The Psychology of Money Review and Lessons

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The Psychology of Money : Timeless Lessons on Wealth, Greed and Happiness by Morgan Housel is a fascinating look at our relationship with money. This is hands down the most interesting easy to read and insightful book I have read. Reading this book will make you realise that personal finance is less about the finance and more about the person.

Morgan Housel is a well known financial journalist and former columnist at The Motley Fool and The Wall Street Journal. Currently he is an author and partner at The Collaborative Fund.  

He writes in a story telling style which makes it very easy to read and understand. His knowledge of human behaviour and history helps him to weave this story together and create relevance.

Psychology of Money Book Review

The Psychology of money is not a long book. It has 20 chapters that deal with specific biases or flaws that people have when dealing with money. He deals with financial topics but looks at them from a human and historical perspective. Financial markets and investing are heavily influenced by human behaviour arguably more than financial fundamentals.

If investing and building wealth was a purely mathematical and logical process life would be easy. The problem we have with money and investing is that it is emotional. Professionals will tell you to take the emotion out of it. That may be possible when you are dealing with someone elses money. Try that with your own money and you realise its not that simple.

Reading this book I made many notes and tried to relate them to my own personal finance journey to financial freedom. This book will need to be read over and over again to get everything out. But for now these are the learnings that I took out of it.

I will use a few quotes from the book because they are so powerful.

Your Money Mindset

Your outlook on life has a direct impact on your finances. Building wealth requires a big picture long term view. You need that to overcome the short term problems. The fact that you have problems now does not mean that it will be like that for ever. In general it gets better, life gets better.

You still need to take action in the short term to overcome these obstacles. Don’t let that rule your life and decision making. It has to be balanced with long term optimism that you will achieve your goals and dreams.

This psychology of money quote sums it up nicely

“You need short-term paranoia to keep you alive long enough to exploit long-term optimism.”

Understanding Risk and Reward

Investing is a balance of risk and reward. The bigger the rewards that you want the bigger the risks that you face.

A conservative approach defeats the object because you will miss out on rewards. Instead have a plan to mitigate the risk. You can do this with a margin of safety. It means plan for the worst case scenario but hope for the best. By doing this you increase your chances of success because you increase your chances of survival.

For example if your success depends on only one scenario out of five working vs needing all five to work out you have a higher chance of success.

“The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking.”

Put another way you must plan for your plan not working out. If you do this and have a backup plan 1 or even 2 then you are building in a margin of safety. When you have this you don’t have to worry about predicting the future.

A practical example I have applied is that I have assumed my investment returns to be just above inflation and below the historic average. I have not included my house value in my total net worth and FI number calculation. You can also call it building fat into your plan.

Critical Money Decisions

Don’t be fooled successful investors are not right all the time. Just like you and me they they make mistakes all the time. In the short term there are many but in the long run there are few. It is those many failures and wrong decisions that help and guide us to the correct decisions.

“The historical odds of making money in U.S. markets are 50/50 over one-day periods, 68% in one-year periods, 88% in 10-year periods, and (so far) 100% in 20-year periods.”

The big successes and wins are usually as a result of single isolated incidents. Warren Buffet says that he has owned  500 stocks but has made money on only 20 of them. This is also true for your behaviour. Just a few critical decisions in your life can mean the difference between success and failure.  

“Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.”

Investing is not hard science. It is driven by a bunch of people who are making imperfect decisions based on historic information not knowing what to expect in future. Over the long run the underlying or fundamental value is important. In the short term it all has to do with sentiment as the psychology of money plays its part..

Past Does Not Predict The Future

Think about history and you will mention a handful of incidents that changed the world. These events were impossible to predict. They happened in the past and they will happen in the future.

“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.”

Every time these events happen we are surprised that we could not predict them. That’s because we fail to realise that the future will not look anything like the past. Over the last 100 years when change was slower we could not see it coming. Maybe with the rapid speed of change now we are getting better at this.

“The correct lesson to learn from surprises is that the world is surprising.”

Change is happening all the time. You have to be in tune to see it. The further back you look in history the less relevant your takeouts should be.  You need to look at more recent history to look out for trends and changes relevant for the future.

In the Psychology of Money Morgan identifies some of these changes happening.

Recessions are becoming less frequent and shorter duration. The recent pandemic in 2020 is a perfect example. Since the 1800’s the time between recessions has grown from 2 years to 12 years currently.

Old financial theories aren’t working and detailed technical analysis is becoming less relevant.

Financial Freedom

In the end it is the ability to have control over your time that brings huge amounts of happiness to people. This has gotten worse over time as generations get busier and busier. No matter how much money you make or how rich you get this still holds true.

“Doing something you love on a schedule you can’t control can feel the same as doing something you hate.”

Money is a great tool to buy time and create that freedom. There are various levels of freedom as you get your finances in order. Like the 6 months emergency fund also called FU money. Gives you the freedom not to be terrified of loosing your job suddenly. Debt free is another level of freedom. Then the ultimate level is to be able to retire when you want to instead of when you have to.

“The ability to do what you want, when you want, with who you want, for as long as you want, is priceless. It is the highest dividend money pays.”

The Path to Wealth

Understanding wealth and how we perceive it is a key to achieving it. Humans like many other animals learn by imitation. Problem is that wealth is not what you see, it is what you don’t see. Wealth is hidden. This makes imitating wealth difficult. Instead you end up imitating what you think is wealth. But that is just spending.

Wealth is money not spent. When you have a lot of money not spent it results in options and flexibility. That is the power of wealth

“The only way to be wealthy is to not spend the money that you do have. It’s not just the only way to accumulate wealth; it’s the very definition of wealth.”

So why do you think people who spend money are wealthy? It is because you want admiration from other people. You try to get that by buying expensive stuff. This is one of the biggest killers of wealth and it has nothing to do with investment returns and everything to do with psychology of money.

Spending Less Beats Earning More

Wealth is the money that you have not spent. You can build wealth without a high income but you cant build wealth without a high savings rate. You are more in control over your savings than your earnings. This is as true for today as it is for the future.

Wealth is relative to what you need because it depends on how much you want to spend. The less you desire the less you spend. You can desire less by not worrying what others think of you. Big psychology of money effect again.

“Think of it like this, and one of the most powerful ways to increase your savings isn’t to raise your income. It’s to raise your humility.”

Lifestyle creep is a result of spending to buy bigger better stuff. But simultaneously you are giving up more control over your time. Buying these tangible things does little to increase happiness. Ironically it is in the intangible benefits of money that are capable of increasing happiness because money buys time.

“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.”

Financial Planning Psychology

Assuming that everything will always work out is a guaranteed recipe for disaster. You have to plan for the opposite. What if it doesn’t work out?

Take a single salary as an example. If everything hinges on that single salary then you are reliant on a single point of failure. If just that one thing breaks the consequences are grave.

That is why an emergency fund is critical in this situation. It gives you breathing room in the short term.

You can’t prepare for what you can’t envision. You can plan on your plan not working out. If you did just that you would already be in a much better position.

We should strive for balance throughout our lives. Change is important but sometimes we need to resist it to avoid regret and encourage endurance.

“We should avoid the extreme ends of financial planning.”

Follow a strategy of moderation to avoid these extremes. Sticking to a plan of  moderate savings, free time, commute, and family increases the odds of being able to stick with a plan. Operating on the extremes introduces possibilities of regrettable decisions that derail the plan.  

Investing Psychology

There were some very interesting views on the psychology of money and the buying experience.

“Why do so many people who are willing to pay the price of cars, houses, food, and vacations try so hard to avoid paying the price of good investment returns?”

The irony is that by trying to avoid the price, investors end up paying double.

You need to change your mindset from seeing the market volatility as a fine to seeing it as a fee. Because you don’t see the price up front you see it as a fine for doing something wrong. Instead you need to see it as a fee for being in the market with its ups and downs.

Personal finance is underrated in that the personal part is crucial. Specifically understanding your time horizon. You need to have your own actions and behaviours and not be persuaded by others.

Optimism Wins But Understand Pessimism

I loved the psychology of money chapter on pessimism. Being an optimist, I was very curios to understand why pessimism was so prevalent in the markets.

Turns out that it is a fertile ground for it to flourish for 3 key reasons

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 markets adapt.

Third is that progress happens too slowly to notice, but setbacks happen too quickly to ignore

The book finishes off with his own confessions about is investing journey. I shared his sentiment as a passive optimistic investor.

“I am a passive investor optimistic in the world’s ability to generate real economic growth and I’m confident that over the next 30 years that growth will accrue to my investments.”

Reading books like the Psychology of Money is the best way to improve your financial literacy. Building wealth and investing is so much more than just the numbers. Understanding to why and how we think will help make the right investment decisions.