The Psychology of Money | Morgan Housel

When you read the title of the book, you might guess that it is only about money and maybe business, but it is about life. With the real time stories shared by Morgan Housel, this book makes stories meaningful and let you know more about personal finance, investment, wealth creation and living a better life.

Doing well with money isn’t necessarily about what you know. It’s about how you behave. And behavior is hard to teach, even to really smart people. Money―investing, personal finance, and business decisions―is typically taught as a math-based field, where data and formulas tell us exactly what to do. But in the real world people don’t make financial decisions on a spreadsheet. They make them at the dinner table, or in a meeting room, where personal history, your own unique view of the world, ego, pride, marketing, and odd incentives are scrambled together. In The Psychology of Money, award-winning author Morgan Housel shares short stories exploring the strange ways people think about money and teaches you how to make better sense of one of life’s most important topics.

No One’s Crazy

As investor Michael Batnick says, “some lessons have to be experienced before they can be understood.” 

In theory people should make investment decisions based on their goals and the characteristics of the investment options available to them at the time.

But that’s not what people do.

The economists found that people’s lifetime investment decisions are heavily anchored to the experiences those investors had in their own generation—especially experiences early in their adult life.

If you grew up when inflation was high, you invested less of your money in bonds later in life compared to those who grew up when inflation was low. If you happened to grow up when the stock market was strong, you invested more of your money in stocks later in life compared to those who grew up when stocks were weak.

The economists wrote: “Our findings suggest that individual investors’ willingness to bear risk depends on personal history.”

Every decision people make with money is justified by taking the information they have at the moment and plugging it into their unique mental model of how the world works. But every financial decision a person makes, makes sense to them in that moment and checks the boxes they need to check. They tell themselves a story about what they’re doing and why they’re doing it, and that story has been shaped by their own unique experiences.

We all do crazy stuff with money, because we’re all relatively new to this game and what looks crazy to you might make sense to me. But no one is crazy—we all make decisions based on our own unique experiences that seem to make sense to us in a given moment.

Luck & Risk

Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort.

Bill Gates went to one of the only high schools in the world that had a computer.

Most university graduate schools did not have a computer anywhere near as advanced as Bill Gates had access to in eighth grade. And he couldn’t get enough of it.

Gates was 13 years old in 1968 when he met classmate Paul Allen. Allen was also obsessed with the school’s computer, and the two hit it off.

Bill and Paul could toy away with the thing at their leisure, letting their creativity run wild—after school, late into the night, on weekends. They quickly became computing experts.

During one of their late-night sessions, Allen recalled Gates showing him a Fortune magazine and saying, “What do you think it’s like to run a Fortune 500 company?” Allen said he had no idea. “Maybe we’ll have our own computer company someday,” Gates said. Microsoft is now worth more than a trillion dollars.

Kent Evans and Bill Gates became best friends in eighth grade. Evans was, by Gates’ own account, the best student in the class. The two talked “on the phone ridiculous amounts,” Gates recalls in the documentary Inside Bill’s Brain. “I still know Kent’s phone number,” he says. “525-7851.”

Evans was as skilled with computers as Gates and Allen. Lakeside once struggled to manually put together the school’s class schedule—a maze of complexity to get hundreds of students the classes they need at times that don’t conflict with other courses. The school tasked Bill and Kent—children, by any measure—to build a computer program to solve the problem. It worked.

And unlike Paul Allen, Kent shared Bill’s business mind and endless ambition. “Kent always had the big briefcase, like a lawyer’s briefcase,” Gates recalls. “We were always scheming about what we’d be doing five or six years in the future. Should we go be CEOs? What kind of impact could you have? Should we go be generals? Should we go be ambassadors?” Whatever it was, Bill and Kent knew they’d do it together.

After reminiscing on his friendship with Kent, Gates trails off.

 “We would have kept working together. I’m sure we would have gone to college together.” Kent could have been a founding partner of Microsoft with Gates and Allen.

But it would never happen. Kent died in a mountaineering accident before he graduated high school.

Every year there are around three dozen mountaineering deaths in the United States. The odds of being killed on a mountain in high school are roughly one in a million.

Bill Gates experienced one in a million luck by ending up at Lakeside. Kent Evans experienced one in a million risk by never getting to finish what he and Gates set out to achieve. The same force, the same magnitude, working in opposite directions.

Luck and risk are both the reality that every outcome in life is guided by forces other than individual effort. They are so similar that you can’t believe in one without equally respecting the other. They both happen because the world is too complex to allow 100% of your actions to dictate 100% of your outcomes. They are driven by the same thing: You are one person in a game with seven billion other people and infinite moving parts. The accidental impact of actions outside of your control can be more consequential than the ones you consciously take.

But both are so hard to measure, and hard to accept, that they too often go overlooked. For every Bill Gates there is a Kent Evans who was just as skilled and driven but ended up on the other side of life roulette.

If you give luck and risk their proper respect, you realize that when judging people’s financial success—both your own and others’—it’s never as good or as bad as it seems.

Not all success is due to hard work, and not all poverty is due to laziness. Keep this in mind when judging people, including yourself. Therefore, focus less on specific individuals and case studies and more on broad patterns.

Never Enough

To make money they didn’t have and didn’t need, they risked what they did have and did need. And that’s foolish. It is just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.

There is no reason to risk what you have and need for what you don’t have and don’t need.

If expectations rise with results there is no logic in striving for more because you’ll feel the same after putting in extra effort. It gets dangerous when the taste of having more—more money, more power, more prestige—increases ambition faster than satisfaction.

Modern capitalism is a pro at two things: generating wealth and generating envy. Perhaps they go hand in hand; wanting to surpass your peers can be the fuel of hard work. But life isn’t any fun without a sense of enough. Happiness, as it’s said, is just results minus expectations.

The only way to win in a Las Vegas casino is to exit as soon as you enter.

Reputation is invaluable.

Freedom and independence are invaluable.

Family and friends are invaluable.

Being loved by those who you want to love you is invaluable.

Happiness is invaluable.

And your best shot at keeping these things is knowing when it’s time to stop taking risks that might harm them. Knowing when you have enough.

Confounding Compounding

It is not necessarily the amount of snow that causes ice sheets but the fact that snow, however little, lasts.

More than 2,000 books are dedicated to how Warren Buffett built his fortune. Many of them are wonderful. But few pay enough attention to the simplest fact: Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child.

Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him.

Consider a little thought experiment. Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. His skill is investing, but his secret is time. None of the 2,000 books picking apart Buffett’s success are titled This Guy Has Been Investing Consistently for Three-Quarters of a Century. But we know that’s the key to the majority of his success.

But good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.

Getting Wealthy vs. Staying Wealthy

Getting money is one thing. Keeping it is another. Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility, and fear that what you’ve made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely.

Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.

Room for error—often called margin of safety—is one of the most underappreciated forces in finance.

It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to be to have a favorable outcome.

Tails, You Win

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 is the result of a tail, it’s easy to underestimate how rare and powerful they are.

Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.

A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy.

Tails drive everything.

When you accept that tails drive everything in business, investing, and finance you realize that it’s normal for lots of things to go wrong, break, fail, and fall.

Take Amazon. It’s not intuitive to think a failed product launch at a major company would be normal and fine. Intuitively, you’d think the CEO should apologize to shareholders. But CEO Jeff Bezos said shortly after the disastrous launch of the company’s Fire Phone: If you think that’s a big failure, we’re working on much bigger failures right now. I am not kidding. Some of them are going to make the Fire Phone look like a tiny little blip. It’s OK for Amazon to lose a lot of money on the Fire Phone because it will be offset by something like Amazon Web Services that earns tens of billions of dollars. Tails to the rescue.

Netflix CEO Reed Hastings once announced his company was canceling several big-budget productions. He responded: Our hit ratio is way too high right now. I’m always pushing the content team. We have to take more risk. You have to try more crazy things, because we should have a higher cancel rate overall.

At the Berkshire Hathaway shareholder meeting in 2013 Warren Buffett said he’s owned 400 to 500 stocks during his life and made most of his money on 10 of them. Charlie Munger followed up: “If you remove just a few of Berkshire’s top investments, its long-term track record is pretty average.”

When we pay special attention to a role model’s successes we overlook that their gains came from a small percent of their actions. That makes our own failures, losses, and setbacks feel like we’re doing something wrong. But it’s possible we are wrong, or just sort of right, just as often as the masters are. They may have been more right when they were right, but they could have been wrong just as often as you.

“It’s not whether you’re right or wrong that’s important,” George Soros once said, “but how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune.

Freedom

The ability to do what you want, when you want, with who you want, for as long as you want, is priceless. It is the highest dividend money pays.

More than your salary. More than the size of your house. More than the prestige of your job. Control over doing what you want, when you want to, with the people you want to, is the broadest lifestyle variable that makes people happy.

Using your money to buy time and options has a lifestyle benefit few luxury goods can compete with.

No one—not a single person—said you should choose your work based on your desired future earning power.

What they did value were things like quality friendships, being part of something bigger than themselves, and spending quality, unstructured time with their children. “Your kids don’t want your money (or what your money buys) anywhere near as much as they want you. Specifically, they want you with them,” Pillemer writes.

Controlling your time is the highest dividend money pays.

Man in the Car Paradox

When you see someone driving a nice car, you rarely think, “Wow, the guy driving that car is cool.” Instead, you think, “Wow, if I had that car people would think I’m cool.” Subconscious or not, this is how people think. There is a paradox here: people tend to want wealth to signal to others that they should be liked and admired. But in reality those other people often bypass admiring you, not because they don’t think wealth is admirable, but because they use your wealth as a benchmark for their own desire to be liked and admired.

If respect and admiration are your goal, be careful how you seek it. Humility, kindness, and empathy will bring you more respect than horsepower ever will.

Wealth is What You Don’t See

Someone driving a $100,000 car might be wealthy. But the only data point you have about their wealth is that they have $100,000 less than they did before they bought the car (or $100,000 more in debt). That’s all you know about them.

We tend to judge wealth by what we see, because that’s the information we have in front of us. We can’t see people’s bank accounts or brokerage statements. So we rely on outward appearances to gauge financial success. Cars. Homes. Instagram photos.

Exercise is like being rich. You think, “I did the work and I now deserve to treat myself to a big meal.” Wealth is turning down that treat meal and actually burning net calories. It’s hard, and requires self-control. But it creates a gap between what you could do and what you choose to do that accrues to you over time.

The problem for many of us is that it is easy to find rich role models. It’s harder to find wealthy ones because by definition their success is more hidden.

There are, of course, wealthy people who also spend a lot of money on stuff. But even in those cases what we see is their richness, not their wealth. We see the cars they chose to buy and perhaps the school they choose to send their kids to. We don’t see the savings, retirement accounts, or investment portfolios. We see the homes they bought, not the homes they could have bought had they stretched themselves thin.

Save Money

Building wealth has little to do with your income or investment returns, and lots to do with your savings rate.

Savings can be created by spending less. You can spend less if you desire less. Money relies more on psychology than finance. And you don’t need a specific reason to save. You can save just for saving’s sake. And indeed you should. Everyone should.

Having more control over your time and options is becoming one of the most valuable currencies in the world.

That’s why more people can, and more people should, save money.

Surprise!

Stanford professor Scott Sagan once said something everyone who follows the economy or investment markets should hang on their wall: “Things that have never happened before happen all the time.”

A trap many investors fall into is what I call “historians as prophets” fallacy: An overreliance on past data as a signal to future conditions in a field where innovation and change are the lifeblood of progress.

The correct lesson to learn from surprises is that the world is surprising. Not that we should use past surprises as a guide to future boundaries; that we should use past surprises as an admission that we have no idea what might happen next.

Room for Error

There is never a moment when you’re so right that you can bet every chip in front of you. The world isn’t that kind to anyone—not consistently, anyways. You have to give yourself room for error. You have to plan on your plan not going according to plan.

The ability to do what you want, when you want, for as long as you want, has an infinite ROI.

A good rule of thumb for a lot of things in life is that everything that can break will eventually break. So if many things rely on one thing working, and that thing breaks, you are counting the days to catastrophe. That’s a single point of failure.

The most important part of every plan is planning on your plan not going according to plan.

Nothing’s Free

Everything has a price, and the key to a lot of things with money is just figuring out what that price is and being willing to pay it.

The problem is that the price of a lot of things is not obvious until you’ve experienced them firsthand, when the bill is overdue.

Responding to critics who said his actions were wrong and what he should have done was obvious, Immelt told his successor, “Every job looks easy when you’re not the one doing it.”

The price of investing success is not immediately obvious. It’s not a price tag you can see, so when the bill comes due it doesn’t feel like a fee for getting something good. It feels like a fine for doing something wrong. And while people are generally fine with paying fees, fines are supposed to be avoided. You’re supposed to make decisions that preempt and avoid fines.

Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.

Same with investing, where volatility is almost always a fee, not a fine.

Market returns are never free and never will be. They demand you pay a price, like any other product. You’re not forced to pay this fee, just like you’re not forced to go to Disneyland. You can go to the local county fair where tickets might be $10, or stay home for free. You might still have a good time. But you’ll usually get what you pay for. Same with markets. The volatility/uncertainty fee—the price of returns—is the cost of admission to get returns greater than low-fee parks like cash and bonds.

The trick is convincing yourself that the market’s fee is worth it. That’s the only way to properly deal with volatility and uncertainty

You & Me

An iron rule of finance is that money chases returns to the greatest extent that it can. If an asset has momentum—it’s been moving consistently up for a period of time—it’s not crazy for a group of short-term traders to assume it will keep moving up. Not indefinitely; just for the short period of time they need it to. Momentum attracts short-term traders in a reasonable way.

Then it’s off to the races.

Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term.

That process feeds on itself. As traders push up short-term returns, they attract even more traders. Before long—and it often doesn’t take long—the dominant market price-setters with the most authority are those with shorter time horizons.

We call everyone investing money “investors” like they’re basketball players, all playing the same game with the same rules. When you realize how wrong that notion is you see how vital it is to simply identify what game you’re playing.

The Seduction of Pessimism

It takes years to realize how important a product or company is, but failures can happen overnight.

And in stock markets, where a 40% decline that takes place in six months will draw congressional investigations, but a 140% gain that takes place over six years can go virtually unnoticed.

And in careers, where reputations take a lifetime to build and a single email to destroy.

When You’ll Believe Anything

At the personal level, there are two things to keep in mind about a story-driven world when managing your money.

1. The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.

2. Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.

Carl Richards writes: “Risk is what’s left over when you think you’ve thought of everything.”

People know this. I have not met an investor who genuinely thinks market forecasts as a whole are accurate or useful. But there’s still tremendous demand for forecasts, in both the media and from financial advisors.

Why?

Psychologist Philip Tetlock once wrote: “We need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need.”

Satisfying that need is a great way to put it. Wanting to believe we are in control is an emotional itch that needs to be scratched, rather than an analytical problem to be calculated and solved. The illusion of control is more persuasive than the reality of uncertainty. So we cling to stories about outcomes being in our control.

Part of this has to do with confusing fields of precision with fields of uncertainty.

All Together Now

Less ego, more wealth. Saving money is the gap between your ego and your income, and wealth is what you don’t see. So wealth is created by suppressing what you could buy today in order to have more stuff or more options in the future. No matter how much you earn, you will never build wealth unless you can put a lid on how much fun you can have with your money right now, today.

If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon. Time is the most powerful force in investing. It makes little things grow big and big mistakes fade away. It can’t neutralize luck and risk, but it pushes results closer towards what people deserve.

Become OK with a lot of things going wrong. You can be wrong half the time and still make a fortune, because a small minority of things account for the majority of outcomes. No matter what you’re doing with your money you should be comfortable with a lot of stuff not working. That’s just how the world is. So you should always measure how you’ve done by looking at your full portfolio, rather than individual investments. It is fine to have a large chunk of poor investments and a few outstanding ones. That’s usually the best-case scenario. Judging how you’ve done by focusing on individual investments makes winners look more brilliant than they were, and losers appear more regrettable than they should.

The ability to do what you want, when you want, with who you want, for as long as you want to, pays the highest dividend that exists in finance.

Save. Just save. You don’t need a specific reason to save. It’s great to save for a car, or a downpayment, or a medical emergency. But saving for things that are impossible to predict or define is one of the best reasons to save. Everyone’s life is a continuous chain of surprises. Savings that aren’t earmarked for anything in particular is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.

Confessions

Charlie Munger once said “I did not intend to get rich. I just wanted to get independent.”

We can leave aside rich, but independence has always been my personal financial goal. Chasing the highest returns or leveraging my assets to live the most luxurious life has little interest to me. Both look like games people do to impress their friends, and both have hidden risks. I mostly just want to wake up every day knowing my family and I can do whatever we want to do on our own terms. Every financial decision we make revolves around that goal.

Independence, to me, doesn’t mean you’ll stop working. It means you only do the work you like with people you like at the times you want for as long as you want.

At some point you have to choose between being happy or being “right.”

Cash is the oxygen of independence.

 “The first rule of compounding is to never interrupt it unnecessarily.”

My investing strategy doesn’t rely on picking the right sector, or timing the next recession. It relies on a high savings rate, patience, and optimism that the global economy will create value over.