3 Key Takeaways from the Psychology of Money by Morgan Housel
A few months ago, I read the book Psychology of Money by Morgan Housel, which was refreshing. The book was not about investments but explored the lesser-talked aspects of our relationship with money by talking about wealth, greed, and happiness.
After conducting numerous financial-related workshops and webinars over the past year, we at J Advisory found that growing one’s net worth has more to do with our mental perception and behaviour towards money than calculations and strategies on a spreadsheet.
Here is a summary of the book:
The Psychology of Money explores how money circulates in an economy, how we create personal biases, how emotional factor plays an important role in our financial decisions, and how to think more rationally and make better financial decisions.
Morgan Housel’s book is an easy read as he shares his discoveries on our beliefs and approach to money with short stories and chapters. The series of short stories are presented in 18 chapters related to our biases, flaws, behaviours or attitudes that affect our financial outcomes. These jointly make up our psychology of money.
Here is a summary of the chapters:
Big Idea: Our minds could not conceptualise the power of the compounding effect, which leads to logic-defying results.
Morgan presented this case with the story of Warren Buffet, the greatest investor of our time. Buffet made his fortune by not only being a good investor by investing in fundamentally strong companies but also staying invested since he was 11 years old.
From the above illustration, we can see that Warren Buffett’s net worth grew exponentially only after his 50th birthday. Buffet has achieved an average annual return of 22%, beating the average stock market return. That sounds impressive, but other investors achieve greater results. For example, Jim Simons, a mathematician who runs the firm Renaissance Technologies achieved 66% returns for the last 33 years. But Simons net worth is a quarter of Buffett’s net worth because Simon’s did not consistently compound his money as long as Buffett.
Start building independence-level wealth by investing in appreciating assets (stocks, bonds, commodities, gold, etc.) now, allowing compounding enough time to work its magic.
“The first rule of compounding is to never interrupt it unnecessarily.”Charlie Munger, Buffet’s partner in crime
The slow and steady nature of compounding leads even the smartest of us to overlook its enormous power when we constantly shift our investing goalpost. Once you achieve your goals, you look toward the next goal. And the cycle never ends. Compounding is deceptively powerful. Stick to the plan and don’t constantly change it.
Big idea: Everything has a price, but not all prices are immediately obvious.
There is no such thing as a free lunch, if at all there is, then most likely it’s a scam. When we are investing, there is a price to pay in the form of market volatility.
Market volatility refers to the daily ups and downs of prices in the market. Stocks have higher volatility as their prices fluctuate more in a day.
If you can’t emotionally handle the ups and downs of the stock market (or other volatile markets), invest in low-volatility assets, like bonds, money market or FD. In return, you will get much lower average annual returns than the stock market.
A more volatile market offers a higher return, but most of us can’t stomach a downturn. When we see our portfolio going red, there will be a higher tendency to sell rather than continue being invested. Therefore, volatility is the emotional price you need to pay to get high average annual returns.
Housel described a great story that could help us stay on course when our stock dips. He suggested embracing volatility by viewing it as a fee, not a fine. If you get a fine for parking in an illegal spot, you change your behaviour and avoid that spot in the future as it gives you a bad experience. But if you pay a fee to park in that spot, you happily pay the fee if the parking spot is the best parking spot in that area.
In the context of investing, if you own a large stock market index like the S&P 500, do not view the dips as a sign you are doing something wrong, but as the fee, you need to pay to receive high average annual returns. If you can do this, you are more likely to stay in the game long enough for investment gains to work for you.
Housel writes, “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 favour.”
Big idea: You can be wrong half the time and still make a fortune.
“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 are the result of a tail, it’s easy to underestimate how rare and powerful they are.”
What are long tails, then? Here is the definition from the book:
“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.”
One great story which brings home this point is the story of Amazon Web Services. Jeff Bezos, the founder of Amazon, made hundreds of small bets on his company. Some were failures like the $170-mil Amazon Fire phone, but one of his winning bets was Amazon Web Services – a small side project that now generates over 60% of Amazon’s operating income. Amazon Web Services is a tail investment – a single investment that massively outperformed all other investments and made up for several poor investments.
Since it is impossible to know which investments will generate huge returns and which will not, it’s wise to diversify your investments instead of going all in on ONE investment. Make at least ten equal investments in a diversified group of stocks, currencies, commodities, or other assets you think could double in the next five years. Do not be alarmed if many of your investments are losers, so long as a few investments are huge winners.
Most personal finance and investment books usually focus on the technical aspects of money and investment, e.g. how to select stocks or build a portfolio. In the Psychology of Money, author Morgan Housel addresses that financial success depends more on our soft skills (how we manage our psychology and emotional impulses) than our technical skills in financial analyses and market rules/laws. It was a great read, and I would recommend it!