Morgan Housel. The Psychology of Money:

Timeless Lessons on Wealth, Greed and Happiness (2020)

In a paragraph

Personal finance is not a hard science but a soft skill and doing well with money is more about psychology than intelligence. Individuals look at finance in different ways depending on their life experiences and conceptual models. Save to create wealth which allows options and control.  Aim for a secure safety margin in cash and to be invested long-term in the global stock market.   

Key points

• Doing well with money is less about how smart you are and more about how you behave. A genius who loses control of their emotions can be a financial disaster, while those with no financial education can be wealthy with decent behavioural skills.

• Financial success is not a hard science, it’s a soft skill, the psychology of money. Finance is overwhelmingly taught as a math-based field. We think about money in ways that are too much like physics (with rules and laws) and not enough like psychology (with emotions and nuance). Physics isn’t impacted by the vagaries of human behaviour and emotions, like finance is.

• Money is everywhere, it affects all of us, and confuses most of us. Everyone thinks about it a little differently. It offers lessons on things that apply to many areas of life, like risk, confidence, and happiness.

• We go through life anchored to a set of views about how money works that vary wildly from person to person. These relate to our generational experience, especially as young adults. What seems crazy to you might make sense to me. 

• Financial management is a new topic. Retirement planning and 401(k) are recent.   

• Know when you have enough. The hardest financial skill is getting the goalpost to stop moving.

• Compounding works with time. 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. But getting and keeping that extraordinary growth requires surviving all the unpredictable ups and downs that everyone inevitably experiences over time.The first rule of compounding is to never interrupt it unnecessarily.

• Have a bar-belled personality—optimistic about the future, but paranoid about what will prevent you from getting to the future. Mix very secure cash for safety and fully exposed stocks for upside.

• Long tails—extreme outcomes—have tremendous influence in finance, where a small number of events can account for the majority of outcomes. Most returns come from a few investments.

• The highest form of wealth is the ability to wake up every morning and say, ‘I can do whatever I want today.’ The ability to do what you want, when you want, with who you want, for as long as you want.Achieve independence and autonomy from unspent assets that give you control.

• Wealth is the nice cars not purchased. Wealth is financial assets that haven’t yet been converted into the stuff you see. Rich is a current income, but wealth is hidden. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth.  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.

• Building wealth depends on your saving rate. Spending beyond a pretty low level of materialism is mostly a reflection of ego, spending money to show people that you have (or had) money. You don’t need a specific reason to save. It gives flexibility to wait for good opportunities, both in your career and for your investments, and provides buffer to deal with the unknown.

• Do not aim to be coldly rational when making financial decisions. Aim to just be pretty reasonable. 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. Academic finance is devoted to finding the mathematically optimal investment strategy, but people want a strategy that lets them sleep at night. “Minimizing future regret” is hard to rationalize on paper but easy to justify in real life.

• There will be surprises. Don’t rely too heavily on history as outlier events dominate and there is structural change.

• The purpose of the margin of safety is to render the forecast unnecessary. Margin of safety—room for error or redundancy—deals with a world governed by odds, not certainties. You have to take risk to get ahead, but no risk that can wipe you out is ever worth taking. The odds are in your favour when playing Russian roulette, but the downside is not worth the potential upside.

• People are poor forecasters of their future selves. Avoid the extreme ends of financial planning. Assuming you’ll be happy with a very low income, or choosing to work endless hours in pursuit of a high one, increases the odds that you’ll one day find yourself at a point of regret.

• Think of market volatility as a fee rather than a fine. Tactical mutual funds try to get returns without paying the fee of market volatility. But they overwhelmingly underperform simple 60/40 stock-bond funds.

• Play your game, don’t takes cues from others playing different games. Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term.

• Optimism is the best bet for most people because the world tends to get better for most people most of the time. The simple idea that most people wake up in the morning trying to make things a little better and more productive than wake up looking to cause trouble is the foundation of optimism. But pessimism holds a special place in our hearts. The fashionable reasons for pessimism change, but the pessimism stays constant. Pessimists often extrapolate present trends without accounting for how markets adapt.

• In a recession we tell stories that inflict narrative damage on ourselves.

• The more you want something to be true, the more likely you are to believe a story that overestimates its likelihood – appealing fictions. People believe in financial quackery because the potential rewards are high.

• 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.

• Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps. Just like my one-year-old daughter, I don’t know what I don’t know. So I am just as susceptible to explaining the world through the limited set of mental models I have at my disposal. 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. Each of us is confident he knows what’s happening based on what he sees but turns out to be wrong because he can’t know the stories going on inside everyone else’s head.

• I’ve shifted my views from stock picking and now every stock we own is a low-cost index fund. Effectively all of our net worth is a house, a checking account, and some Vanguard index funds.

Comments

This is a readable short book about how to deal well with money, concentrating on the psychological challenges involved. It doesn’t try to comprehensively cover ‘The Psychology of Money’ but instead sets out and illustrates some key points.

The ideas that Housel concentrates are all valuable.  Yes, saving gives control and options.  Yes, keep a secure cash reserve for a margin of safety but also aim to stay in the market to benefit from potential compounding. Yes, follow your own objectives and don’t be distracted by others playing different games. He also makes some more philosophical points with which I agree. Yes, people have different views of finance as they have different life experiences and conceptual models. Yes, rare events dominate finance as life generally. Yes, long run optimism is justified despite our pessimistic chatter.

The topics covered in ‘The Psychology of Money’ sit on the intersection of my interests in philosophy and in finance, so it is not surprising that the ideas in the book are familiar to me, and have influenced my own financial planning.  

But my interest and enthusiasm is unusual.  I am aware from personal experience that while many people get by with their personal finances, some do very badly.  And so much can be lost by doing finance badly, emotional as well as financial.  There must be great potential to improve welfare through doing better with money. Could this come from teaching some simple strategies that overcome the psychological challenges of finance?  If so, this book should be useful.    

Links

Psychology of Money at Amazon UK

Morgan Housel website

EXTRACTS

Introduction: The Greatest Show On Earth

The premise of this book is that doing well with money has a little to do with how smart you are and a lot to do with how you behave.

A genius who loses control of their emotions can be a financial disaster. The opposite is also true. Ordinary folks with no financial education can be wealthy if they have a handful of behavioral skills. Ronald Read was patient; Richard Fuscone was greedy. That’s all it took to eclipse the massive education and experience gap between the two.

Financial success is not a hard science. It’s a soft skill, where how you behave is more important than what you know. I call this soft skill the psychology of money.

The aim of this book is to use short stories to convince you that soft skills are more important than the technical side of money.

Finance is overwhelmingly taught as a math-based field.  We think about and are taught about money in ways that are too much like physics (with rules and laws) and not enough like psychology (with emotions and nuance).

Money is everywhere, it affects all of us, and confuses most of us. Everyone thinks about it a little differently. It offers lessons on things that apply to many areas of life, like risk, confidence, and happiness. Few topics offer a more powerful magnifying glass that helps explain why people behave the way they do than money. It is one of the greatest shows on Earth.

1. No One’s Crazy

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. Some lessons have to be experienced before they can be understood.

The economists found that people’s lifetime investment decisions are heavily anchored to the experiences those investors had in their own generation—especially experiences early in their adult life.

Another important point that helps explain why money decisions are so difficult, and why there is so much misbehavior, is to recognize how new this topic is. The entire concept of being entitled to retirement is, at most, two generations old. The 401(k)—the backbone savings vehicle of American retirement—did not exist until 1978.

2. Luck & Risk

Bill Gates experienced one in a million luck by ending up at Lakeside School. Kent Evans experienced one in a million risk by never getting to finish what he and Gates set out to achieve.

The line between bold and reckless can be thin. Mark Zuckerberg is thought a genius for turning down Yahoo!’s 2006 $ 1 billion offer to buy his company. He saw the future and stuck to his guns. But people criticize Yahoo! with as much passion for turning down its own big buyout offer from Microsoft.

3. Never Enough

I have something he will never have … enough.

The question we should ask of both Gupta and Madoff is why someone worth hundreds of millions of dollars would be so desperate for more money that they risked everything in pursuit of even more. There is no reason to risk what you have and need for what you don’t have and don’t need.

The hardest financial skill is getting the goalpost to stop moving.

4. Confounding 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.

5. Getting Wealthy Vs. Staying Wealthy

There are two reasons why a survival mentality is so key with money. One is the obvious: few gains are so great that they’re worth wiping yourself out over. The other, as we saw in chapter 4, is the counterintuitive math of compounding. Compounding only works if you can give an asset years and 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.  But getting and keeping that extraordinary growth requires surviving all the unpredictable ups and downs that everyone inevitably experiences over time.

More than I want big returns, I want to be financially unbreakable. And if I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able to stick around long enough for compounding to work wonders. If that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year—it could be many multiples of that.

Room for error—often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline— anything that lets you live happily with a range of outcomes.

A bar-belled personality—optimistic about the future, but paranoid about what will prevent you from getting to the future.

6. Tails, You Win

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.

It is not 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.

Not only do a few companies account for most of the market’s return, but within those companies are even more tail events.

Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control. Do the average thing when all those around them are going crazy.

If you’re terrific in this business, you’re right six times out of 10.

There are 100 billion planets in our galaxy and only one, as far as we know, with intelligent life. The fact that you are reading this book is the result of the longest tail you can imagine.

7. Freedom 

The highest form of wealth is the ability to wake up every morning and say, ‘I can do whatever I want today.’ 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.

Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing.  Money’s greatest intrinsic value—and this can’t be overstated—is its ability to give you control over your time. To obtain, bit by bit, a level of independence and autonomy that comes from unspent assets that give you greater control

We’ve used our greater wealth to buy bigger and better stuff. But we’ve simultaneously given up more control over our time. You might be on the clock for fewer hours than you would in 1950, but, with constant communications it feels like you’re working 24/ 7.

8. Man in the Car Paradox 

People generally aspire to be respected and admired by others, and using money to buy fancy things may bring less of it than you imagine.

9. Wealth is What You Don’t See

Wealth is the nice cars not purchased. Wealth is financial assets that haven’t yet been converted into the stuff you see. Rich is a current income. 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.

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.

10. Save Money

Building wealth has little to do with your income or investment returns, and lots to do with your savings rate.

Spending beyond a pretty low level of materialism is mostly a reflection of ego approaching income, a way to spend money to show people that you have (or had) money.

You don’t need a specific reason to save. It gives flexibility to wait for good opportunities, both in your career and for your investments.

11. Reasonable >Rational

Do not aim to be coldly rational when making financial decisions. Aim to just be pretty reasonable. 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.

Academic finance is devoted to finding the mathematically optimal investment strategies. My own theory is that, in the real world, people do not want the mathematically optimal strategy. They want the strategy that maximizes for how well they sleep at night. “Minimizing future regret” is hard to rationalize on paper but easy to justify in real life.

12. Surprise!

Things that have never happened before happen all the time.

The most important driver of anything tied to money is the stories people tell themselves and the preferences they have for goods and services. Those things don’t tend to sit still. They change with culture and generation. They’re always changing and always will.

Two dangerous things happen when you rely too heavily on investment history. You’ll likely miss the outlier events that move the needle the most and it doesn’t account for structural changes.

13. Room for Error

The purpose of the margin of safety is to render the forecast unnecessary. Margin of safety—you can also call it room for error or redundancy—is the only effective way to safely navigate a world that is governed by odds, not certainties.

Room for error lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low-probability outcome fall in your favor.

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 are in your favor when playing Russian roulette, but the downside is not worth the potential upside.

Save for things you can’t possibly predict or even comprehend—the financial equivalent of the field mice that destroyed German tanks.

14.  You’ll Change

People are poor forecasters of their future selves. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is something entirely different.

We should avoid the extreme ends of financial planning. Assuming you’ll be happy with a very low income, or choosing to work endless hours in pursuit of a high one, increases the odds that you’ll one day find yourself at a point of regret.

When you accept the End of History Illusion (that you won’t change), you realize that the odds of picking a job when you’re not old enough to drink that you will still enjoy when you’re a pensioner are low. 

15. Nothing’s Free

Tactical mutual funds try to get returns without paying the fee of market volatility.  But they overwhelmingly underperform simple 60/40 stock-bond funds.

Thinking of market volatility as a fee rather than a fine is an important part of developing the kind of mindset that lets you stick around long enough for investing gains to work in your favor.

16. You & Me

Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term. Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term traders playing another.

17. The Seduction of Pessimism

Optimism is the best bet for most people because the world tends to get better for most people most of the time. But pessimism holds a special place in our hearts. The simple idea that most people wake up in the morning trying to make things a little better and more productive than wake up looking to cause trouble is the foundation of optimism. In my own adult lifetime the fashionable reasons for pessimism changed, but the pessimism was constant.

While health issues tend to be individual, money issues are more systemic.

Pessimists often extrapolate present trends without accounting for how markets adapt.

Progress happens too slowly to notice, but setbacks happen too quickly to ignore. There are lots of overnight tragedies but rarely overnight miracles.  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.

18. When You’ll Believe Anything

There was one change an alien couldn’t see between 2007 and 2009: the stories we told ourselves about the economy. In 2009 we inflicted narrative damage on ourselves, and it was vicious.

The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true. Appealing fictions. During the plague, Londoners would believe any cure.

People believe in financial quackery in a way they never would for, say, weather quackery because the rewards for correctly predicting the stock market are high.

Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps. Just like my one year old daughter, I don’t know what I don’t know. So I am just as susceptible to explaining the world through the limited set of mental models I have at my disposal. 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.

Since big events come out of nowhere, forecasts may do more harm than good, giving the illusion of predictability in a world where unforeseen events control most outcomes.

Astrophysics is a field of precision. It isn’t impacted by the vagaries of human behavior and emotions, like finance is.

Each of us is confident he knows what’s happening based on what he sees but turns out to be wrong because he can’t know the stories going on inside everyone else’s head.

19. All Together Now

Find humility when things are going right and forgiveness/ compassion when they go wrong.

Less ego, more wealth.

Manage your money in a way that helps you sleep at night.

Increase your investment time horizon.

Use money to gain control over your time

Be nicer and less flashy.

Save.

Define the cost of success and be ready to pay it.

Room for error.

Avoid the extreme ends of financial decisions.

You should like risk because it pays off over time. But you should be paranoid of ruinous risk because it prevents you from taking future risks.

Define the game you’re playing, and make sure your actions are not being influenced by people playing a different game.

Respect the mess. Smart, informed, and reasonable people can disagree in finance, because people have vastly different goals and desires. There is no single right answer; just the answer that works for you.

20. Confessions

A doctor may throw the kitchen sink at her patient’s cancer, but choose palliative care for herself.

I did not intend to get rich. I just wanted to get independent.  Independence, at any income level, is driven by your savings rate. Cash is the oxygen of independence.  The first rule of compounding is to never interrupt it unnecessarily.

I’ve shifted my views and now every stock we own is a low-cost index fund. Effectively all of our net worth is a house, a checking account, and some Vanguard index funds.