Morgan Housel defines ‘Psychology of Money’ as “a soft skill where how you behave is more important than what you know.” It’s been one of my favorite books of 2020. From exploring what wealth/money means to us, to why we make decisions managing our finances. There’s a lot of broad wisdom shared in this book and the principles can definitely help people reading it improve their behaviors/outlook on personal finance.

Here are some of my key takeaways from his book -

Power of Compounding

“As I write this Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s.”

Compounding is one of the easiest ways to grow your wealth. A term that is conceptually understood but only one observes the practice behind the principle does one truly understand how people become wealthy.

You may not be excited by this power of compounding on your investments when you first start off. But as your wealth grows over time the effects of compounding become stronger and stronger.

Morgan mentions that Warren Buffet’s greatest secret to being successful is time. He started investing when he was 11 and the more time you have to let compounding work the greater the results.

He argues that you don’t even need to be a great investor to get great returns. Often enough, just average investors that start early in compounding their wealth often end up growing their wealth faster.

Highest ROI from money - time

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

What is it that gives the best ROI when it comes to money? Time. Time spent with family, friends, and do whatever one wants.

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.

Even work that one enjoys doing on a schedule can feel like a chore because people love to be in control. When there is an attempt to get people to do something, they feel disempowered. And so they say no or do something else, even when they might have originally been happy to go along.

Morgan hints that in our current situation - we’ve used our greater wealth to buy bigger and better stuff. And in this process, we have simultaneously given up more control over our time.

Understanding your own financial time horizons and goals

This is what Morgan had to say about how ‘bubbles’ are formed -

• 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.
• The formation of bubbles isn’t so much about people irrationally participating in long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture the momentum that had been feeding on itself.

This point is especially important when you realize when you see sometimes wonder why a stock seems to be exponentially rising without any particular reason. What we don’t realize is that the traders who were setting the marginal price of the stock were playing a different game than what a long-term investor was.

Sixty dollars a share was a reasonable price for the traders because they planned on selling the stock before the end of the day when its price would probably be higher. But sixty dollars was a disaster in the making for you because you planned on holding shares for the long run.

It’s hard to grasp that other investors have different goals than we do because an anchor of psychology is not realizing that rational people can see the world through a different lens than your own.

And while we can see how much money other people spend on cars, homes, clothes, and vacations, we don’t get to see their goals, worries, and aspirations. A young lawyer aiming to be a partner at a prestigious law firm might need to maintain an appearance that I, a writer who can work in sweatpants, have no need for. But when his purchases set my own expectations, I’m wandering down a path of potential disappointment because I’m spending the money without the career boost he’s getting. We might not even have different styles. We’re just playing a different game. It took me years to figure this out.

Morgan’s takeaway here is that few things will 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.

Hence, go out of your way to identify what game you’re playing.

And this brings us to the next takeaway -

Reasonable > Rational

“Aiming to be most reasonable works better than trying to be coldly rational”

Not all of the rational choices presented to us when it comes to finance are the ones that will bring us the most peace and joy.

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 a strategy that maximizes how well they sleep at night.

I thought what I wanted from my personal finance system was the most optimal strategy (always be optimizing). For eg - ensuring that I had the credit cards that maxed out my returns. While using multiple credit cards for the right cashback optimization can lead to decent savings - I think that it’s not worth it for the peace of mind.

It also helped me understand the thinking behind day traders in this para -

Day trading and picking individual stocks is not rational for most investors—the odds are heavily against your success. But they’re both reasonable in small amounts if they scratch an itch hard enough to leave the rest of your more diversified investments alone. Investor Josh Brown, who advocates and mostly owns diversified funds, once explained why he gets to do whatever.” Quite reasonable.

Having Room for Error

So now that you understand you have hopefully reflected on your financial goals and horizons and considered what is a reasonable approach, I wanted to bring the next big takeaway from the book: having room for error.

The book states that 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.

There are 2 reasons why people avoid the Room for Error - 1) the idea that somebody must know what the future holds, driven by the uncomfortable feeling that comes from admitting the opposite. 2) not taking actions that fully exploit an accurate view of that future coming true.

Having a gap between what you can technically endure versus what’s emotionally possible is an overlooked version of room for error.

What you can action from this is to think of your money as barbelled. Take risks with one portion and be terrified of losing the other.

The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.

You will change

Before you go ahead and set your financial goals in writing - having awareness of our ever-changing desires from the 2 concepts below will be key in setting the right goals.

End of History Illusion

The End of History Illusion is what psychologists call the tendency for people to be keenly aware of how much they have changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future.

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 the lost time.

Morgan argues that - “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 falls to the extreme sides of the spectrum.”

Sunk cost fallacy

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. It’s the equivalent of a stranger making major life decisions for you.

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.

This is a hard one to truly come out of. It requires strength to accept that what we may have spent large amounts of time working on might be something we have to let go because you’ve to discover something that is better aligned with your changing mind.

Pessimism just sounds smarter and more plausible than optimism

How many times have we come across a situation where we tell someone that everything will be great and they’re likely to either shrug you off or offer a skeptical eye. Or perhaps tell them that they’re in danger and you have their undivided attention.

The book quoted Matt Ridley from his book - ‘The Rational Optimist’ -

A constant drumbeat of pessimism usually drowns out any triumphalist song … If you say the world has been getting better you may get away with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If, on the other hand, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Peace Prize. In my own adult lifetime … the fashionable reasons for pessimism changed, but the pessimism was constant.

This argument is true beyond just finance.

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.

There is a large asymmetry in the news we read about the stock market today. Stocks rising 1% might be briefly mentioned in the evening news. But a 1% fall will be reported in bold, all-caps letters usually written in blood red.

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. 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.

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.

The bigger the gap between what you want to be true and what you need to be true to have an acceptable outcome, the more you are protecting yourself from falling victim to an appealing financial fiction.

For eg - If you think a recession is coming and you cash out your stocks in anticipation, your view of the economy is suddenly going to be warped by what you want to happen. Every blip, every anecdote, will look like a sign that doom has arrived—maybe not because it has, but because you want it to.

When planning we focus on what we want to do and can do, neglecting the plans and skills of others whose decisions might affect our outcomes.

Awareness of our tendency to do this can help us avoid big financial mistakes

Staying wealthy by becoming financially unbreakable

There’s only one way to stay wealthy: some combination of frugality and paranoia.

While getting money requires taking risks, being optimistic, and putting yourself out there. Keeping money requires the opposite of taking risks. 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.

The book highlights 3 key ways of keeping wealth

1) Be Financially Unbreakable - More than wanting big returns, be financially unbreakable. And if you’re unbreakable you will get the biggest returns, because you will be able to stick around long enough for compounding to work wonders 2) Planning is important - Plan for Room for Error - A frugal budget, flexible thinking, and a loose timeline—anything that lets you live happily with a range of outcomes. 3) Barbelled personality - optimistic about the future, but paranoid about what will prevent you from getting to the future—is vital.

Knowing when to stop

“Enough” is realizing that the opposite—an insatiable appetite for more—will push you to the point of regret.

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

People get susceptible to risky financial behavior when they don’t realize what having enough means. Social comparison is one of the issues here.

The point is that the ceiling of social comparison is so high that virtually no one will ever hit it. This means it’s a battle that can never be won, or that the only way to win is to not fight to begin with—to accept that you might have enough, even if it’s less than those around you.

Modern capitalism is a pro at two things: generating wealth and generating envy. Perhaps they go hand in hand; wanting to surpass your peers can be the fuel of hard work. But life isn’t any fun without a sense of enough. Happiness, as it’s said, is just results minus expectations.

Many will only stop reaching for more when they break and are forced to. This can be as innocent as burning out at work or a risky investment allocation you can’t maintain. But the key point to remember is -

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.

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