Insightful read on the behavioral drivers that influence how we understand and engage with money, personal finance and wealth creation. Definitely a useful topic during these times, I hope you enjoy!
The following are the passages I most enjoyed from the book The Psychology of Money by Morgan Housel. All content credit goes to the author.
Introduction: The Greatest Show on Earth
- 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).
- To grasp why people bury themselves in debt you don’t need to study interest rates; you need to study the history of greed, insecurity, and optimism. To get why investors sell out at the bottom of a bear market you don’t need to study the math of expected future returns; you need to think about the agony of looking at your family and wondering if your investments are imperiling their future.
1. No One’s Crazy
Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.
- People from different generations, raised by different parents who earned different incomes and held different values, in different parts of the world, born into different economies, experiencing different job markets with different incentives and different degrees of luck, learn very different lessons. Everyone has their own unique experience with how the world works. And what you’ve experienced is more compelling than what you learn second-hand. 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.
- 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.
- Every decision people make with money is justified by taking the information they have at the moment and plugging it into their unique mental model of how the world works.
- every financial decision a person makes, makes sense to them in that moment and checks the boxes they need to check. They tell themselves a story about what they’re doing and why they’re doing it, and that story has been shaped by their own unique experiences.
2. Luck & Risk
Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort.
- When judging others, attributing success to luck makes you look jealous and mean, even if we know it exists. And when judging yourself, attributing success to luck can be too demoralizing to accept.
- We tend to seek out these lessons by observing successes and failures and saying, “Do what she did, avoid what he did.” If we had a magic wand we would find out exactly what proportion of these outcomes were caused by actions that are repeatable, versus the role of random risk and luck that swayed those actions one way or the other. But we don’t have a magic wand. We have brains that prefer easy answers without much appetite for nuance. So identifying the traits we should emulate or avoid can be agonizingly hard.
- The line between bold and reckless can be thin. When we don’t give risk and luck their proper billing it’s often invisible.
- Focus less on specific individuals and case studies and more on broad patterns.
- The more extreme the outcome, the less likely you can apply its lessons to your own life, because the more likely the outcome was influenced by extreme ends of luck or risk.
- You’ll get closer to actionable takeaways by looking for broad patterns of success and failure. The more common the pattern, the more applicable it might be to your life.
- When things are going extremely well, realize it’s not as good as you think. You are not invincible, and if you acknowledge that luck brought you success then you have to believe in luck’s cousin, risk, which can turn your story around just as quickly. But the same is true in the other direction. Failure can be a lousy teacher, because it seduces smart people into thinking their decisions were terrible when sometimes they just reflect the unforgiving realities of risk. The trick when dealing with failure is arranging your financial life in a way that a bad investment here and a missed financial goal there won’t wipe you out so you can keep playing until the odds fall in your favor. But more important is that 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. Nothing is as good or as bad as it seems.
3. Never Enough
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. If expectations rise with results there is no logic in striving for more because you’ll feel the same after putting in extra effort. It gets dangerous when the taste of having more—more money, more power, more prestige—increases ambition faster than satisfaction.
- Happiness, as it’s said, is just results minus expectations.
- Social comparison is the problem here… The ceiling of social comparison is so high that virtually no one will ever hit it.
- Reputation is invaluable. Freedom and independence are invaluable. Family and friends are invaluable. Being loved by those who you want to love you is invaluable. Happiness is invaluable. And 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.
4. Confounding Compounding
Linear thinking is so much more intuitive than exponential thinking.
- The danger here is that when compounding isn’t intuitive we often ignore its potential and focus on solving problems through other means. Not because we’re overthinking, but because we rarely stop to consider compounding potential.
- The practical takeaway is that the counterintuitiveness of compounding may be responsible for the majority of disappointing trades, bad strategies, and successful investing attempts.
- 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’s only one way to stay wealthy: some combination of frugality and paranoia.
- Capitalism is hard. But part of the reason this happens is because 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 humility, and fear that what you’ve made can be taken away from you just as fast. It requires 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.
- Survival. Not “growth” or “brains” or “insight.” 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.
- No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff. Say cash earns 1% and stocks return 10% a year. That 9% gap will gnaw at you every day. But 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, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.
- Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. 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.
6. Tails, You Win
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.
- “The great investors bought vast quantities of art,” the firm writes. “A subset of the collections turned out to be great investments, and they were held for a sufficiently long period of time to allow the portfolio return to converge upon the return of the best elements in the portfolio. That’s all that happens.” The great art dealers operated like index funds. They bought everything they could. And they bought it in portfolios, not individual pieces they happened to like. Then they sat and waited for a few winners to emerge. That’s all that happens.
- Anything that is huge, profitable, famous, or influential is the result of a tail event—an outlying one-in-thousands or millions event. And most of our attention goes to things that are huge, profitable, famous, or influential. When most of what we pay attention to is the result of a tail, it’s easy to underestimate how rare and powerful they are.
- Most financial advice is about today. What should you do right now, and what stocks look like good buys today? But 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.
- When we pay special attention to a role model’s successes we overlook that their gains came from a small percent of their actions. That makes our own failures, losses, and setbacks feel like we’re doing something wrong. But it’s possible we are wrong, or just sort of right, just as often as the masters are. They may have been more right when they were right, but they could have been wrong just as often as you.
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 today.”
- Happiness is a complicated subject because everyone’s different. But if there’s a common denominator in happiness—a universal fuel of joy—it’s that people want to control their lives. 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 most powerful common denominator of happiness was simple. Campbell summed it up: Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing than any of the objective conditions of life we have considered.
- More of us have jobs that look closer to Rockefeller than a typical 1950s manufacturing worker, which means our days don’t end when we clock out and leave the factory. We’re constantly working in our heads, which means it feels like work never ends. If your job is to build cars, there is little you can do when you’re not on the assembly line. You detach from work and leave your tools in the factory. But if your job is to create a marketing campaign—a thought-based and decision job—your tool is your head, which never leaves you. You might be thinking about your project during your commute, as you’re making dinner, while you put your kids to sleep, and when you wake up stressed at three in the morning. You might be on the clock for fewer hours than you would in 1950. But it feels like you’re working 24/7. Compared to generations prior, control over your time has diminished. And since controlling your time is such a key happiness influencer, we shouldn’t be surprised that people don’t feel much happier even though we are, on average, richer than ever.
8. Man in the Car Paradox
No one is impressed with your possessions as much as you are.
- There is a paradox here: people tend to want wealth to signal to others that they should be liked and admired. But in reality those other people often bypass admiring you, not because they don’t think wealth is admirable, but because they use your wealth as a benchmark for their own desire to be liked and admired.
- 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. 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.
9. Wealth is What You Don’t See
Spending money to show people how much money you have is the fastest way to lose money.
- We tend to judge wealth by what we see, because that’s the information we have in front of us. We can’t see people’s bank accounts or brokerage statements. So we rely on outward appearances to gauge financial success.
- 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.
- 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.
On the mindset driving or preventing savings…
- Investment returns can make you rich. But whether an investing strategy will work, and how long it will work for, and whether markets will cooperate, is always in doubt. Results are shrouded in uncertainty. Personal savings and frugality—finance’s conservation and efficiency—are parts of the money equation that are more in your control and have a 100% chance of being as effective in the future as they are today.
- Wealth is just the accumulated leftovers after you spend what you take in. And since you can build wealth without a high income, but have no chance of building wealth without a high savings rate, it’s clear which one matters more.
- Learning to be happy with less money creates a gap between what you have and what you want—similar to the gap you get from growing your paycheck, but easier and more in your control.
- One of the most powerful ways to increase your savings isn’t to raise your income. It’s to raise your humility.
On the impact of saving for times of uncertainty
- 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.
- When you don’t have control over your time, you’re forced to accept whatever bad luck is thrown your way. But if you have flexibility you have the time to wait for no-brainer opportunities to fall in your lap. This is a hidden return on your savings.
- Savings in the bank that earn 0% interest might actually generate an extraordinary return if they give you the flexibility to take a job with a lower salary but more purpose, or wait for investment opportunities that come when those without flexibility turn desperate.
- 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 feel less urgency to chase competitors who can do things you can’t, and 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. The ability to do those things when most others can’t is one of the few things that will set you apart in a world where intelligence is no longer a sustainable advantage.
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.
- A rational investor makes decisions based on numeric facts. A reasonable investor makes them in a conference room surrounded by co-workers you want to think highly of you, with a spouse you don’t want to let down, or judged against the silly but realistic competitors that are your brother-in-law, your neighbor, and your own personal doubts. Investing has a social component that’s often ignored when viewed through a strictly financial lens.
- Reasonable investors who love their technically imperfect strategies have an edge, because they’re more likely to stick with those strategies.
The correct lesson to learn from surprises is that the world is surprising. Not that we should use past surprises as a guide to future boundaries; that we should use past surprises as an admission that we have no idea what might happen next.
- It is smart to have a deep appreciation for economic and investing history. 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.
- A trap many investors fall into is what I call “historians as prophets” fallacy: An overreliance on past data as a signal to future conditions in a field where innovation and change are the lifeblood of progress.
- 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.
- That doesn’t mean we should ignore history when thinking about money. But there’s an important nuance: 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. Historians are not prophets.
13. Room for Error
The purpose of the margin of safety is to render the forecast unnecessary.
- You have to give yourself room for error. You have to plan on your plan not going according to plan.
- History is littered with good ideas taken too far, which are indistinguishable from bad ideas. The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance—“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.
- 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 biggest gains occur infrequently, either because they don’t happen often or because they take time to compound. So the person with enough room for error in part of their strategy (cash) to let them endure hardship in another (stocks) has an edge over the person who gets wiped out, game over, insert more tokens, when they’re wrong.
On using room for error appropriately..
- 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. That’s a single point of failure.
- 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.
14. You’ll Change
It’s hard to make enduring long-term decisions when your view of what you’ll want in the future is likely to shift.
- An underpinning of psychology is that 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. The fuel of the End of History Illusion is that people adapt to most circumstances, so the benefits of an extreme plan—the simplicity of having hardly anything, or the thrill of having almost everything—wear off. But the downsides of those extremes—not being able to afford retirement, or looking back at a life spent devoted to chasing dollars—become enduring regrets. Regrets are especially painful when you abandon a previous plan and feel like you have to run in the other direction twice as fast to make up for lost time.
- We should also come to accept the reality of changing our minds. Some of the most miserable workers I’ve met are people who stay loyal to a career only because it’s the field they picked when deciding on a college major at age 18. When you accept the End of History Illusion, 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 old enough to qualify for Social Security are low.
- Sunk costs—anchoring decisions to past efforts that can’t be refunded—are a devil in a world where people change over time. They make our future selves prisoners to our past, different, selves.
15. Nothing’s Free
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.
- Most things are harder in practice than they are in theory. Sometimes this is because we’re overconfident. More often it’s because we’re not good at identifying what the price of success is, which prevents us from being able to pay it.
- Here’s the important part. Like the car, you have a few options: You can pay this price, accepting volatility and upheaval. Or you can find an asset with less uncertainty and a lower payoff, the equivalent of a used car. Or you can attempt the equivalent of grand-theft auto: Try to get the return while avoiding the volatility that comes along with it.
- It sounds trivial, but 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
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 the factors those investors pay attention to are different.
- 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. That process feeds on itself. As traders push up short-term returns, they attract even more traders. Before long—and it often doesn’t take long—the dominant market price-setters with the most authority are those with shorter time horizons. Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: time horizons shrinking as more short-term traders enter the playing field.
- These two investors rarely even know that each other exist. But they’re on the same field, running toward each other. When their paths blindly collide, someone gets hurt. Many finance and investment decisions are rooted in watching what other people do and either copying them or betting against them. But when you don’t know why someone behaves like they do you won’t know how long they’ll continue acting that way, what will make them change their mind, or whether they’ll ever learn their lesson.
- 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.
17. The Seduction of Pessimism
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…. Pessimism just sounds smarter and more plausible than optimism.
- John Stuart Mill wrote in the 1840s: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”
- Part of it is instinctual and unavoidable. Kahneman says the asymmetric aversion to loss is an evolutionary shield. He writes: “When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”
- It’s 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.
- 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. Which, ironically, is something to be optimistic about.
18. When You’ll Believe Anything
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.
- When we think about the growth of economies, businesses, investments and careers, we tend to think about tangible things—how much stuff do we have and what are we capable of? But stories are, by far, the most powerful force in the economy. They are the fuel that can let the tangible parts of the economy work, or the brake that holds our capabilities back.
- Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
- Daniel Kahneman once told me about the stories people tell themselves to make sense of the past. He said: 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.
- Coming to terms with how much you don’t know means coming to terms with how much of what happens in the world is out of your control. And that can be hard to accept.
19. All Together Now (All the Ideas)
The following is the author’s summary chapter where he ties the ideas together:
Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong. Because it’s never as good or as bad as it looks. The world is big and complex. Luck and risk are both real and hard to identify. Do so when judging both yourself and others. Respect the power of luck and risk and you’ll have a better chance of focusing on things you can actually control. You’ll also have a better chance of finding the right role models.
Less ego, more wealth. Saving money is the gap between your ego and your income, and wealth is what you don’t see. So wealth is created by suppressing what you could buy today in order to have more stuff or more options in the future. No matter how much you earn, you will never build wealth unless you can put a lid on how much fun you can have with your money right now, today.
If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon. Time is the most powerful force in investing. It makes little things grow big and big mistakes fade away. It can’t neutralize luck and risk, but it pushes results closer towards what people deserve.
Become OK with a lot of things going wrong. You can be wrong half the time and still make a fortune, because a small minority of things account for the majority of outcomes.
The ability to do what you want, when you want, with who you want, for as long as you want to, pays the highest dividend that exists in finance.
Be nicer and less flashy. No one is impressed with your possessions as much as you are.
Saving for things that are impossible to predict or define is one of the best reasons to save. Everyone’s life is a continuous chain of surprises. Savings that aren’t earmarked for anything in particular is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.
Define the cost of success and be ready to pay it. Because nothing worthwhile is free. And remember that most financial costs don’t have visible price tags. Uncertainty, doubt, and regret are common costs in the finance world. They’re often worth paying. But you have to view them as fees (a price worth paying to get something nice in exchange) rather than fines (a penalty you should avoid).
Worship room for error. A gap between what could happen in the future and what you need to happen in the future in order to do well is what gives you endurance, and endurance is what makes compounding magic over time. Room for error often looks like a conservative hedge, but if it keeps you in the game it can pay for itself many times over.
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.
- [Wealth Creation] It’s mostly a matter of keeping your expectations in check and living below your means. Independence, at any income level, is driven by your savings rate. And past a certain level of income your savings rate is driven by your ability to keep your lifestyle expectations from running away.
- If I had to summarize my views on investing, it’s this: Every investor should pick a strategy that has the highest odds of successfully meeting their goals. And I think for most investors, dollar-cost averaging into a low-cost index fund will provide the highest odds of long-term success.
- One of my deeply held investing beliefs is that there is little correlation between investment effort and investment results. The reason is because the world is driven by tails—a few variables account for the majority of returns.
I greatly enjoyed the insights and concepts shared by the author. A reminder to be more humane and empathetic when in our personal and financial lives. All content credit goes to the author. I’ve simply shared the bits I’ve enjoyed the most and found most useful.
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Cheers ’till next time!