The psychology of money (Morgan Housel)
Review.
I recently re-read this master piece by Morgan Housel, a brilliant text at the level of The outsiders (William Thorndike) or 100 baggers (Christopher Mayer). It is one of the most enjoyable books I have run into so I feel glad this new section is inaugurated by it.
Link to the book in Amazon below:
The psychology of money. Morgan Housel
People’s money management has no link with how smart they are or the level of their studies. Despite finance being taught like a science, it is not science. Physics is not controversial. It is guided by laws. Finance is different. It is guided by people’s everyday behaviour. It is psychology.
Unique perspectives.
Each person has a unique experience and environment in life (beliefs, goals, personal matters...) which truly determine his or her view in relation to money. Each of us sees the world through different lens.
What makes sense to me may sound nuts to you or vice versa, as our experiences and perception of money are deeply connected to who we are and, in a sense, unique.
The impact of the unmeasurable.
Luck and risk are two sides of the same coin. Real, unobjectionable, unpredictable and far from our control. The same force working in opposite directions.
Both are hardly quantifiable but extremely determinant in the financial success of any of us and, by extension, any organisation around the world. Be aware who you look up to and who you look down to, as not all success comes from hard work and not all poverty is due to laziness.
If we want to study success, we will more likely get a better understanding by looking at the broad patters rather than by studying individuals. The more extreme the outcome, the the less likely you can apply it to your own life with the same results. Often, nothing is as good or bad as it appears to be.
Knowing when to be satisfied.
Whoever loves money never has enough; whoever loves wealth is never satisfied with their income. This, too, is vanity.
Ecclesiastes 5:10.
Reputation, freedom, happiness, family and friends are invaluable assets and deeply interconnected. Take them into account before taking financial risks. Knowing where you draw the line labelled “enough” may help you in keeping track of the ultimate goal: living a fulfilling life.
For the past year I have been studying Francois Rochon (CIO at Giverny Capital) and one of the pillars in his investment philosophy strongly echoes with this concept. I am talking about what he describes as “the middle-way”, representing the equilibrium, the middle path between extremes, between utmost greed and maximum fear, between euphoria and depression. It is a very powerful tool when isolating oneself from the emotions which so commonly blindfold us investors in the financial markets.
Wealth is what we don’t see.
When most people say they want to be a millionaire, what they actually mean is they would like to spend a million dollars. And that is literally the opposite of being a millionaire.
There is a big difference between being wealthy and being rich. Richness represents the current income, whereas wealth is actually hidden. True wealth is income not spent.
We tend to judge wealth by what we see (expensive cars, big houses or Instagram pictures about luxurious places), but true wealth lays at the other extreme of the spectrum.
The world is filled with people who look modest but are actually wealthy and people who look rich but live at the razor’s edge of insolvency.
Living below our means.
Building wealth has little to do with your income or investment returns, and lots to do with your savings rate.
Few ideas which I found most interesting:
No matter how much income or investment returns you get. There is no path to wealth if savings are not part of the equation. Savings provide us with freedom. In fact, if we fully spend our income, we are going to get used to that lifestyle.
If we develop a frugal approach to life and combine it with reasonable investments and sentimental detachment from the daily quotes that Mr. Market is constantly throwing at us, our wealth should increase notably over a lifespan.
Keeping an inner scorecard is equally important. Living according to our own standards and moral principles is an effective way to reduce the need to impress others. The fastest path to stop being wealthy is by showing others how wealthy you are.
Savings mean, in a sense, a degree of knowledge, value and control over your own time, flexibility and independence capabilities.
The importance of margin of safety.
The most important part of every plan is planning on your plan, not executing it perfectly.
The room for error or, as Benjamin Graham defined it, margin of safety, is the necessary gap between what you think will happen and what how the future reality truly materialises in order to avoid wiping you out entirely. In order to succeed, the first premise must be surviving.
The finance world is governed by odds rather than certainties. Hence, whether estimating hurdle rates or savings for retirement it is of primary importance not to underestimate the unpredictable.
Everything has a price.
Everything has a price, but not all prices appear on labels.
The price of a lot of things stays hidden until you have experienced it first-hand. Successful investments demand a price: volatility, fear and uncertainty, and it is easy to overlook them until you are already dealing with them.
The comparison with the options we are given when buying a car looks exemplary:
Pay the full price for a new vehicle, accepting volatility (stocks).
Buy a cheaper used car, with less uncertainty and a lower payoff (bonds/cash).
Steal the car, with high odds of being caught and punished. Many investors try to use strategies to get the return without paying the price. They attempt to buying and selling while timing the market. Some of them success (at least temporarily), but the majority do not.
If you consider volatility as a part of the contract from the beginning, it is more likely that you will embrace it when times are rough and see the light at the end of the tunnel. You will then enjoy the marvels of compounding.
However, if you consider it a fine, odds are you will never enjoy its magical effects.
The long game.
Investors often take cues from other investors who are playing a different game than the former ones.
All of us have different goals and time horizons. What could make sense for one could sound ridiculous for another.
Whether it is cars, fashion, vacations or stocks, an important component of consumer spending is socially driven. Maybe you do not need, or even worst, enjoy it, but you do it anyway (likely influenced by people who you look up to or seeking social status and acceptance within your closest group of friends).
When your realise what are your actual needs, you are not persuaded by the behaviour of people playing different games than yours. Identify what game you are playing upfront.
Luring pessimism.
In investing you must identify the price of success (volatility and loss amid the long backdrop of growth) and be willing to pay it.
Pessimism is more attractive than optimism. It has always been that way. This, too, seems to be deeply wired within our DNA as human beings and, fundamentally, animals.
We have evolved due to a primary reason: we have learned to survive. Survival means being keen on cues of dangers at all moments.
See these examples: Japan’s development after WWII, the GFC of 2008, the oil embargo… who could have imagined what happened next? People’s adapting capacity is enormous. Problems turn into opportunities. As the old adage goes: Necessity is the mother of all invention.
Pessimism catches more attention than optimism in an asymmetric proportion, especially when it comes to money. Growth is driven by compounding, which always takes time. For destruction, it takes only an instant.
Confirmation bias.
Stories are likely the most powerful force in economy. We tend to believe narratives that change everything, despite there may have not been tangible changes.
The more you want something to be true, the more you will believe in a story that overestimates the odds of you being right.
We tend to suffer from confirmation bias: the tendency to search for, interpret and recall information in a way that confirms or supports one’s prior beliefs. And in that process we are effectively underestimating risk and missing an objective perspective on the matter. Think about Bernie Madoff. He told a good story, and people wanted to believe it.
This is one of the reasons why the concept of margin of safety is relevant, as the bigger the gap between what you want to be true and what you need to be true to have an acceptable outcome, the more you are protecting yourself from falling victim to an appealing financial fiction.
We all have an incomplete understanding of what is happening, but our brains fill the missing portion with a narrative. As human beings it is coded within us. We need to believe we live in a controllable and predictable world, so the natural tendency is to look for patterns even where there is no one to be found.
The illusion of control is more persuasive than the reality of uncertainty.
Key take-aways.
Never let your money interfere with your emotions. Establish a set of rules within your life which enable you to play the long, reasonable game situated in “the middle way”.
Manage your money in a way that helps you sleep at night.The less ego, the more likely we will enjoy our quest to wealth.
We do not need any apparent reason to save. Saving for the unpredictable is enough reason on its own.
Be aware of the fact that everything has a price, even if it is not shown in a label.
Allow yourself some room for error, as it is only matter of time for you to make a mistake. The pivotal idea is that even if the worst-case scenario materialises, you will continue to live to see another day.
Avoid the extreme ends of financial decisions.
When we purchase something it is not money that we are paying it with, but the time we have spent to get that money. Time is the utmost valuable asset in life, including finance too. Use your money to gain control over your time.