into different economies, experiencing different job markets with different incentives and different degrees of luck, learn very different lessons.
For example, person who grew up in poverty thinks about risk and reward in ways the child of a wealthy banker cannot fathom even if he tried. Similarly, the Australian who hasn't seen a recession in 30 years has experienced something no American ever has. On and on.
Studying history makes you feel like you understand something. But until you've lived through it and personally felt its consequences (especially experiences early in adult life), you may not understand it enough to change your behavior. This is equally applicable to one's lifetime investment decisions. We all make decisions based on our own unique experiences that seem to make to us in a given moment.
Luck & Risk
Luck & Risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort. They are so similar that you can't believe in one without equally respecting the other.
But both are so hard to measure, and hard to accept, that they often go overlooked. For every Bill Gates there is a Kent Evans who was just as skilled and driven but ended up the other side of life roulette.
If you give luck and risk their proper respect, you realize that when judging people's financial success - both your own and others' - it's never as good or as bad as it seems. However, since it's hard to quantify luck and rude to suggest people's success is owed to it, the default stance is often to implicitly ignore luck as a factor of success.
When things are going extremely well, realize it's not as good as you think. You are not invincible, and if you acknowledge that luck brought you success then you have to believe in luck's cousin, risk, which can turn your story around just as quickly. But the same is true in the other direction. More important is that as we recognize the role of luck in success, the role of risk means we should forgive ourselves and leave room for understanding when judging failures. Nothing is as good or as bad as it seems.
Never Enough
There's no reason to risk what you have and need for what you don't have and don't need.
The hardest financial skill is getting the goalpost to stop moving (define your financial goal and have sense of enough)
Social comparison is the problem here - the ceiling of social comparison is so high that virtually no one will ever hit it. Which means it's a battle that can never be won, or that the only way to win is to not fight to begin with - to accept that you might have enough, even if it's less than those around you.
"Enough" is not too little - the idea of having "enough" might look like conservatism, leaving opportunity and potential on the table - this is not right. "Enough" is realizing that the opposite - an insatiable appetite for more - will push you on the point of regret.
There are many things never worth risking, no matter the potential gain. Reputation, Freedom, Independence, Family, Friends, Happiness are invaluable. Your best shot at keeping these things is knowing when it's time to stop taking risks that might harm them. Knowing when you have enough - building enough is simple but not easy.
Compounding
Warren Buffett skill is investing, but his secret is time (key driver of success) → that's how compounding works. For us humans, linear thinking is so much intuitive than exponential thinking. The counterintuitive nature of compounding leads even the smartest of us to overlook its power.
Good investing isn't necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can't be repeated. It's about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That's when compounding runs wild.
Compounding only works if you can give an asset years and years to grow. It's like planting oak trees: A year of growth will never show much progress, 10 years can make a meaningful difference, and 50 years can create something absolutely extraordinary.
Getting Wealthy vs Staying Wealthy
Good investing is not necessarily about making good decisions. It's about consistently not screwing up.
There are multiple ways to get wealthy, but there's only one way to stay wealthy - some combination of frugality and paranoia - "survival" is key to money success.
Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility, and fear that what you've made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you've made is attributable to luck, so past success can't be relied upon to repeat indefinitely.
Not "growth" or "brains" or "insight". The ability to stick around for a long time, without wiping out or being forced to give up, is what makes the biggest difference. This should be the cornerstone of your strategy, whether it's investing or your career or a business you own.
How Warren Buffett managed to stay wealthy - he didn't get carried away with debt; he didn't panic and sell during 14 recessions he's lived through; he didn't sully his business reputation; he didn't attach himself to one strategy, one world view, or one passing trend; he didn't burn himself out and quit or retire; he survived.
Survival gave him longevity. And longevity - investing consistently from age 10 to at least age 89 - is what made compounding work wonders. That single point is what matters most when describing his success.
Nassim Taleb put it - "Having an 'edge' and surviving are two different things: the first requires the second. You need to avoid ruin. At all costs."
More than I want big returns, I want to be financially unbreakable. And if I'm unbreakable I actually think I'll get the biggest returns, because I'll be able to stick around long enough for compounding to work wonders. - Say cash earns 1% and stocks return 10% a year (during bull market). That 9% gap will gnaw at you every day. But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year - it could be many multiples of that, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.
Planning is more important, but the most important part of every plan is to plan on the plan not going according to plan. - A plan is only useful if it can survive reality. And a future filled with unknowns is everyone's reality. Frugality is different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to have a favorable outcome.
A barbelled personality - optimistic about the future, but paranoid about what will prevent you from getting to the future - is vital.
Tails, you win
You can be wrong half the time and still make a fortune. Long tails - the farthest ends of a distribution of outcomes - have tremendous influence in finance, where a small number of events can account for the majority of outcomes. Remember, tails drive everything - the distribution of success among large public stocks over time is not much different - most public companies are duds, a few do well, and a handful become extraordinary winners that account for the majority of the stock market's return.
In 2018, Amazon drove 6% of the S&P 500's returns. And Amazon's growth is almost entirely due to Prime and Amazon Web Services, which itself are tail events in a company that has experimented with hundreds of products, from the Fire Phone to travel agencies.
The idea that a few things account for most results is not just true for companies in your investment portfolio, it is also an important part of your own behavior as an investor. Over the course of your lifetime as an investor the decisions that you make today or tomorrow or next week will not matter nearly as much as what you do during the small number of days - likely 1% of the time or less - when everyone else around you is going crazy. Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.
A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy.
At the Berkshire Hathaway shareholder meeting in 2013, Warren Buffet said he's owed 400 to 500 stocks during his life and made most of his money on 10 of them. Charlie Munger followed up: "If you remove just a few of Berkshire's top investments, it's long-term track record is pretty average".
Freedom
Controlling your time is the highest dividend money pays - the highest form of wealth is the ability to wake up every morning and say, "I can do whatever I want today". The ability to do what you want, when you want, with who you want, for as long as you want, is priceless.
More than your salary, more than the size of your house, more than the prestige of your job, control over doing what you want, when you want to, with the people you want to, is the broadest lifestyle variable that makes people happy.
Wealth is What You Don't See
Spending money to show people how much money you have is the fastest way to have less money.
We tend to judge wealth by what we see, because that's the information we have in front of us. We can't see people's bank accounts or brokerage statements. So we rely on outward appearances to gauge financial success. Cars. Homes. Instagram photos. But the truth is that wealth is what we don't see.
Wealth is the nice cars not purchased. The diamonds not bought. The watches not worn, the clothes forgone and the first-class upgrade declined. Wealth is financial assets that haven't yet been converted into the stuff you see.
Difference between Wealthy and Rich -
Rich is a current income. Someone driving a $100,000 car is almost certainly rich, because even if they purchased the car with debt you need a certain level of income to afford the monthly payment.
But wealth is hidden. It's income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now.
Create the gap between what you could do and what you choose to do that accrues to you over time.
Save Money
The first idea - simple, but easy to overlook - is that building wealth has little to do with your income or investment returns, and lots to do with your savings rate.
Investment returns can make you rich. But whether an investing strategy will work, and how long it will work for, and whether markets will cooperate, is always in doubt. Results are shrouded in uncertainty.
Personal savings and frugality - finance's conservation and efficiency - are parts of the money equation that are more in your control and have 100% chance of being as effective in the future as they are today. If you view building wealth as something that will require more money or big investment returns, you may become as pessimistic as the path forward looks hard and out of control. However if you view it as powered by your own frugality and efficiency, the destiny is clearer.
For example, say you and I have the same net worth. And say you're a better investor than me (8% vs 12% annual returns). But I'm more efficient with my money. Let's say I need half as much money to be happy while your lifestyle compounds as fast as your assets. I'm better off than you are, despite being a worse investor. I'm getting more benefit from my investments despite lower returns.
Savings can be created by spending less. You can spend less if you desire less. And you will desire less if you care less about what others think of you.
Only saving for a specific goal makes sense in a predictable world. But ours isn't. Saving is a hedge against life's inevitable ability to surprise the hell out of you at the worst possible moment. Savings without a spending goal gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. It lets you change course on your own terms.
Having more control over your time and options is becoming one of the most valuable currencies in the world. That's why more people can, and more people should, save money.
History is the study of change, ironically used as a map of the future!
It is smart to have a deep appreciation of economic and investing history. History helps us calibrate our expectations, study where people tend to go wrong, and offers a rough guide of what tends to work. But it is not, in any way, a map of the future.
If you view history as a hard science, history should be a perfect guide to the future. Geologists can look at a billion years of historical data and form models of how earth behaves. So can meteorologists. And doctors - kidney operate the same way in 2020 as they did in 1020. But investing is not a hard science. It's a massive group of people making imperfect decisions with limited information about things that will have a massive impact on their wellbeing, which can make even smart people nervous, greedy and paranoid.
Two dangerous things happen when you rely too heavily on investment history as a guide to what's going to happen next -
You'll likely miss the outlier events that move the needle the most.
History can be misleading guide to the future of the economy and stock market because it doesn't account for structural changes that are relevant to today's world.
That doesn't mean we should ignore history when thinking about money. But there's an important nuance: The further back in history you look, the more general your takeaways should be. General things like people's relationship to greed and fear, how they behave under stress, and how they respond to incentives tend to be stable in time. The history of money is useful for that kind of stuff. But specific trends, specific trades, specific sectors, specific causal relationships about markets, and what people should do with their money are always an example of evolution in progress.
Most important part of every plan is planning on your plan not going according to plan
Use room for error when estimating your future returns. This is more art than science. An important cousin of room for error is optimism bias in risk-taking or "Russian roulette should statistically work" syndrome: An attachment to favorable odds when the downside is unacceptable in any circumstances.
Nassim Taleb says, "You can be risk loving and yet completely averse to ruin." And indeed, you should.
The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking. The odds are in your favor when playing Russian roulette. But the downside is not worth the potential upside. There is no margin of safety that can compensate for the risk.
Room for error does more than just widen the target around what you think might happen. It also helps protect you from things you'd never imagine, which can be the most troublesome events we face.
A good rule of thumb for a lot of things in life is that everything that can break will eventually break. So if many things rely on one thing working, and that thing breaks, you are counting the days to catastrophe. That's a single point of failure. The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.
Everything has a price, but not all prices appear on labels.
Successful investing demands a price. But its currency is not dollars and cents. It's volatility, fear, doubt, uncertainty, and regret - all of which are easy to overlook until you're dealing with them in real time. Money Gods do not look highly upon those who seek a reward without paying the price.
The average equity fund investor underperformed the funds they invested in by half a percent per year, according to Morningstar - the result of buying and selling when they should have just bought and held. The irony is that by trying to avoid the price, investors end up paying double.
The question is why do so many people try so hard to avoid paying the price of good investment returns? The answer is simple: The price of investing success is not immediately obvious. It's not a price tag you can see, so when the bill comes due it doesn't feel like a fee for getting something good. It feels like a fine for doing something wrong. And while people are generally fine with paying fees, fines are supposed to be avoided.
It sounds trivial, but thinking of market volatility as a fee rather than a fine is an important part of developing the kind of mindset that lets you stick around long enough for investing gains to work in your favor.
Market returns are never free and never will be. They demand you pay a price, like any other product. The volatility/uncertainty fee - the price of returns - is the cost of admission to get returns greater than low-fee parks like cash and bonds. The trick is convincing yourself that the market's fee is worth it. That's the only way to properly deal with volatility and uncertainty - not just putting up with it, but realizing that it's an admission fee worth paying.
You & Me - beware of taking financial cues from people playing a different game than you are.
When investors have different goals and time horizons - and they do in every asset class - prices that look ridiculous to one person can make sense to another, because the factors those investors pay attention to are different.
Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term traders playing another. Cisco stock rose 300% in 1999 to $60 per share. At that price the company was valued at $600 billion, some pointed out that Cisco's implied growth rate at that valuation meant it would become larger than the entire US economy within 20 years. As a long term investor, you should realize that the traders who were setting the marginal price of the stock were playing a different game than you were. $60 a share was reasonable price for the traders, because they planned on selling the stock before the end of the day, when its price would probably be higher. But $60 was a disaster in the making for you, because you planned on holding shares for the long run.
Being swayed by people playing a different game can also throw off how you think you're supposed to spend your money. So much consumer spending, particularly in developed countries, is socially driven: subtly influenced by people you admire, and done because you subtly want people to admire you. A takeaway here is that few things matter more with money than understanding by the actions and behaviors of people playing different games than you are.
Write your mission statement down (a passive investor optimistic in the world's ability to generate real economic growth and confident that over the next 30 years that growth will accrue to my investments), you realize that everything that's unrelated to it - what the market did this year, or whether we'll have a recession next year - is part of a game I'm not playing. So I don't pay attention to it, and am in no danger of being persuaded by it.
Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.
John Stuart Mill wrote in 1840s: "I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage." The question is, why? There are valid reasons why pessimism is seductive when dealing with money. One is that money is ubiquitous, so something bad happening tends to affect everyone and captures everyone's attention. Another is that pessimists often extrapolate present trends without accounting for how market adapt. A third is that progress happens too slowly to notice, but setbacks happen too quickly to ignore.
There are two topics that will affect your life whether you are interested in them or not: money and health. While health issues tend to be individual, money issues are more systemic.
At the personal level, there are two things to keep in mind about a story-driven world when managing your money -
The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.
Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
All Together Now - what we've learned about the psychology of our own money.
Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong. The world is big and complex. Luck and risk are both real and hard to identify. Do so when judging both yourself and others. Respect power of luck and risk and you'll have a better chance of focusing on things you can actually control.
Less ego, more wealth. Saving money is the gap between your ego and your income, and wealth is what you don't see. So wealth is created by suppressing what you could buy today in order to have more stuff or more options in the future. No matter how much you earn, you will never build wealth unless you can put a lid on how much fun you can have with your money right now, today.
Manage your money in a way that helps you sleep at night. Some people won't sleep well unless they're earning the highest returns; others will only get a good rest if they're conservatively invested. But the foundation of, "does this help me sleep at night?" is the best universal guidepost for all financial decisions.
If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon.
Become OK with a lot of things going wrong. You can be wrong half the time and still make a fortune, because a small minority of things account for the majority of outcomes. It is fine to have a large chunk of poor investments and a few outstanding ones. That's usually the best-case scenario.
Use money to gain control over your time, because not having control of your time is such a powerful and universal drag on happiness. The ability to do what you want, when you want, with who you want, for as long as you want to, pays the highest dividend that exists in finance.
Be nicer and less flashy. Reasonable person most probably want is respect and admiration. And you're more likely to gain those things through kindness and humility than horsepower and chrome.
Save. Just save. You don't need a specific reason to save. It's great to save for a car, or a down payment, or a medical emergency. But saving for things that are impossible to predict or define is one of the best reasons to save. Everyone's life is a continuous chain of surprises. Savings that aren't earmarked for anything in particular is a hedge against life's inevitable ability to surprise the hell out of you at the worst possible moment.
Define the cost of success and be ready to pay it. Uncertainty, doubt, and regret are common costs in the finance world. They're often worth paying. But you have to view them as fees rather than fines.
Worship room for error. A gap between what could happen in the future and what you need to happen in the future in order to do well is what gives you endurance, and endurance is what makes compounding magic over time. Room for error often looks like a conservative hedge, but if it keeps you in the game it can pay for itself many times over.
Avoid the extreme ends of financial decisions.
You should like risk because it pays off over time.
Define the game you're playing, and make sure your actions are not being influenced by people playing a different game.
Respect the mess. Smart, informed, and reasonable people can disagree in finance, because people have vastly different goals and desires. There is no single right answer; just the answer that works for you.
Cash is oxygen of independence, and - more importantly - it will help to never force you to sell the stocks you own. Not being forced to sell stocks to cover an expense also means increasing the odds of letting the stocks you own compound for the longest period of time. Charlie Munger put it well: "The first rule of compounding is to never interrupt it unnecessarily."
The ultimate goal - the mastery of the psychology of money - independence and always do whatever maximizes for sleeping well at night.