I read Morgan Housel’s “The Psychology of Money” towards the end of last year. I found it an insightful book that took a more personal and nuanced look at money and building wealth. It is not a “how to get rich quick book.”
Its core advice is to take advantage of compounding and take a reasonable approach to risk — hardly rocket science. However, it explores some of the more common pitfalls and anti-patterns when people think of money.
While I would strongly recommend everyone to read the book — it is fantastic, here is a quick summary of my notes from reading (and enjoying) the book. I hope you find it helpful!
A more personal view of money
People think of money as an abstract. We think about and are taught about money like we are taught physics. We assume that money is governed by rules and laws. Yet, psychology, with its study of emotions and nuance, may offer a better way to think about money.
Most people make financial decisions by taking the information that they have access to and plugging it into their mental model of how the world works. But these mental models are driven profoundly by personal experience.
Mr. Housel’s book takes a personal and intimate approach to understand how money works and illuminates some of the difficulties we face when making money decisions.
How to get rich and stay rich
Compound growth is the key to growing wealth. There is plenty of material available that describes viable strategies for becoming wealthy. However, Mr. Housel states that there is only one way to stay wealthy — “some combination of frugality and paranoia.”
If one can stick around for a long time without wiping out or being forced to give up, the power of compounding comes into play and helps generate wealth.
The key to a successful investment strategy is to not risk what you have and need for what you don’t have and don’t need.
The importance of sensible optimism
Successful investors take an optimistic view that, in the long run, the odds are in their favor, and over time things will balance out to a good outcome even if what happens in between is filled with misery.
But the optimism must be balanced with a healthy dose of paranoia. This means accepting nuance and understanding that the key to exploiting long-term optimism is survival.
It is critical not to get swept up in short-term momentum or get giddy about short-term gains or losses. The most effective long-term strategy is to not get overly influenced by short-term events.
Understanding wealth
When most people think about becoming a millionaire, they think of the ability to spend a million dollars. However, the true meaning of wealth is the ability to deploy money towards living a life that lets you do what you want, when you want, with who you want, where you want, for as long as you want. So, true wealth is financial assets that haven’t yet been converted into consumption.
The ability to save is also critical to building wealth. Savings are a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment. The most potent way of increasing savings is not to raise your income but to raise your humility.
Making reasonable financial decisions
Financial decisions making is thought of as making coldly rational decisions in the light of available information and knowledge of the past. However, history is primarily the study of unanticipated events.
Therefore, relying on history as an unassailable guide to the future is risky. It is important to consider the past but to look at it in terms of generalities.
So, one must not be overly influenced by history and take a reasonable and pragmatic approach when making financial decisions. Having savings gives a buffer to absorb short-term volatility. Having a realistic and flexible approach to financial decisions makes it likely to stick with your investment strategy in the long run.
The role of skill and of luck
Money constantly changes returns. If an asset has momentum, a group of short-term traders will assume it will keep moving up. We have seen this play out in recent times with the GameStop saga.
It is not an unreasonable strategy for the short term. Executing such short term strategy doesn’t really require much skill but does need some luck in timing the strategy just right. Plenty of traders both lost and made huge amounts of money trying to time their GameStop trade. It was all about momentum.
The mistake we are susceptible to is focusing solely on what we want to do and have the ability to do. We ignore the plans and skills of others whose decisions might affect our outcomes. We also focus too much on the causal role of skill and neglect the role of luck. This makes us overly confident in our beliefs.