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The psychology of money is an insightful book by award-winning author Morgan Housel. It shares timeless lessons on wealth, greed and happiness. By exploring the strange ways people think about money, it will teach you how to make a better sense of it.
Doing well with money isn’t necessarily about what you know or how smart you are. In fact, it has a lot to do with how you behave. But behavior is hard to teach.
Although investing, personal finance, and business decisions can be taught formally, people don’t make financial decisions on a spreadsheet in the real world. Decisions are made based on one's personal history, their unique view of the world and experiences.
No one is crazy
Your investment decisions are based on the experiences early in your adult life. The willingness to bear risk depends on personal history. Since everyone goes through life with a completely different view on how the stock market works
- No one will respond to financial information the same way
- No one will be influenced by the same incentives.
- No one should be expected to trust the same sources of advice.
Every decision you make with money is based on the information you have at the moment and then pluged into your unique mental model of how the world works.
You make decisions based on your own unique experiences that seem to make sense to you in a given moment.
Luck & Risk
Other than individual effort, every outcome in life is guided by luck and risk. As such, judging yours or others’ financial success is not as good or as bad as it seems.
Luck and risk belong to both sides of the same coin.
When trying to learn about the best way to manage money, you need to differentiate between luck, risk and skill. Unfortunately, this is challenging. But two things can point you in a better direction.
- Be careful who you praise and admire
- Be careful who you look down upon and wish to avoid becoming.
Be careful when you assume that 100% of outcomes can be attributed to effort and decisions. Instead, focus less on specific individuals and case studies. Look into more on broad patterns.
When things are going extremely well, know that it is not as good as you think.
You are not invincible. If you acknowledge that luck brought you success then you have to believe that risk can turn your story around just as quickly. The same is true in the other direction.
At times, failure reflects the unforgiving realities of risk instead of the one’s “terrible” decisions. To manage failure, arrange your financial life in a way that a bad investment or missed financial goal will not wipe you out so you can keep playing until the odds fall in your favor.
As much 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.
There is no reason to risk what you have and need for what you don’t have and don’t need. For example, making money illegally.
Most of us earn a salary or have enough money to cover every reasonable thing we want and need.
If you’re one of them, remember a few things.
- The hardest financial skill is to make the goal post to stop moving.
- It gets dangerous when the taste of having more—more money, more power, more prestige—increases ambition faster than satisfaction. It's the scenario of one step forward, but the goal post is two steps ahead.
- If you feel like you’re falling behind, the only way to catch up is to take a greater amount of risk.
- Happiness is just results minus expectations.
- Social comparison is a battle that can never be won. The only way to win is to not to participate in it or accept that you might have enough, even if it’s less than those around you.
“Enough” is not too little. It is realizing that the opposite (an insatiable appetite for more), will push you to the point of regret.
The only way to know how much food you can eat is to eat until you’re sick. Few try this because vomiting hurts. Same goes for business and investing. The inability to deny a potential dollar will eventually catch up to you.
There are many things never worth risking, no matter the potential gain.
- Freedom and independence
- Family and friends
- Being loved by those who you want to love you
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.
Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his early years and the longevity he maintained afterwards.
Out of the 2,000 books that picks apart Buffett’s success, none are titled "This Guy Has Been Investing Consistently for Three-Quarters of a Century". But you know that’s the key to the majority of his success. The most powerful and important book should be called Shut Up And Wait.
His skill is investing, but his secret is time.
That’s how compounding works.
Getting wealthy vs staying wealthy
Good investing is not necessarily about making good decisions. It's about consistently not screwing up. There’s only one way to stay wealthy: some combination of frugality and paranoia.
Getting money and keeping money are two different skills.
Getting money requires taking risks, being optimistic, and putting yourself out there.
But keeping money requires the opposite of taking risk. It requires
- Fear that what you’ve made can be taken away from you
- 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.
You can’t be complacent and assume that yesterday’s success will translate into tomorrow’s good fortune.
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
Why a survival mentality is vital.
- Few gains are so great that they’re worth wiping yourself out over.
- Compounding only works if you can give an asset years and years to grow.
But getting and keeping that extraordinary growth requires surviving all the unpredictable ups and downs that one will inevitably experience over time.
Applying the survival mindset to the real world comes down to appreciating three things.
- Instead of aiming for short-lived big returns, aim to be financially unbreakable so that you are able to stick around long enough for compounding to work wonders.
- Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time—especially in times of chaos and havoc—will always win.
- Planning is important, but the most important part of every plan is to plan on the aspect which is 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.
- Note that financial and investment planning are still critical, because they let you know whether your current actions are within the realm of reasonable.
- A good plan embraces the risks/unknowns and emphasizes room for error. The more you need specific elements of a plan to be true, the more fragile your financial life becomes. If there’s enough room for error, the plan becomes more valuable.
- Room for error (margin of safety) comes in many forms: A frugal budget, flexible thinking, and a loose timeline—anything that lets you live happily with a range of outcomes.
- It’s 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 be to have a favorable outcome.
- Having the traits of being optimistic about the future, but paranoid about what will prevent you from getting to the future.
- Optimism is usually defined as a belief that things will go well. But that’s incomplete. Sensible optimism is a belief that the odds are in your favor, and over time things will balance out to a good outcome even if what happens in between is filled with misery.
- A mindset that can be paranoid and optimistic at the same time is hard to maintain, because seeing things as black or white takes less effort than accepting nuance. But you need short-term paranoia to keep you alive long enough to exploit long-term optimism.
Tails you win
A lot of things in business and investing work this way. Long tails (the farthest ends of a distribution of outcomes) have tremendous influence in finance, where a small number of events account for the majority of outcomes.
It may not be intuitive that an investor can be wrong half the time and still make a fortune. It means we underestimate how normal it is for a lot of things to fail. Which causes us to overreact when they do.
The idea that a few things account for most results is true for the companies in your investment portfolio and your own behavior as an investor.
Although most financial advice is about today - What should you do right now, and what stocks look like good buys today? Most of the time, today is not that important.
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.
There is the old pilot quip that their jobs are “hours and hours of boredom punctuated by moments of sheer terror.”
It’s the same in investing. 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.
Tails drive everything. Some gains came from a small percent of one’s actions.
There are fields where you must be perfect or pretty good every time. But not for investing, business, and finance. Both investors and entrepreneurs don’t make good decisions all the time.
“It’s not whether you’re right or wrong that’s important. But how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune.
Money’s greatest intrinsic value is its ability to give you control over your time
The 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.
When you use your wealth to buy bigger and better stuff, you have simultaneously given up more control over our time.
The highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want today.”
Aligning money towards 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, has incredible return.
Take it from those who have lived through everything: Controlling your time is the highest dividend money pays.
Wealth is what you don't see
I highlighted the differences between wealth and money here. This is another perspective of how these two terms differ.
Rich is a current income. It’s not hard to spot rich people. They often go out of their way to make themselves known.
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.
Exercise is like being rich. You think, “I did the work and I now deserve to treat myself to a big meal.” Wealth is turning down that treat meal and actually burning net calories. It’s hard, and requires self-control. But it creates a gap between what you could do and what you choose to do that accrues to you over time.
The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. Keep this in mind when quickly judging others’ success and setting your own goals.
Building wealth has little to do with your income or investment returns, and lots to do with your savings rate.
Whether an investing strategy will work, how long it will work for, or whether markets will cooperate, is out of your control. But your savings rate and frugality are within your control.
You can build wealth without a high income, but not without a high savings rate.
Learning to be happy with less money creates a gap between what you have and what you want.
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. Every bit of savings is like taking a point in the future that would have been owned by someone else and giving it back to yourself. That flexibility and control over your time is an unseen return on wealth.
Reasonable triumphs rational
When making financial decisions, aiming to be mostly reasonable works better than trying to be cold rational. Reasonable is more realistic and you have a better chance of sticking with it for the long run, which is what matters most when managing money. Instead of using mathematically optimal strategy for your investments, one that allows you to sleep better at night is a more sensible choice.
When you invest in a promising company you don’t care about, and you might enjoy it when everything’s going well. But when the tide turns and you’re losing money on something you’re not interested in, it is a burden.
But if you’re passionate about the company to begin with, you won’t give up and move on even when you’re losing money.
History helps us calibrate our expectations, study where people tend to go wrong, and offers a rough guide of what tends to work. It is the study of change, not a map of the future.
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.
Whenever we are surprised by something, even if we admit that we made a mistake, we say, ‘Oh I’ll never make that mistake again.’ But, in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate.
The correct lesson to learn from surprises is that the world is surprising. Not that you should use past surprises as a guide to future boundaries. Instead, you should use past surprises as an admission that you will have no idea what might happen next.
The most important economic events of the future—things that will move the needle the most—are things that history gives us little to no guide about. They will be unprecedented events. Their unprecedented nature means you won’t be prepared for them, which is part of what makes them so impactful.
This is true for both scary events like recessions and wars, and great events like innovation.
- History can be a 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
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 this perspective
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.
Since economies evolve, recent history is often the best guide to the future, because it’s more likely to include important conditions that are relevant to the future.
Room for error
The most important part of every plan is planning on your plan not going according to plan.
The wisdom in having room for error is acknowledging that uncertainty, randomness, and unknowns are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day
Graham’s margin of safety is a simple suggestion that you don’t need to view the world as black or white. The grey area—pursuing things where a range of potential outcomes are acceptable—is the smart way to proceed.
“have enough money in the bank to pay a year’s worth of payroll even if we didn’t get any payments coming in.”
“to always run Berkshire with more than ample cash ... When forced to choose, I will not trade even a night's sleep for the chance of extra profits.”
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 of many lucrative things are in your favor. Real estate prices go up most years, and during most years you’ll get a paycheck every other week.
But if something has 95% odds of being right, the 5% odds of being wrong means you will almost certainly experience the downside at some point in your life. And if the cost of the downside is ruin, the upside the other 95% of the time likely isn’t worth the risk, no matter how appealing it looks.
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.
You will change
It’s essential to make long term planning even though it is hard, because your goal and desire change over time. Similarly, your view of what you’ll want in the future is likely to shift.
But there are two things to keep in mind when making what you think are long-term decisions.
- You should avoid the extreme ends of financial planning as it increases the odds that you’ll find yourself at a point of regret on day.
Example: assuming you’ll be happy with a very low income, or choosing to work endless hours in pursuit of a high one.
Compounding works best when you can give a plan years or decades to grow. This is true for savings, careers and relationships. Endurance is key. Since we have the tendency to change who we are over time, balance at every point in our life becomes a strategy to avoid future regret and encourage endurance.
At every point in your working life, aiming to have moderate annual savings, free time etc increases the odds of being able to stick with a plan and avoid regret than if any one of those things fall to the extreme sides of the spectrum.
- You should also accept the reality of changing your minds and change itself. Move on as soon as possible.
Sunk costs (anchoring decisions to past efforts that can’t be refunded) does not make sense in a world where people change over time. They make our future selves prisoners to our past. It’s the equivalent of a stranger making major life decisions for you.
Embracing the idea that financial goals or decisions made when you were a different person should be abandoned to minimize future regret.
The quicker it’s done, the sooner you can get back to compounding.
Everything has a price, and the key to a lot of things is just figuring out what that price is and being willing to pay it.
The problem is that the price of a lot of things is not obvious until you’ve experienced them firsthand, when the bill is overdue.
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.
You & me
Beware of taking financial cues from people playing a different game than you are.
People make financial decisions they regret when it is done with scarce information and without logic. But the decisions made sense to them when they were made
Investors often innocently take cues from other investors who are playing a different game than they 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 those investors pay attention to different factors.
It’s hard to grasp that other investors have different goals than we do, because an anchor of psychology is not realizing that rational people can see the world through a different lens than your own. It causes one to be detached from their own reality by the actions of someone in a different game.
Being swayed by people playing a different game can also throw off how you think you’re supposed to spend your money. Do not let your consumer spending stem from wanting people to admire you.
A takeaway here is that few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are.
The main thing I can recommend is going out of your way to identify what game you’re playing.
Not all investors play the same game with the same rules. If you are a passive investor optimistic in the world’s ability to generate real economic growth, you will 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 that you’re not playing. So you don’t need to pay attention or be persuaded by it.
The seduction of pessimism
Don't be too pessimistic.
It’s easier to create a narrative around pessimism because progress happens too slowly to notice, but setbacks happen too quickly to ignore.
Optimistic narratives require looking at a long stretch of history and developments, which people tend to forget and take more effort to piece together.
Growth is driven by compounding, which always takes time. Destruction is driven by single points of failure, which can happen in seconds, and loss of confidence, which can happen in an instant.
“Are you always this cheerful?”
“My expectations were reduced to zero when I was 21. Everything since then has been a bonus,”
Expecting things to be great means a best-case scenario that feels flat.
Pessimism reduces expectations, narrowing the gap between possible outcomes and outcomes you feel great about. Maybe that’s why it’s so seductive. Expecting things to be bad is the best way to be pleasantly surprised when they’re not.
At the personal level, everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps. Hindsight (the ability to explain the past), gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn’t make sense. That’s a big deal in producing mistakes in many fields.
Most people, when confronted with something they don’t understand, do not realize they don’t understand it because they’re able to come up with an explanation that makes sense based on their own unique perspective and experiences in the world, however limited those experiences are. We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.
What these stories do to us financially can be both fascinating and terrifying.
When planning, you focus on what we want to do and can do, but neglect the plans and skills of others whose decisions might affect your outcomes.
When you focus on what you know and neglect what you do not know, it makes you overly confident in your beliefs.
For a TDLR, here is a quick summary of the book.