18 Key Money Lessons from The Psychology of Money by Morgan Housel
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Reading time: 11 minutes
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Introduction
In this blog post, we provide an in-depth analysis of Morgan Housel’s bestselling book “The Psychology of Money”, an essential book for mastering personal finance and achieving long-term financial success. The book delves into the emotional relationship between individuals and money, and explores the psychological factors that influence our financial decisions and behaviors. Housel offers insights into why people make certain choices and how understanding the underlying psychology can lead to better money management. This book will guide you to develop a smarter mindset toward managing money and personal finances and help you achieve long-term financial success.
One overarching theme of the book is that achieving financial success depends less on intelligence and more on your financial habits and behavior. The good news is that most people with low financial literacy can achieve financial success if they master a few behavioral skills that are unrelated to formal measures of intelligence or financial expertize. Below we break down the 18 key takeaways from the book.
18 lessons from The Psychology of Money
1. Recognize That Nobody is Crazy
People face incredibly different experiences with money. And what people experience is far more compelling than what they learn second-hand. Is it reasonable to expect people coming from different generations, growing up in different countries and family backgrounds, and born into different economies to show the same understanding of money?
If you were born in the 1960s in the US, inflation during your impressionable teens and twenties sent prices up threefold. Later in life this generation is more likely to invest more of their money in stocks and less in bonds. Someone in this cohort experienced a very different relationships with money than someone growing up, say, in the 1990s.
The same holds for different background, parents, and values, or for different incomes, incentives, and regions of the world. Everyone has different attitudes and relationships with money and different mental models resulting from vastly different experiences. Nobody is crazy, so don’t be so quick to judge—what seems crazy to some is perfectly rational to others.
2. Differentiate Between Luck and Risk
Nothing is as good or bad as it seems. We tend to focus and try to learn from stories of successful individuals, but we are generally not good at acknowledging the role that luck played in their story. Consider Bill Gates, who attended one of the only high schools in the US that had a computer. Only one in a million high-school-aged students attended a high school with a computer. Is it even possible to explain Bill Gates’ success without considering this incredibly lucky circumstance?
The more extreme the outcome, the less likely you can apply it to your situation. Of course, it is perfectly fine to draw motivation from Bill Gates or other successful individuals, but we shouldn’t expect to be able to mirror their success just by learning how they were good at their specific job. The world is far too complex to allow explaining any given outcome only by someone’s efforts, without considering chance.
Focus instead on trends and patterns, not on individuals. There are just too many moving pieces and it is very difficult to differentiate. between luck, risk, and skill. You will get closer to actionable takeaways by identifying broad trends and patterns of success and failure. The more common the pattern, the more likely you can apply it to your situation.
3. It Is Never Enough
One of the toughest personal finance skills is learning how to define and stick to your financial goals. Humans are wired to strive for more—more money, more power, more prestige. But if happiness is results minus expectations, we need to find a way to stop the goal posts from moving. Unfortunately, our expectations today are strongly grounded by social comparisons in an online, hyper-connected world.
The ceiling of social comparison is so high that almost nobody will ever reach it. Bertrand Russell warned that it is impossible to escape envy by means of success alone and reminds us that those who desired glory in the past envied Napoleon. But Napoleon envied Caesar, Caesar envied Alexander, and Alexander envied… Hercules, who never existed. The same is true with money. We should convince ourselves that this is not a game we can win if our main goal is to lead a good life. Stop the goal post, learn what is enough for you, and stick to it.
The true value of money lies in buying freedom and options. Photo by Eneko Uruñuela on Unsplash.
4. Confounding Compounding
96% of Warren buffet’s net worth came after his 65th birthday, at the time of the book’s publishing. There are thousands of articles, books, and videos praising Warren Buffett for his investing genius, but nearly none focusing on the secret behind Warren Buffett’s financial success: the power of long-term investing and compounding interest. The most important factor explaining his success is that he stuck with it, he remained invested for many decades and let the compounding do the heavy lifting. The takeaway is that successful investing is not just about high returns but also about consistency and patience over time, it is about earning pretty good returns and about following a strategy you can stick with over a long period of time.
5. Staying Wealthy Is a Different Game Than Getting Wealthy
Getting money and keeping money require two very different set of skills. The former requires taking risks, being optimistic, and being brave, while the latter requires a certain degree of humility, and even fear that you may loose what it took you so long to acquire. Staying wealthy requires a survivor mentality; the ability to stick around for a long time, without making major mistakes, to be able to fully benefit from the power of compounding.
6. The Importance of Tail Events
A small number of events typically account for the majority of outcomes. Recognize that many things in business and investing work this way. Long tails—the farthest ends of a distribution of outcomes—have a critical importance in finance. Since 1980, the overall returns from the Russell 3000 index—which roughly represents the US economy—were explained by only 7% of the stocks. 40% of stocks lost over 70% of their value and never recovered during the same period. Charlie Munger recognized that “if you remove just a few of Berkshire’s top investments, its long-term track is pretty average”. Remember, tails drive everything in investing, and it is incredibly challenging to correctly identify the needle in the haystack.
7. Financial Freedom Is The Ultimate Goal
Money’s greatest intrinsic value is its ability to give you control over your time. Housel argues that if there is a common denominator in happiness, it is that people want to control their own lives. I think many of us can relate to this; even for those who objectively enjoy their job, doing it on a schedule you don’t control can sometimes feel similar to doing something you dislike.
Despite the US being the richest country in history, there is little evidence that their citizens are becoming happier. The author suggests that this is, in part, because we have given up more control over our time. Due to the changing nature of today’s white collar jobs, many workers continue to think about work in their free time. We are constantly working in our heads, so it feels like work never ends. Remember that controlling your time is the highest dividend money can pay.
8. Man In The Car Paradox
They are looking at your car, not at you. Many individuals desire wealth as a status symbol to gain respect and admiration from others. Unfortunately for the person owning the fancy car, it simply doesn’t work this way. When he drives by with his ride, by-passers may take a hard look at the Ferrari, at the gadget, but mostly ignore the person. They are not thinking “wow, this guy is really cool and successful, he is driving a Ferrari. How admirable”. In fact, most are just daydreaming what it would be like for them to drive a Ferrari. Buying fancy objects is just the wrong place to invest your money if what you are after is respect and admiration. Housel argues that this is much easier to achieve this with humility, kindness, and empathy, which is free. Remember that nobody is impressed by your possessions as much as you are.
Are you truly wealthy or just rich? Photo by Dieter Blom on Unsplash.
9. Wealth Is What You Don’t See
Spending to show off your wealth is one of the quickest ways to sabotage your financial health. We tend to judge wealth by what we see, because that is all the information that is in front of us. We rely on outward appearances to gauge financial success: a nice home, a fancy car, an exotic holiday. This is a terrible way to make inferences on wealth. In reality, wealth is what you don’t see: the fancy cars not purchased, the watches not worn, the diamonds not bought. As Housel reminds us, “wealth is financial assets that haven’t yet been converted into the stuff you see”. True wealth comes when you don’t spend the money, and it is what buys you freedom and flexibility. For most, acquiring true wealth requires discipline, self-control, and being OK with not looking rich.
10. Keep Calm and Focus On Saving Money
Your savings rate plays a more critical role in wealth-building than your income or stock market returns. Housel argues that embracing a frugal lifestyle and finding contentment with less are key to achieving financial independence and long-term wealth, since they are more in your control and have a 100% chance of being effective over time. On the other hand, if you view building wealth as always needing more income or higher returns, then your financial journey and ultimate success may be a hard and bumpy one—a path largely out of your control. The risk is that you may be easily discouraged by the output and not focus on regularly saving and investing.
Increasing your humility and learning to be happy with less also leads to wealth and financial safety. The book defines savings as the difference between your ego and your income. Let that sink in for a moment… you may then realize why so many people with good incomes fail to save enough money. Again, remember the distinction we mentioned earlier between being rich and being wealthy. Which one do you prefer? Are you ultimately seeking status, peer approval, and short term gratification or do you prefer to gain the freedom that is generated by the wealth that is not externally visible? Housel argues that having control over your time and options is increasingly “becoming one of the most valuable currencies” in a world were intelligence no longer provides a sustainable advantage.
11. Being Reasonable Works Better Than Being Rational
When it comes to financial decisions, aiming to be pretty reasonable is often more realistic and has better outcomes than being coldly rational. Rather than trying to find the mathematically optimal investment strategy, try to maximize instead for how well you sleep at night. Consider the following example: there is consensus in the financial community that there is an investment premium to investing in value stock. With this information, the perfectly rational decision may be to invest 100% of your stock portfolio in a fund that focuses exclusively on value stocks. The problem is that although this may be true in the long term, you may have to sit on a very volatile fund that underperforms a simple index fund for more than a decade. Can you stomach the underperformance and the second-guessing that may come from adopting this strategy? Consider instead buying a simple, low-cost index fund, which will provide you with very acceptable returns and will allow you to sleep better at night.
12. Expect Surprises Along The Way
Understand that financial markets are unpredictable and learn how to adapt your personal finance strategy accordingly. While it is useful to have an understanding of the past, relying on it too strongly may miss the outlier events that will move the needle the most in the future. Acknowledge that the majority of what is happening in the global economy at any given moment can be tied back to a handful of past events that were impossible to predict. In finance, the further back in history we look, the more general your takeaways should be. Remember that structural changes in today’s world mean past lessons from history may no longer applicable.
In the short term, the world is a very unpredictable place. Take a step back though and acknowledge that over time optimism is the correct lens to adopt. Photo by Chris Lawton on Unsplash.
13. Leave Some Room For Error
Adopting a margin of safety—some room for error—is an effective strategy to navigate a world that is driven by odds—not certainties—and subject to surprises. What we generally want is to pursue strategies where we are happy with a wide range of potential outcomes. Implementing a margin of safety comes in numerous forms. For example, by adopting a frugal budget and living below your means you will be more likely to weather any unexpected event, e.g., job loss, lower income, or lower than expected returns from your investments. Flexible thinking and a having a loose timeline for your financial strategy will also make it easier for you to adapt when the unpredictable happens. You should definitely avoid any plan that is too rigid in its assumptions (e.g., my plan only works if I receive the historic average market return or my plan only works if I am continuously employed throughout the entire timeline of the plan). Remember, you should aim to be happy with a wide range of outcomes, so be carful when setting the assumptions underlying your plan.
14. Remember The End of History Illusion
Long-term planning is difficult because people change over time, and so do their goals and desires. I am certainly a very different person than I was 10 years ago: I think differently, my political views have slowly changed over time, and what I expect from my working career has also shifted. Remember 'The End of History Illusion,' which is what psychologists call the tendency for people to be very aware of how much they have changed in the past, but to underestimate how much their personalities, desires, and goals will continue to change in the future. Housel recommends to minimize regret by adopting a moderate mindset and avoiding extreme financial commitments. We may be happy with our current level of frugality, but our future self may think differently. We may feel desperately the need for changing something in our lives today, but our future self may experience regret at what is perceived in hindsight as running away from something.
15. Nothing Is Free–There’s Always a Cost to Investing
Remember that successful investing always demands a price. Most financial costs don’t have visible price tags. Their currency is not dollars, but volatility, fear, doubt, uncertainty, and regret. Consider that Netflix returned more than 35,000% between 2002 and 2018, but traded below its previous all-time high on 94% of days. If you were holding Netflix, you were sure to experience a bumpy ride. Whether you are a value stock investor or a passive index fund investor, you are going to deal with some serious volatility and uncertainty throughout your investing journey, which at times will be difficult to stomach. Many investors try shortcuts to avoid paying “the price”: some of them try chasing “easy” returns or perhaps try to time the market by jumping in and out of stock holdings. Unfortunately for them, here is no free lunch when it comes to investing, and those who avoid paying the price typically end up paying double.
Nothing is free. There is always a price tag, also with investing. Photo by Jesse Schoff on Unsplash.
16. Which Game Are You Playing?
Recognize that there are different types of investors playing very different games. When investors have different goals and time horizons, prices that look ridiculous to one investor can make perfect sense to another. Why? Because the factors they pay attention to are very different. For instance, bubbles are damaging when long-term investors playing one game start taking cues from short-term traders that are playing a very different game. The important takeaway is to understand at a deep level your own time horizon so you are not at risk of being persuaded by the behaviors of investors playing different games. The latest start-up’s IPO? No, thanks. The latest cryptocurrency? No, thanks. Cathie Wood’s latest world-changing innovation ETF? No, thanks.
17. Pessimism Is Attractive
Pessimism sounds like someone is trying to help you, while optimism sounds like a sales pitch. However, recognize that optimism is actually our best bet when it comes to investing, because the world tends to get better for most people most of the time. Pessimism sounds smarter, more plausible, and generally sells better. Think about the last time you turned on the TV to watch a discussion between two business experts agreeing with each other that the stock market is doing fantastic and that we should just sit tight for decades and never sell. Despite the stock market performing as a whole incredibly well over time, irrespective of the actual situation, you will typically hear that there is a crash around the corner, that events A and B may disrupt everything, that you should not be complacent, etc. Remember that pessimism is their business—their goal is to keep you glued to the TV. They certainly don’t have sincere concerns for your retirement portfolio.
18. Be Careful About What You Believe
Acknowledge that the more you want something to be true, the more likely you will believe a story that overestimates the odds of it being true. Consider that 85% of mutual funds underperformed their benchmark over the 10 years ending in 2018. Does an industry with such poor track record go out of business? The reality is completely the opposite: there are trillions of dollars in these funds and no shortage of people willing to hand over their life savings to active investors charging very high fees. As mentioned above, people want to avoid paying the price, and will unfortunately follow the misleading marketing that many of these funds are selling. Be careful about what you believe.
Enjoyed this post? Don’t miss our insights on flexible withdrawal strategies for early retirement and our post on the importance of index funds in your financial independence journey.
