The biggest value of money isn’t to buy luxury goods but to gain control over your time and life – the ultimate form of freedom.
Morgan Housel’s Psychology of money is a must-read for anyone who wants to make smarter financial decisions and have a better relationship with money. The psychology of money is the study of our behavior with money. According to the author, the key to managing your relationship with money and having a happy and fulfilling life is twofold -
Who is this review for?
The psychology of money is the study of our behavior with money.
Let me share some good news - success with money isn’t about knowledge, IQ, or mathematical prowess. It’s about behavior. Everyone is prone to certain behaviors over others. We’re all wired differently. Our passions, fears, and dreams are different. When we hear the wordmoney, we all have unique thoughts and emotions too. Understanding the psychology of money will help us be aware of those thoughts, emotions and behaviors. Once you become aware of your tendencies, Housel writes, you can harness the power of your own mind, your thoughts and your will—and you can literally change your life.
Even though Finance is overwhelmingly taught as a math-based technical field, where you put data into a formula and the formula tells you what to do, we humans are irrational, emotional beings, and not ROI-optimizing machines. Many finance books focus on the technical aspects of money and investment, like how to select stocks or optimize a portfolio. But financial success depends more on one's soft skills (how one manages their psychological and emotional impulses) than one's technical skills on financial analyses, market rules/laws, etc.
Think about it - through collective trial and error over the years humans have learned how to become better farmers, skilled plumbers, and advanced chemists. But has trial and error taught us to become better with our personal finances? Are we less likely to bury ourselves in debt? More likely to save for a rainy day? Prepare for retirement? The author states, and I agree, that he hasn't seen compelling evidence that supports the idea that humans have a better relationship with money now than they had decades or centuries back. And that’s GREAT NEWS! I don’t have an MBA in Finance and I am a Financial Engineer. But that does not stop me or anyone else from being wealthy in the future. We just need to be patient and have a better relationship with money.
The Psychology of Money is a collection of short stories exploring the strange ways people think about money. The author presents related biases, flaws, behaviors, and attitudesthat affect one's financial outcomes and shows how one's psychology can work for and against them. Using this knowledge, he argues, we can make better sense of one of life’s most important topics - money. What follows is an attempt at summarizing this inspiring book - a few short and actionable lessons that can help you make better financial decisions. Let us see how our psychology can either work for us or against us.
Key Takeaways
Chapter 1. No one's crazy - people have different views about money
Even though money has been around for thousand's of years, many of us are bad at saving and investing for retirement. We all do crazy stuff with money. But, we are not crazy. The reason why we don’t always do what we’re supposed to with money is because of the following two reasons -
a. We are all relatively new to this game -
Most of our modern investment/financial tools are actually very new. For example, USA’s 401(k)—the backbone of their retirement planning—was introduced in 1978, and the Roth IRA was added only in 1998. If it were a person it would be barely old enough to drink. Even index funds were developed only in the 1970s. We’ve only had <50 years to master these new tools/concepts, making us collectively inexperienced in the modern money game.
b. We all view and think about money differently -
The person who grew up in poverty thinks about risk and reward in ways the child of a wealthy banker cannot fathom if he tried. The stock broker who lost everything during the Great Depression experienced something the tech worker basking in the glory of the late 1990s can’t imagine. The Australian who hasn’t seen a recession in 30 years has experienced something no American ever has.
So all of us—you, me, everyone—go through life anchored to a set of views about how money works that vary wildly from person to person. What seems crazy to you might make sense to me. That’s not because one of us is smarter than the other, or has better information. It’s because we’ve had different lives shaped by different and equally persuasive experiences. We all make decisions based on our own unique experiences that seem to make sense to us in a given moment.
“Your personal experiences with money make up maybe 0.00000000001% of what’s happened in the world, but maybe 80% of how you think the world works.”
Hence, we must learn to make investment decisions based on our goals and investment options rather than experiences.The world is always changing and relying on your experiences means you are basing your decisions on knowledge of a different world.
Chapter 2. Luck & Risk - they have a bigger impact than financial skills
“Nothing is as good as or as bad as it seems”
Not all success is due to hard work, and not all poverty is due to laziness. We tend to over-emphasize skills and effort, when outcomes are often influenced more by luck and risk. No financial outcome, either a successor a failure, is purely due to hard work and/or sound decisions. We are one person in a game with seven billion other people and infinite moving parts. The accidental impact of actions outside of our control can be more consequential than the ones we consciously take.
To explain this point, the author uses the example of Bill Gates. Bill Gates was smart, hardworking, and had a rare affinity with computers. However, he was also lucky to attend one of the only high schools in his time with a computer which the author estimates to be a 1 in a million chance. Gates eventually co-founded Microsoft with his classmate Paul Allen. They had a close friend, Kent Evans, who also shared their skills and passion with computers. Yet, Evans wasn’t a part of Microsoft because he died on a mountaineering accident before he graduated high school. The odds of being killed on a mountain in high school are roughly one in a million. Both Gates and Evans were smart and loved computers, but they fell on 2 extreme ends of luck and risk.
When looking at the successes of billionaires, CEOs, and other rich people, it is difficult to identify what is luck, what is skill, and what is risk? Hence, when trying to learn about the best way to manage money, we should not be observing successes and failures of individuals and saying, “Do what she did, avoid what he did.” Those at the top may have been the benefactors of luck while those at the bottom may have been the victims of risk.
The author suggests that we focus less on specific individuals and more on broad patterns of success and failure. The more common the pattern, the more applicable it might be to your life. Trying to emulate Warren Buffett’s investment success is hard, because his results are so extreme that the role of luck in his lifetime performance is very likely high, and luck isn’t something you can reliably emulate. But realizing that people who have control over their time tend to be happier in life is a broad and common enough observation that you can do something with it.
Finally, recognizing the role of luck in success and the role of risk in failure helps us develop greater humility when things are going right and compassion when they are going wrong. When things are going well, know that you’re not invincible. When things are going bad, know that you’re not a disaster.
Chapter 3. Never enough - learn to stop shifting the goalpost
There are countless rich individuals who have lost everything because they felt the millions they had were not enough. The lesson we learn from these failures is that we shouldn’t risk what we have and need for what we don’t have and don’t need.
In the book the author gives the examples of Rajat Gupta and Bernie Madoff - people who had everything but wanted more. They brought ruin upon themselves because they were greedy and didn’t know when to stop. The hardest financial skill, it seems, is to stop the goalposts from moving. Once we achieve our goals, we look towards the next goal. And the cycle never ends. This is often driven by comparing ourself to others who are above us in the ladder that we benchmark ourselves against. When it comes to money, someone will always have more of it than us. And that’s totally okay.
Enough doesn't mean that we stop the pursuit of financial success. Enough means that we know when to avoid doing something we will regret. Many things are not worth the risk, regardless of the gains - reputation, freedom, family and friends, love, and happiness.
“There is no reason to risk what you have and need for what you don’t have and don’t need.”
Chapter 4. Confounding Compounding - leverage the power of compounding
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.
The author presents us with the example of Warren Buffet. Buffett may be a brilliant investor, but his biggest secret isn’t his investment strategy or formula; it’s time. Unlike most people, he started investing when he was 10 years old, so by the time he was 30 (when most people start investing), he already had a net worth of $1million. Even then, $81.5 billion of his $84.5 billion net worth came after his 65th birthday. 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. That’s the power of compounding and time.
But, compounding only works if you can give an asset 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. Don’t take big risks in hope for the highest-possible returns. Go for decent returns that can be sustained over a long time. Start investing as early as possible and wait for the money to grow. The counterintuitive nature of compounding leads even the smartest of us to overlook its enormous power.
“$81.5 billion of Warren Buffett’s $84.5 billion net worth came after his 65th birthday.Our minds are not built to handle such absurdities.”
Chapter 5. Getting Wealthy vs Staying Wealthy - both take different skillsets
“Good investing is not necessarily about making good decisions. It’s about consistently not screwing up.”
Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires the following two things.
a. Humility and fear that what you’ve made can be taken away from you just as fast.
b. 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.
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 in investing or your career, or a business you own.According to the author, financial success can be summarized by one word: survival. Applying the survival mindset to the real world comes down to appreciating three things.
But do you know what happened during this period?
Our standard of living increased 20-fold in these 170 years even though barely a day went by that lacked tangible reasons for pessimism.
Chapter 6. Tails, You Win - be okay with failures because they are inevitable
“You can be wrong half the time and still make a fortune.”
Warren Buffet has owned 400 to 500 stocks during his life. He’s made the majority of his money on 10 of them. 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 can account for the majority of outcomes. The investment decisions you make on 99% of days don’t matter. It’s the decisions you make on a small number of days when something big is happening – a massive downturn, a frothy market, a speculative bubble, etc. –that make all the difference. The author describes an investing genius as an individual who can do the average thing when all those around them are going crazy.
Chapter 7. 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, when I want, with who I want, for as long as I want.” Money’s greatest intrinsic value is its ability to give you control over your time. This, more than your salary, more than the size of your house, more than the prestige of your job, more than anything, is the highest dividend money pays.
Chapter 8. Man in the Car Paradox - money does not buy respect
“No one is impressed with your possessions as much as you are.”
The Man in the Car Paradox is that people rarely think somebody is cool if they see them driving a nice car. Instead, people imagine how cool other people would think they are if they had that car. This is a paradox because others would have the same thoughts and not consider you cool. The author applies this more broadly to wealth. People acquire wealth because they believe this will make them be liked and admired. But, wealth just makes others use this as a benchmark for their own desire to be liked and admired. If respect and admiration are your goal, be careful how you seek it.Humility, kindness, and empathy will bring you more respect than horsepower ever will.
Chapter 9. Wealth is What You Don’t See - difference between rich and wealthy
“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. But the truth is that wealth is what you don’t see. Rich is a current income. Nice cars purchased. Diamonds bought. But wealth is hidden. Those who decide not to buy something now to buy something later will stay wealthy for longer. Wealth’s value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now. Not knowing the difference is a source of countless poor money decisions.
Chapter 10. Save Money - your savings rate is key
“The only factor you can control generates one of the only things that matters.”
Building wealth has little to do with your income or investment returns, and lots to do with your savings rate. One can build wealth without a high income, but has no chance of building wealth without a high savings rate.
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. But saving does not require a goal of purchasing something specific. You can save just for saving’s sake. 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.
If you have flexibility you can wait for good opportunities, both in your career and for your investments. You’ll have a better chance of being able to learn a new skill when it’s necessary. You’ll have more leeway to find your passion and your niche at your own pace. You can find a new routine, a slower pace, and think about life with a different set of assumptions.
Chapter 11. Reasonable > Rational - being rational is draining
“Aiming to be mostly reasonable works better than trying to be coldly rational.”
Being coldly rational with your financial decisions will lead to burnout. So, you are better off being reasonable and realistic about your financial decisions. Adopting a financial plan that you can stick to over the long run is more important than being completely rational about every financial decision. Stick to your guns and don’t let short-term volatility force a bad decision. Positive returns over a one-year period are 68% likely, 88% likely over 10 years, and 100% likely over 20 years.
A rational investor makes decisions based on numeric facts. A reasonable investor makes these decisions in a conference room surrounded by co-workers who want to think highly of you. Investing has a social component that’s often ignored when viewed through a strictly financial lens. The optimal portfolio is one that allows you to sleep at night. It allows you to generate reasonable returns, while also maximizing your quality of life and control over your life. It will stand the test of tough recessions and other blips in the road. Most academic understandings of the ideal portfolio ignore the very real human factors that come into play and that may cause you to deviate from the strategy.
Chapter 12. Surprise! - things that have never happened before happen all the time
“History is the study of change, ironically used as a map for the future.”
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.We should use past surprises as an admission that we 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 we 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 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.
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.
Chapter 13. Room for Error - have a margin of safety
“The most important part of every plan is planning on your plan not going according to plan.”
Things that haven't happened before happen all the time. Avoiding these kinds of unknown risks is, almost by definition, impossible. You can’t prepare for what you can’t envision. If there’s one way to guard against their damage, it’s avoiding single points of failure. 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.
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. Use room for error when estimating your future returns. For his own investments, the author assumes the future returns he’ll earn in his lifetime will be ⅓ lower than the historic average of 6.8% for the S&P 500 since 1870. So, he saves more than he would if he assumed that the future will resemble the past and he will earn 6.8% yearly. It’s his margin of safety.
One needs to realize that there doesn’t need to be a specific reason to save. It’s fine to save for a car, or a home, or for retirement. But it’s equally important to save for things you can’t possibly predict or even comprehend. Predicting what you’ll use your savings for assumes you live in a world where you know exactly what your future expenses will be, which no one does. Save as much as you can because you have no idea what you'll use the savings for in the future.
Chapter 14. You’ll Change - expect your future self to have different goals and desires
“Long-term planning is harder than it seems because people’s goals and desires change over time.”
Long-term financial planning is harder than it seems because people's goals and desires change over time. As humans, we tend to underestimate how much our personality and goals will change with time. The End of History Illusionis what psychologists call the tendency for people to be keenly aware of how much they’ve changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future. We may think we’ll never have kids or a big house when we’re young, so we plan as if that’s the case, but then we find ourselves with a house and kids that the plan didn’t account for.
When thinking about your investment strategy, try to accept the reality that we as individuals are prone to change. What matters to you today, may be viewed as inconsequential in a decade. Aiming, at every point in your working life, to have moderate annual savings, moderate free time, no more than a moderate commute, and at least moderate time with your family, 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.
Chapter 15. Nothing’s Free - be willing to pay the price for success
“Everything has a price, but not all prices appear on labels.”
Like everything else worthwhile, 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. Few investors have the disposition to say that they are fine if they lose 20% of their money. When you invest in the long term, you need to be willing to accept the short-term price of market fluctuations.
You should view any market volatility as a fee rather than a fine. Disneyland tickets cost $100. But you get an awesome day in return that you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one. 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. Work out whether it is an admission fee worth paying as there’s no guarantee that it will be. If you can do this, you are more likely to stay in the game long enough for investment gains to work for you.
Chapter 16. You & Me - find your personal financial identity and play your own game
“Beware taking financial cues from people playing a different game than you are.”
The author highly recommend us going out of our way to identify whether we are -
1. long-term investors who are optimistic in the world’s ability to generate real economic growth over the next 30 years which will accrue to our investments.
2. short-term investors who don't really care about the price of a stock is long as it has momentum and will increase between now and lunchtime.
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. When investors have different goals and time horizons, prices that look ridiculous to one person can make sense to another, because the factors those investors pay attention to are different. When a commentator on CNBC says, “You should buy this stock,” keep in mind that they do not know who you are. Are you a teenager trading for fun? An elderly widow on a limited budget? A hedge fund manager trying to shore up your books before the quarter ends? Are we supposed to think those three people have the same priorities, and that whatever level a particular stock is trading at is right for all three of them? It's crazy.
Chapter 17. The Seduction of Pessimism - there is cause for optimism in the long run
“Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.”
Create an investment plan that makes sense to you and stay the course. Do not withdraw or change your investment behavior when the market drops. This is critical to long-term success. The media uses fear to scare investors into making irrational decisions about their investments. And it works as well because it is easier to create a narrative around pessimism because the story pieces tend to be fresher and more recent.
Optimistic narratives require looking at a long stretch of history and developments, which people tend to forget and take more effort to piece together. Consider the stock markets, where a 40% decline that takes place in six months will draw congressional investigations, but a 140% gain that takes place over six years can go virtually unnoticed. The short sting of pessimism prevails while the powerful pull of optimism goes unnoticed. Keeping your cool during uncertain times is key. Market volatility cannot be escaped. True financial optimism, Housel posits, is to expect things to be bad and be surprised when they’re not. Optimism is a belief that the odds of a good outcome are in your favor over time, even when there will be setbacks along the way.
Chapter 18. When You’ll Believe Anything - stories trump statistics
“Appealing fictions, and why stories are more powerful than statistics.”
The more you want something to be true, the more likely you are going to believe a story that overestimates the odds of it being true. For instance, after World War I ended many people thought that there would never be another world war. World War II began 21 years later, killing 75 million people. Housel writes there are many things in life that we think are true because we desperately want them to be true. He calls these things appealing fictions and they have a big impact on how we think about money—particularly investments and the economy.
Chapter 19. All Together Now
How can you change your behavior to become financially successful?
This chapter is a bit of a summary of all the prior chapters.
Chapter 20. Confessions
This chapter highlights some of the financial behaviors and beliefs of the author.
Half of all U.S. mutual fund portfolio managers do not invest a cent of their own money in their funds, according to Morningstar. There can often be a mile-wide gap between what people suggest you do and what they do for themselves, which isn’t always a bad thing. It just underscores that when dealing with complicated and emotional issues that affect you and your family, there is no one right answer. There is no universal truth. There’s only what works for you and your family and leaves you comfortable and sleeping well at night. What works for one person may not work for another. You have to find what works for you. Here’s what works for the author.
This was a pretty long summary but I wanted to pack in as much information as I could since all of it was valuable. Let me know what you think about it in the comments.
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