Book Summary: The Psychology of Money by Morgan Housel

This book uses short stories to illustrate how managing money to become wealthy (not rich) relies more on how we think about money rather than the technical aspects of making money. The stories used to illustrate key aspects of the human condition and its relationship with the construct of money are wide-ranging and vivid. So, while my top takeaways below are direct from the bullet points from the penultimate chapter in the book, they are likely to mean a lot less to you without those stories and how you interpret them to your own context. Ultimately I felt vindicated for what would be likely be perceived by many as a conservative approach to my finances. The game I play seems a lot like the game Morgan plays — little but consistent plays that provide for long-term happiness.

From the author

“Financial success is not a hard science. It’s a soft skill, where how you behave is more important than what you know.

Finance is overwhelmingly taught as a math-based field, where you put data into a formula and the formula tells you what to do, and it’s assumed that you’ll just go do it…

…knowing what to do tells you nothing about what happens in your head when you try to do it.

What you are holding is 20 chapters, each describing what I consider to be the most important and often counterintuitive features of the psychology of money.”

Morgan Housel

Favourite quotes

“Achieving some level of independence does not rely on earning a doctor’s income. 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.”

“Expectations always move slower than facts.”

Top Takeaways

• Get out of your own way to find humility when things are going right and forgiveness/compassion when they go wrong because it’s never as good or bad as it looks.
• Less ego, more wealth. Wealth is created by suppressing what you could buy today in order to have more stuff or options in the future.
• Manage your money in a way that helps you sleep at night
• If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon.
• 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.
• Use money to gain control over your time, because not having control over your time is such a powerful and universal drag on happiness.
• Be nice and less flashy.
• Save. You don’t need a specific reason to save.
• Define the cost of success and be ready to pay for it, because nothing worthwhile is free.
• Worship 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 that will pay off over time.
• Define the game you are playing, and make sure your actions are not being influenced by people playing a different game.
• Respect the mess. There is no single right answer, just the one that works for you.

Deep Dives

No one’s crazy

An individual’s willingness to bear risk depends on personal history — in what generation they are born into, under what values they were raised, how much their parents earned, in what part of the world and in which economy, and what kind of job market they encountered with its unique incentives and degrees of luck.

We all make decisions based on our own unique experiences that seem to make sense to us in each moment.

Also, a lot of financial misadventure can be explained by how new the topic of personal financial management is. Planning for retirement is two generations old. Index funds are less than 50 years old. We’re not crazy, we are just new to all this.

Luck and risk

It’s impossible to know the role that random luck or risk plays in any one person’s financial success. The same is true of the role of calculated and repeatable actions. We tend to defer to a clear-cut case of cause and effect when you succeed (good decisions) or others fail (bad decisions) but make up stories to justify our own failure (risk) or others' success (luck).

At the end of the day, we need to realise that when things are going well, it is luck that in some proportion or another brought you success — you are not invincible. Likewise, if you fail, realise that risk played a role. It is not over — you can keep playing until the odds fall in your favour.

Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort.

The difficulty in identifying what is luck, what is skill, and what is risk is one of the biggest problems we face when trying to learn about the best way to manage money.

But two things can help:

1. Be careful who you praise and admire. Be careful who you look down upon and wish to avoid becoming.

2. Focus less on specific individuals and case studies and more on broad patterns.

Never Enough

If you earn a salary or have a sum of money sufficient to cover every reasonable thing you need and a lot of what you want to remember a few things:

1. The hardest financial skill is getting the goal post to stop moving. Life isn’t any fun without a sense of enough. Happiness = results - expectation.
2. Social comparison is the problem. What you earn or have materially is but one aspect of who you are and only one person can be the richest no matter what perimeter you put on it. Trying to keep up with aiming to surpass other people’s wealth is a game of zeros. There are so many other aspects of life that make us rich.
3. ‘Enough’ is not too little. You might think the idea of having ‘enough’ is about leaving opportunity unrealised, but really believing you cannot have ‘enough’ will result in regret — burn-out, risky investments, or poor decisions.
4. There are many things never worth risking, no matter the potential gain. The best way to ensure you build and maintain a good reputation, freedom, independence, family, friends, being loved by those who you want to love you, and being happy is knowing when to stop taking risks that will harm others ie known when is enough.

Confounding compounding

Never underestimate the power of compounding. This is the simplest and yet most powerful tool for building enough and yet the one most often ignored.

…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.

Getting wealthy vs staying wealthy

There are a million ways to get wealthy, but staying wealthy requires a different skill set — the opposite of risk.

[Keeping money] 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.

There are two reasons why a survival mentality is key:

1. Few gains are so great they are worth wiping yourself over
2. Realising the counter-intuitive math of compounding

Warren Buffet succeeded in part because of what he didn’t do — get carried away with debt, panic and sell during recessions (there have been 14 over this life), damage his reputation, attach himself to passing trends or one world view, rely on others’ money, burn-out, quit or retire. He survived.

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

Tails, you win

Long tails — the farthest ends of the distribution of outcomes — have tremendous influence on finance, where a small number of events can account for the majority of outcomes.

That can be hard to deal with, even if you understand the math. It’s 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. Which is why we overreact when they do.

Tails drive everything, venture capital, large public stocks, and even the success of individual companies (Amazon’s growth is attributable to Prime and AWS, Apple to the iPhone). The idea that a few things account for the most results applies to your own behaviour as an investor.

If you can maintain your cool on the small number of occasions that everyone is losing their minds, you’ll be OK. You’ll realise that it’s normal for lots of things to go wrong for one thing to go very right.

Freedom

More than your salary. More than the size of your house. More than the prestige of your job. Control over doing what you want, when you want to, with the people you want to, is the broadest lifestyle variable that makes people happy.

Money’s greatest intrinsic value — and this can’t be overstated — is its ability to give you control over your time.

Household income has more than doubled in 60 years and yet we’re no happier — even with bigger homes, faster cars, more gadgets, and holidays. The saying ‘money doesn’t buy happiness’ is true. The knowledge-based economy is controlling more of our time —a key happiness influencer. When we are old the things we are going to wish we had more of aren’t money, but friendships, a sense of making a difference, and connecting with family.

Controlling your time is the highest dividend money pays.

Man in the car paradox

No one is as impressed with your possessions as you are.

If respect and admiration are your goal, be careful with how you seek it. Humility, kindness, and empathy will bring you more respect than horsepower ever will.

Wealth is what you don’t see

Spending money to show people how much money you have is the fastest way to have less money. And the only way to be wealthy is to not spend the money you have. Wealth is hidden. Its value is the ability to provide you with better options later.

When most people say they want to be a millionaire, what they actually mean is “I’d like to spend a million dollars”. And that is literally the opposite of being a millionaire.

…It is so engrained in us that to have money is to spend money that we don’t get to see the restraint it takes to actually be wealthy.

Save money

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

Personal savings and frugality are part 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.

The value of wealth is relative to what you need.

Learning to be happy with less creates a money gap between what you have and what you want.

Past a certain level of income, what you need is just what sits below your ego. People with enduring financial success tend to not care what people think about them.

…one of the most powerful ways to increase your savings isn’t to increase your income. It’s to increase your humility.

So, people’s ability to save is more in their control than they might think.

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.

And you don’t need a specific reason to save.

Only saving for a specific goal makes sense in a predictable world. But ours isn’t. Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.

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.

That flexibility and control over your time is an unseen return on wealth.

And that hidden return is becoming more important.

Intelligence is not a reliable advantage in a world that’s become as connected as our has. But flexibility is.

Reasonable>rational

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

Surprise!

History is mostly the study of surprising events. But it is often used by investors and economists as an unreasonable guide to the future.

If you rely too heavily on investment history as a guide to what the future holds two dangerous things happen:

1. You’ll likely miss outlier events that move the needle the most (vaccines, antibiotics, fall of USSR, 11 September, internet, data)
2. It doesn’t account for structural changes that are relevant to today’s world (superannuation, VC, tech stocks, changed accounting rules).

..specific trends, specific trades, specific sectors, specific causal relationships about markets, and what people should do with their money are always examples of evolution in progress. Historians are not prophets.

Room for error

The most important part of every plan is planning on your plan not going according to plan.

The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance — ‘unknowns” — are an ever-present part of life.

Throwing all your eggs in one basket can wipe you out. Spreading the risk keeps you in the game. Practicing the allowance of a margin of error, especially when it comes to volatile markets and saving for retirement, provides for endurance and protects you when things you’d never imaging happening happen.

For my own investments…I assume the future returns I’ll earn in my lifetime will be 1/3 lower than the historic average. So, I save more that I would if I assumed the future will resemble the past. It’s my margin of safety.

Be careful of optimism bias in risk-taking — when favourable odds have an unacceptable downside. No risk that can wipe you out is ever worth taking, just think of Russian roulette.

When it comes to finances, don’t risk it with a single point of failure. Save for the single point of failure in the future that your brain can’t even imagine happening. Plan on your plan not going according to plan.

You’ll change

Long-term planning is harder than it seems because people’s goals and desires change over time.

People underestimate how much they will change in the future. We need to ensure that we encourage moderation (savings, free time, commuting, family time). Doing so increases the odds we’ll stick to a plan and avoid regret should we choose instead an extreme side of the spectrum. We also need to accept the reality of change and move on as soon as possible. Don’t allow the concept of sunk cost to tie you to decisions you made when your ideas were different. Accept the change quickly and get on with compounding.

Compounding works best when you can give a plan years or decades to grow. This is true not only for savings but careers and relationships. Endurance is key. And when you consider our tendency to change who we are over time, balance at every point in your life becomes a strategy to avoid future regret and encourage endurance.

Nothing’s free

Everything has a price, but not all prices appear on labels.

All financial strategies have a price. Market volatility is the fee, not a fine. It’s the price we pay for admission to experience financial return in the long term. Find the price you are willing to pay.

You & me

Beware of taking financial cues from people playing a different game than you are.

How much you should pay for an asset depends on the time frame of your investment horizon and what goals you are working to achieve. Everyone is different. Identify what game you are playing and don’t be persuaded by other investors that are very likely playing a different game to you. Flippers and day traders are working on completely different time horizons and goals than those who are in it for the long term.

The seduction of pessimism

Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.

Real optimists don’t believe that eveything will be great. That’s complacency. Optimism is a belief that the odds of a good outcome are in your favour over time, even when there will be setbacks along the way.

People tend to believe in a pessimistic outlook than an optimistic one. Pessimism seems smart and more plausible and people who practice it are perceived as sage.

An aversion to loss is an evolutionary trait, but financial pessimism is more common and more persuasive than optimism. This is because money affects everyone and captures their attention — progress is slow and barely noticeable but setbacks happen quickly and are hard to ignore. Pessimists extrapolate present trends without consideration of how the market will adapt.

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.

Become too pessimistic and you’ll never risk anything.

When you’ll believe anything

Appealing fictions, and why stories are more powerful than statistics.

The more you want to believe something is true, the more likely you are to believe a story that overestimates the odds of it being true.

Just think of astrology, dreams, old wives’ tales, gambling, financial and political pundits. Limited control and high stakes have us searching out ‘answers’ that appeal to the strategy or side you’ve selected. But the risk is that every blip is a signal that the end is nigh — and perhaps that’s exactly what you are banking on.

Incentives are a powerful motivator, and we should always remember how they influence our own financial goals and outlooks. In can’t be overstated: there is no greater force in finance than room for error, and the higher the stakes, the wider it should be.

In an incomplete world, we form a narrative to fill the gaps to feel in control.

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.

We neglect the role of luck and the plans and skills of others. Instead, we focus on what we know, making us overly confident in our beliefs.