“The Psychology of Money” is a concise and engaging book about personal finance. Author Morgan Housel – writer and partner of the Collaborative Fund – explores the impact our behavior has on our ability to manage money.
The first indication of the book’s conciseness is its total length (less than 250 pages). The book is divided into 20 short chapters. Each chapter has a central message that the author conveys by using stories and anecdotes.
Housel gives the premise of the book as: “doing well with money has a little to do with how smart you are and a lot to do with how you behave.” Through its chapters, the book connects the attitude of individuals towards money with their actions.
Below is a compilation of our favorite parts of the book:
In the chapter “No One’s Crazy”, Housel identifies the reality that we have our own biases about how the world functions.
“Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.”
Why is it so?
According to Housel, his quote comes about because many of us don’t make financial decisions based on an analysis of the fundamentals. Instead, we make them “at the dinner table, or in a company meeting.” In these discussions we use our worldview, personal history, ego, pride, and marketing to build a narrative, he adds.
Another point that resonated with me is that many of us are just not experienced enough to know better. “We all do crazy stuff with money, because we’re all relatively new to this game and what looks crazy to you might make sense to me.”
Many people have made investment decisions that made perfect sense at the time, but they didn’t produce me much in returns. The truth is that our experiences help us judge our money decisions. However, this judgment is, in turn, flawed because of our personal biases.
In the chapter “Confounding Compounding,” Housel shows how time factors into the decision-making process of successful investors. He argues that good investors focus on “earning pretty good returns that you can stick with and which can be repeated for the longest period of time.” According to the chapter, this means that those investors who are successful focus on building a solid foundation so that they can execute their skill and improve over time.
To explain his point, Housel gives the example of Warren Buffett, the famed investor and “Oracle of Omaha,” and Jim Simmons, a well-known hedge fund manager. Buffet began investing at 10, but the vast majority of his $84.5 billion net worth came after his 50th birthday.
Simmons has compounded his investments at 66% per annum since the late 1980s. In contrast, Buffet has compounded at ‘only’ 22%. Without a doubt, this makes Simmons a better investor. However, Simmons’s net worth is nowhere near that of Buffet’s. “Because Simmons did not find his investment stride until he was 50 years old. He’s had less than half as many years to compound as Buffett,” explains Housel.
The author also mentions Warren Buffett’s comments on his long-term approach. When asked about his investment partner Rick Guerin, Buffet said: “Charlie (another investment partner) and I always knew that we would become incredibly wealthy. We were not in a hurry to get wealthy; we knew it would happen. Rick was just as smart as us, but he was in a hurry.”
Housel says that “Getting money is one thing. Keeping it is another.” One of the best segments in the book is the difference in his thought process for becoming wealthy and staying wealthy.
To become wealthy, you need to take risks and have an optimistic outlook. However, to stay wealthy, you need to be frugal and also fearful that you can lose your accumulated wealth, explains Housel.
Housel sums up the mindset required for keeping money by calling it the “survival mentality.” You can benefit from compounding only when you’re able to survive the ups and downs of investing money, he argues.
The author sums up the survival mindset with these three points:
- Believing that being financially unbreakable is more important than big returns. Financial strength allows you to “stick around long enough” so compounding can work its magic.
- Be prepared for the plan not materializing according to your expectations. This means that you should, firstly, work on a plan. At the same time, however, you should also leave some breathing space because things may not go to plan. “Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right.”
- Think of your future as bright but also be mindful of everything that may prevent you from making it bright. When being optimistic about the future, make sure you take the sensible approach that “things will balance out to a good outcome overtime.” In other words, most people and markets experience loss but also show growth amid loss, Housel adds.
Housel emphasizes that individual effort is not enough to explain outcomes. “Nothing is as good or as bad as it seems.” In fact, luck and risk are part of every outcome in life. Indeed, sometimes things that are out of our control leave a lasting impact. So, when judging yours, or someone else’s success, it’s important to give luck and risk the importance they deserve.
At the same time, it’s difficult to define the role of luck in your success/ failure. Talking about the role of luck, Housel shares a response he loves. When asked (by him) “What do you want to know about investing that we can’t know?”, Nobel Prize-winning economist Robert Shiller has said “the exact role of luck in successful outcomes.”
The author concedes that difficulty in differentiating among luck, skill, and risk is a big hurdle in managing money. With this said, he does give two tips for better management:
- Be careful in choosing your heroes and villains. The circumstances and environment can play defining role in success and failure. However, they are not the only role players: “not all success is due to hard work, and not all poverty is due to laziness.”
- Pay more attention to broad patterns instead of specific people or research. When looking for examples to follow, avoid the extreme ones. You are more likely to find actionable advice by seeking “broad patterns of success and failure,” he says.
The Difficulty of the Long-term
Our goals and desires change with time. So as a planner, it’s hard to make long-term decisions because, in reality, you don’t what your thought process will be in the future.
In the chapter titled “You’ll Change,” Housel brings home this point, mentioning our tendency to see how much we’ve changed in the past but underestimating how much our personalities and goals will change in the future (known as The End of History Illusion in psychology).
Suppose you plan on making a long-term commitment so you can maximize the compound effect. In the middle of it, however, your views about money and investment change. It’s a hard problem to solve, admits Housel. For those looking to make long term decisions, he has the following advice:
- Avoid planning like an extremist. “The End of History Illusion” is there because “people adapt to most circumstances, so the benefits of an extreme plan — the simplicity of having hardly anything, or the thrill of having almost everything—wear off.” The advantages may wear off but the disadvantages – not having enough savings – stay, he adds.
- Accept the fact that you think differently now. Many unhappy people stick to what they do because it’s what they decided to do at a young age. Interestingly, the same people may cringe at the other decisions they made at that age.” The trick is to accept the reality of change and move on as soon as possible.”
The Power of Stories
Who doesn’t like a good story? Housel talks about investment-related stories and why stories hold more power than stats. He gives the example of the 2009 housing crisis. Once the narrative – that started in 2007 – broke, the economy suffered its worst loss in 80 years even though “we had an identical—if not greater—capacity for wealth and growth in 2009 as we did in 2007.”
For people looking to manage their money, Housel makes two observations about stories:
- If you want something to be true, you’re more likely to believe a story that exaggerates. When forecasting an outcome, you may be tempted to create enough room for error that your assumptions are validated. “There is no greater force in finance than room for error, and the higher the stakes, the wider it should be.”
- Our view of the world is incomplete, but we try to create a story to try and complete it. ”We all want the complicated world we live in to make sense.” We try to fill this gap with stories but the financial implications of these stories “can be both fascinating and terrifying.”
In Conclusion“The Psychology of Money” is one of the better books about money management we have read. While there are plenty of books that explain the “x’s and o’s” of managing one’s money, there is a dearth of books which address the emotional and psychological components, which ultimately are required for being successful as investors. We encourage everyone to read this book to further their financial education.