Most people approach money based on scientific principles. There are many formulae and theorems on how to invest and grow money. After the stock market crash of 2008, Morgan Housel, author of the book ‘Psychology of Money’, observed that handling money is more of an art than science and the success in handling money depends on how one handles the emotions and stress associated with money.
Unlike hard sciences like Physics, money is not dependent on some universal rules, it has behavioral connotations. In 2008 Mr.Housel wrote a report titled ‘Psychology of Money’ that contained 20 behavioral aspects relating to Money. The book 'The Psychology of Money - Timeless Lessons on Wealth, Greed and Happiness' is an elaboration of the ideas that were briefly discussed in the 2008 report.
The book is structured across Introduction, 20 chapters followed by a postscript on the evolution of the American investor over the last century. 18 chapters discusses the behavioral aspects of money, the penultimate chapter is a summary of the principles discussed in the earlier chapters. Chapter 20 discusses how he invests his money.
One, money has behavioural implications. How you make money depends on how you handle your emotions. The main emotions are fear and greed. People with calm temperament and reasonable expectations will succeed in financial markets. It is important to keep your balance when the whole world is either in panic or in euphoria.
Two, the idea of money is unique to each individual. It depends on her upbringing, education and experiences in the early adult age. It also is dependent on their goals and the life stage. This means that no single opinion is applicable to every investor. That is why you should be wary about the advises given in the finance channels. One’s personal experiences with money may have zero impact on how the world behaves, but it will have 80% impact on how they think about money.
Mr.Housel digs deeper into this point in the postscript of the book where he dissects the evolution of American investor over the last century. In the early part of the century, America was more egalitarian and income inequality was minimal. Policies were adopted to get people to spend. Policies like low interest rates, low mortgage rates and easy credit availability boosted the economy. The decade of 70s saw economy crash. The generation became more scared and cynical. Income inequality started growing. As things stand, while economy has boomed, the income inequality is at its highest. The idea of money held by the early generation is different from that of the current generation like chalk and cheese.
Three, being wealthy is different from staying wealthy. The behaviours required for both are polar opposites. While you need to take risks to become wealthy, you need risk aversion to stay wealthy. The approach that made one wealthy will not work to stay wealthy. Most people do not realize this simple fact.
Four, huge wealth is generated through compounding. For compounding to work, you must give it time. Also compounding is highly influenced by ‘Tail Events’, those once in a life time events which one cannot anticipate. The only way to do both, giving time and benefiting from tail events, is to stay invested in the market.
Five, history is a bad predictor of future in financial markets. The only lesson one should take from history is how successful people handled their emotions as things got difficult.
I am a fan of Morgan Housel. I try to read all the articles that he writes in his firm Collaborativefund.com. However I am a bit disappointed with this book. Except for occasional flashes of brilliance, the book is fairly pedestrian. He has written well, in simple language and short paragraphs (sometimes you get a feeling that you are reading a series of tweets), but that is Morgan Housel. He writes well.
To illustrate the point that handling emotions matter, author starts off the book with two examples, a janitor who died as a multi-millionaire and a brilliant businessman who lost all his money. The only difference was that the janitor accumulated shares of blue chip companies and let them compound without interruption, while the businessman frittered away all his money in conspicuous consumption.
What is the value of money? The greatest value of money is its ability to give control over your time. It gives you options. And making and keeping money depends on how you control your emotions.
Simple, no?
Luck and risks are two sides of the same coin. We need to recognize their role in financial success. When we analyze the impressive financial performance of others we do not spend time in analyzing the role of luck in their success. It is possible that the successful person might have taken some risks that went his way. Conversely, when we see failure we do not acknowledge the risks that were taken and which did not go as per plan. Surprisingly when we analyze our performance, we attribute our success to our efforts and failure to external environment (Market crashed, what could I do?)
Greed, the feeling of never having enough, is another behaviour that could torpedo our financial roadmap. It is important to know when something is enough. Greed is driven by external benchmark rather than an internal direction. Greed is also driven by a fear of leaving something on the table.
Few people 'really' understand the counter-intuitive nature of compounding. The first hard drive was 3.5MB, the latest ones are 100 TB, which is about 35 million times more than the first one. In 1950 nobody would have predicted this. The wildest prediction would have been 300 GB which is almost 10000 times more than the first one. When compounding is not intuitive, we try to fit other reasons.
One advantage of staying for a long time in the market is that you get the benefit of tail event - anything that is huge, profitable and influential is a tail event. A tail event is where you make huge returns that augments the compounding story. The challenge is that the tail events entail huge risks too.
There is a discussion in the book about the difference between being rich and being wealthy. Being rich is related to current income, the more your CI, the richer you are, while being wealthy is related to how much money can help you to do what you want to do. That should be the objective, and how do you achieve that? By saving more, by spending below your earning. In the long-term, your savings is all that matter.
Do not chase returns. Having a wealth goal, and enough savings will take you there. Greed is one of the enemies of wealth creation. Greed converts an internal goal to an external one. You are always chasing the next return rather than deciding what returns you want and what wealth you want to create.
When investing always try to be reasonable rather than being rational. Wanting to 'minimize my regret' is a good enough reason to invest conservatively. Don't compare yourself with Buffet and Lynch.
Factor of safety is very important. Author calls it 'Margin of Error'. Consider volatility in investing. Expect future returns to be lower than past returns and increase your savings and investment rates. Do not get into debt. Expect Murphy to strike, expect 'everything that can go wrong to go wrong'. Be paranoid.
Many people plan their money based on life goals. What they don’t do not realize is that the goals change, they change. What looked an exciting goal at one stage in life may not be relevant at another stage in life. The concept of 'End of history illusion' refers to the tendency of the people to overestimate their past changes and underestimate how much their personalities, desires and goals are likely to change in the future. The only goal of investing should be free time to do anything you want.
There are two things to keep in mind when making a long-term decisions. One, avoid extreme ends of financial planning. People adopt and adapt. Current extreme decision will constrain the future decision making. Take stock at every stage of life and take decisions that are best for that stage of life. A focus on moderation - moderate goals, moderate income - could help you stay the long-term course. Two, we should also accept the possibility of our minds changing. Don't hang on to sunk costs.
There is nothing like free lunch. You have to pay the price. The price you pay in investment is the volatility. You have to handle the emotions as the value of your investment falls. A person who pays anything before buying, balk at the price charged by the market. The reason is that the price comes after market raises the value of your investment. Instead of feeling like a price, the volatility loss feels like a fine for doing something wrong.
The above concept of prices of investment is from Chapter 15 That along with Chapter 16 and 17 are the best chapters in this book. This chapter discusses the bubbles. Bubbles happen as short term investors start chasing the prices and not the value. Author gives the example of CISCO. At one time the company was valued at 600 Billion Dollars an implicit growth rate at which company would have been valued bigger than US economy. This doesn't make any sense from an investor's perspective, but it makes all the sense from the perspective of a day trader who chases price and momentum. The duration of day trader is 20 hours or even 20 minutes. If a long-term investor decides to buy the stock of CISCO at that price, he would be making a big mistake.
The lesson is that the price and value of any investment is not fixed. It is dependent on the motives and mental makeup of the investor. One of the biggest mistakes that long-term investors make is in chasing the price. The rules are different for different types of investors. So if you are a long-term investor you should know what kind of investor you are, what kind of investments you are going to make and what kind of decisions you are going to make. Author gives an example of his vision statement. It states that 'he is a long-term investor who is optimistic about the future of the country'. He will invest in the stock market based on that view point.
While reading this chapter, I was thinking about value investors who came out of the market during the 2004-08 bull run. They said that there are no longer any value left in the market.
Pessimism is very easy to spread. Pessimists comes across as intellectuals. No one bothers to listen to people who are positive and optimistic. One of the reason why pessimism is very important is the historical evolutionary against loss aversion. There are three reasons why pessimism about money is rampant. One, money is ubiquitous and hence any bad news about money spreads very fast. Two, pessimists often extrapolate the current bad situation to future without considering how markets adapt. If there is a crash, there is an expectation that markets will stay down for a long time. But if there is growth, people are always asking the question 'when is the next crash'. Pessimism sells. The third reason is that growth happens too slowly to notice while setbacks happen too quickly to ignore.
The example of Wright brothers is relevant here. In the late 19th century, common wisdom was that man cannot fly. It took five years for the world to take notice of their achievement. All these five years, they were flying all over Dayton, Ohio and no one bothered. Even after it was established that man can fly, the conventional wisdom in 1905 was man cannot transport cargo across the country. The first Cargo flight took off in 1909.
Growth is driven by compounding. It always takes time. None notices. Destruction happens due to single point of contact and that is always too big to ignore. Pessimism has an advantage that it reduces expectation. It narrows the gap between possible outcome and outcome you feel great about. This ensures that more things will fall in your favour, which makes you more happy. Paradoxically, that is the definition of optimism.
In summary, the key message in the book is that your psychology matters most in investing. Understand what you need, accept that you will change over the time, be flexible and take reasonable risks. Most importantly the value of money is the amount of free time it can give you and the best way is to use the power of compounding. Compounding works and it takes time.
So just shut up and stay in the market.
So just shut up and stay in the market.
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