Book Review: The Psychology of Money
Book Review: The Psychology of Money by Morgan Housel
Morgan Housel’s widely acclaimed book looks at how individuals approach money. He notes that “Finance is overwhelmingly taught as a math-based field, where you put your data into a formula and [it] tells you what to do.” This fails to predict what happens when we try to do these things. He notes that people are mostly shaped by personal experience, but since we all have different experiences, we arrive at different points of view. Even reading about the experiences of others has less impact on our beliefs than what we personal live through. While it seems like good decision making is straightforward, people rarely make these “optimal” financial decisions. Housel argues that it is not that people are crazy.[1] They have reasons for what they do.
We tend to ascribe skill to our successes and bad luck to our failures. We only see the one outcome that did occur, and not all of the possibilities that could have. “Risk and luck are doppelgangers.” Rather than studying individuals and emulating their actions, we should look for broad patterns.[2] “The trick when dealing with failure is arranging your financial life in a way that a bad investment her and a missed financial goal there won’t wipe you out so you can keep playing until the odds are in your favor.”
Housel goes on to explore several big concepts in rapid fire, short chapters. The hardest thing in personal finance is to feel like you have enough. The more we have the more we usually desire, as we keep changing our reference sets (by spending time with wealthier people). Compounding over a long period of time is the surest way to build wealth, but this requires the compounding to not be interrupted, and it requires a lot of time. A great return over a short time is no match for a good return over a very long time. Getting wealthy requires a very different skillset than staying wealthy. “There are a million ways to get wealthy… but there’s only one way to stay wealthy: some combination of frugality and paranoia.”
It is common belief that wealth makes us happy and if we have more of it, we will be happier. This turns out to not be true. Having control of our lives is much more predictive of happiness than income or wealth. Rather than using our money to buy more stuff, we should use it build “a life that lets you do what you want, when you want, with who you want, where you want, for as long as you want.”
Perhaps my favorite chapter was also the shortest (two pages.) Housel observes that people buy expensive cars because they want others to see them as cool. Instead, people see their car as cool and do not even notice the person driving the car. People imagine themselves driving the car. The same goes for other outward signs of wealth. This leads into the next chapter, where we see that we mistakenly make assumptions of people’s wealth based on the possessions we can see. These represent money already spent and tell us nothing of what has been unspent. Real wealth is what we cannot see. The logical conclusion is that we should save more money. “Wealth is just the accumulated leftovers after you spend what you take in. And since you can build wealth without a high savings rate, it’s clear which one matters more.” The best way to save more is to spend less, and the way to do that is to quit worrying about what others think of us and just be humble. “Saving money is the gap between your ego and your income, and wealth is what you don’t see.” We should save not just for things we want to buy or to fund a comfortable retirement. Those are good reasons to save, but we should also save because we do not know what will happen in the future, or what we will want or need. Savings is security and optionality, which allows us to maintain control of our lives.
Housel discusses the concept of “long tails” – the very small percentage of very significant events that can make a major difference. We should plan in a way to capture some of these that are positive and to survive those that are negative to us. Planning is not just preparing for known needs and risks, but acknowledging that we do not know what will happen. “The most important part of every plan is planning on your plan not going according to plan.” We need to allow for mistakes, bad luck, and unforeseen circumstances. We do not even know what we will want in the future. Our dream job may turn out to be a nightmare. Our current desires will likely change over time. As such, we should plan for maximum flexibility. Keep a high savings rate, and avoid planning for extremes, which may seem attractive at the time, but such a plan could lock in a lifestyle that turns out to not be enjoyable.
Regarding investing, we should understand what game we are playing. It may make sense for short-term traders to buy a stock at an astronomical valuation multiple, because they are playing a different game. A long-term investor should ignore what the short-term traders are doing. What works for them won’t work for the long-term investor. There is a different set of rules. We can see what other people are doing, but we don’t know why. We should focus on the actions most likely to bring our own goals to fruition.
Mindset and expectations are important. If we want to have good investment returns, we need to accept some risk, which means we will lose money at times. If we think of these losses (as they are occurring, not in theory) as penalties, they will train us to avoid them – to not accept the risk that accompanies a good return. On the other hand, if we think of them as the price of long-term success, we will endure them, knowing that nothing good comes without a cost. Managing expectations is critical. If we expect our portfolio to have some major setbacks along the way, we will not be surprised by them and will be more willing to stick to the plan.
Conclusion: Psychology of money is a great collection of articles covering a variety of topics, with the overarching theme of preparing oneself financial for the unexpected by saving more than you think you need, controlling your “needs”, being patient, and accepting that the world is uncertain. It is a great read for anyone wanting to prudently prepare for the future.
[1] The academic literature generally uses the term “irrational.” A couple of great books on why people make cognitive errors are “Thinking Fast and Slow” by Daniel Kahneman and “Predictably Irrational” by Dan Ariely. Both point out ways that our decision-making processes that serve us well in some situations fare very poorly in others, yet we often do not realize the difference in decision making.
[2] This is a great point, and one that immediately struck me when I read “Good to Great” by Jim Collins years ago. He examined companies which changed from being good, but ordinary, companies into dominant ones. His point was that other companies should copy these moves to reach the next level. Because Collins focused on only the successful companies, he introduced survivorship bias to his study. One of his findings was that good to great companies “bet the company” on a major initiative. Indeed, accepting a large amount of risk on a single project could be a great way to cause substantial growth – or to sink the company.