The Psychology of Money
Cover & Diagrams
How should investors manage the inevitabilities of risk? What are the most powerful wealth-building tools that require little technical skill? How do our brains hold us back from a more prosperous future?
In The Psychology of Money, investor and finance journalist Morgan Housel answers these questions and shares how human thought, habits, and emotions are intertwined with investment. He shares insights and strategies for how investors can leverage these connections for personal gain — not only financial but personal and emotional as well.
Top 20 insights
- Someone's personal experiences make up only a small portion of what happens, but it makes up most of how that person thinks the world works. In theory, financial decisions should be driven by an investor's goals and the characteristics of investment options available to them. Economists from the National Bureau of Economic Research found that instead, investment decisions are anchored by early adulthood experiences. They found that investors tend to weigh more heavily the experience of the economy when they were young than what the economy is like now.
- Both luck and risk are often the factors that determine success and failure. Because they are hard to measure, they are often discounted. Some of Bill Gate's success can be attributed to hard work and good decisions. Some of it can also be attributed to his going to a high school with a computer. This was a roughly 1 in 1 million chance in the '60s. To account for risk and luck in decisions, an investor should: 1) Avoid idolization of specific investors when it cannot be known how much luck or risk influenced their success. 2) Focus less on specific individuals and case studies and more on broad patterns.
- There is never a reason to risk what you have and need for what you don't have and don't need. Social comparison often causes investors to look up to whoever has more than them and become so convinced that they need to have what they have that they take unnecessary risks that cause them to lose. If someone has enough to cover everything they need, they can avoid unnecessary risks by keeping four things in mind: 1) The hardest financial skill is to get the goalpost to stop moving. 2) Social comparison is the problem that causes unnecessary risk. 3) ""Enough"" is not too little. 4) Decide what is never worth risking.
- The key to good investing is not to earn the highest returns; it is to earn pretty good returns consistently. The powerful nature of compounding interest is counterintuitive but is the backbone of investment. Warren Buffett has managed to achieve an average annual return of 22% throughout his career. On the other hand, James Simons of Renaissance Technologies has achieved an incredible 66% per year. Yet, Buffett is 75% wealthier than Simons because he has invested for forty years younger than Simons. More than 97% of Warren Buffett's wealth has been accumulated after the age of 65.
- Getting wealthy and staying wealthy are two different skills. Getting wealthy requires risks and being optimistic. Staying wealthy requires caution and paranoia. 40% of companies successful enough to become publicly traded lose all of their value over time. The Forbes 400 list has, on average, a 20% turnover rate per decade. To avoid these fates, investors should: 1) Prioritize being financially unbreakable over bigger returns. 2) Build the possible (and likely) failure of any plan into your plans. 3) Develop a personality that is optimistic yet paranoid.
- Most investments either fail or break even. The vast majority of your success is determined by a small number of big winners – ""tail events."" In the Russell 3000 Index, 40% of companies lost at least 75% of their value. Effectively all of the Index's returns were driven by only 7% of companies that outperformed the average by at least two standard deviations. In VC investing, approximately 65% of companies lose money, 2.5% return 10-20x their investment, 1% return >20x their investment, 0.5% return 50x their investment. The majority of VC returns come from the last category. To allow enough time to take advantage of tail events: 1) Don't panic in a crisis and sell prematurely. 2) Be a consistent investor. 3) Take advantage of a wide range of investments.
- If the goal is happiness, then a person should structure their wealth to maximize their control over their own time. In 1981 psychologist Angus Campbell studied what made people happy. He found that most people were happier than most psychologists assumed but could not be grouped by income, geography, or education. He found that the most influential factor was whether people felt they had control of their own time. Money can contribute to giving people control of their own time, but it is not a guarantee.
- Wealth is the money that is not spent. But to accumulate wealth, people must accept that being wealthy and looking wealthy are different things. In 2009 Rihanna nearly went bankrupt after she lost 82% of her wealth in a year. She sued her financial advisor for gross mismanagement, who responded, ""was it really necessary to tell her that if you spend money on things you'll end up with the things and not the money?"" People tend to imagine wealth as what you can buy with wealth. That is the opposite of wealth.
- Building wealth is less about income or investment return and more about savings rate. In the 1970's it appeared that the world was going to run out of oil. The rate of oil consumption was increasing faster than the rate of oil production. But those predictions did not account for the new efficiency technology would create. The US now uses 65% less energy per dollar of GDP than in 1950. Saving is like that oil. It is easier and more effective to use the already available wealth more efficiently than to find new sources of wealth.
- It's more important to have flexibility. One hundred years ago, 75% of people had neither a telephone nor regular mail. The only real competition that most people had were the people in their immediate surroundings. Now, the entire world is competition, and it is increasingly hard to compete. Each year almost 600 people get a perfect score on the SAT, and 7,000 come within a few points. In the past, each of these people would be unrivaled in their immediate area. Now they are competing against each other. As it becomes harder and harder to compete, it becomes more and more important to save because savings provide flexibility and time to wait for good opportunities both in a career and in investments.
- If being reasonable is easier to maintain than being coldly rational, that should be done because anything that helps keep an investor in the game long enough to benefit from tail events will have a quantifiable advantage. In 2008 a pair of researchers at Yale created a retirement strategy whereby investing using a two-to-one margin when buying stocks investors could increase their retirement savings by 90%. However, this strategy also makes it easy to lose everything when you're young and expects you to pick up from that and keep going so that it works. It's entirely rational, but no reasonable person would behave like that. It's hard to be rational. It's easier to be reasonable.
- One good way to stay in the game long enough to benefit from tail events is for investors to have an emotional connection to their investments. Many investors pride themselves on a lack of emotion, but with no love of the investments, they've made it easy to panic in a downturn and sell too early. If investors invest in something they love, they will be more willing to ride out turbulence and stay in the game longer.
- History is a poor guide to investing because it tricks investors to think that the future will be like the past. Things that have never happened before happen all the time. The future is rarely like the past, and if investors forget, they will miss the unprecedented events that have the most significant effect on the future. To avoid this, when looking at history, look for patterns and generalities instead of discrete events. The further back history goes, the more general conclusions should become.
- No one can know everything that is going to happen, so they have to invest safely enough to experience tail events. When people are asked about other people's home renovation projects, they predict that they will run, on average, between 25% and 50% over budget. But when they're asked about their own, they usually predict they will come in at budget. Over time, the stock market returns an average of 6.8% per year, but it does go down, and what if that happens at a critical time? Investors need to build a margin of error into all of their plans to be prepared for these eventualities and ensure they are not wiped out.
- Therefore, long-term financial plans should have the potential for change built into them. Only 27% of college graduates work in a field related to their degree. 29% of stay-at-home parents have a college degree. Research shows that from age 18 to 68, people underestimate how much they and their goals will change and that makes long-term financial planning hard. To plan for this change: 1) Avoid the extreme ends of planning. 2) Reject the sunk cost fallacy.
- Most investors who try to game the system see it come back to bite them. Morningstar studied 112 tactical mutual funds from 2010-2011, which tried to beat market returns and compared them to simple 60/40 stock-bond mutual funds. They found that ""with few exceptions, [tactical funds] gained less, were more volatile and were subject to just as much downside risk."" Volatility, loss, uncertainty, and doubt are natural parts of investing. Investors have to accept that sometimes they will make a loss and not get out because of that.
- Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long-term to primarily short-term. From 2000 to 2004, the number of homes sold more than once in twelve months – that were flipped – rose from 20,000 to 100,000 per quarter. This, in turn, drove up the price of homes. Similarly, in the late '90s, day traders, to whom the cost of a stock was largely irrelevant as long as it went up in a day, drove up the price of most stocks. Cisco rose 300% in 1999 and Yahoo! rose to $500 in the same year.
- Bubbles, however, do their damage when long-term investors start taking their cues from short-term investors. In 1999, the average mutual fund had a 120% annual turnover, meaning that long-term investors were not investing for the long term. Different investors have different goals, and one of the biggest financial mistakes that can be made is to take advice or cues from investors who have different goals from you.
- Bad news will get more coverage but identification of the places with potential can be massive. In 1889 the Detroit Free Press wrote that flying machines ""appear impossible."" Four years later, the Wright Brothers flew the first airplane. Even then, most wrote it off. It wasn't until World War I, which began in 1914, that airplanes began to get regular use. The first major coverage of an airplane in the media, however, was a crash in 1908. Progress tends to happen too slowly to notice, but setbacks happen too quickly to ignore.
- Predictors of the future tend to extrapolate current trends into the future, but they rarely do, or can, account for how markets will adapt. In 2008 it was written that by 2030 China would need 98 million barrels of oil per day, but that only 85 million barrels were produced worldwide and not much more was likely ever to be produced. However, growing demand drove up the price of oil, which made it profitable for the first time to tap harder-to-get-to oil reserves, driving up production well above what was needed. In 1985 the journal ""nature"" predicted that by 2000 women would consistently run faster marathons than men. They figured this because the average marathon times of professional female runners were increasing faster than that of males. However, if you extrapolated those numbers at that rate indefinitely into the future, women would quickly run faster than 1,000 miles per hour.
Morgan Housel is a partner at the Collaborative Fund and a former columnist at The Wall Street Journal and The Motley Fool. His work has been focused on the exploration of how investors deal with risk and how to handle it in more productive ways.
During the 1800s, scientists came to the consensus that the Earth had experienced a number of ice ages in which large parts of the planet had been covered in ice sheets. During the last glacial maximum, the location of what is now Boston had more than a full kilometer of ice above it. Toronto had two kilometers. Montréal had more than three. The southernmost edges of the North American ice sheet were in northern Kentucky and West Virginia.
It was unknown, however, what caused these ice sheets to form. Each theory could explain one or two instances, but not all of them. That is, until Russian meteorologist Wladimir Köppen made an unexpected discovery. The cause, Köppen discovered, was not especially cold winters but slightly colder summers.
Each winter, snow would be left behind, but the slightly colder summer meant that a small amount of it would survive to the next. Over time, more and more snow piled on top of what had survived in years before and covered more and more of the ground in permanent snow. Each summer, the leftover snow would increase the chances of more remaining, and the new snow cover would reflect more sunlight, cooling the ground and causing more to remain the following year. Eventually, this became ice sheets thousands of meters thick.
It feels counterintuitive that such small change can have such massive results, but it is the same operating principle behind compounding returns. If something, like ice or money, compounds and a little bit of progress builds more progress, that small progress can have tremendous results. The number one rule of investing is that you don't need massive returns. You need on average ok returns that can compound for long periods.
Tails, you win
In 1936 Heinz Berggruen fled Nazi Germany. In his new life in America, he would become an art dealer until, in 2000, he sold the core of his massive collection to the German government. This sale, which would go on to make up the core of the Berggruen Museum in Berlin, included 85 works by Picasso and 80 other pieces of art by artists like Klee, Braque, Matisse, and Giacometti. The 165 pieces were valued at over $1 billion.
How did Berggruen acquire such an impressive collection of famous masterpieces? Luck? Skill? Horizon Research wrote that the secret was that Berggruen bought and sold thousands of pieces of art throughout his career. Most of them were probably of little value, but if a tiny percentage of those thousands turn out to be Picassos and Matisses, they can make up for all the ones that weren't. Most of Berggruen's investments could be bad, but he made enough of them that it didn't matter.
The reality is most companies and most investments lose money or break even, but a few are big winners. Those big winners are the ones that create value. In 2018 Amazon single-handedly drove 6% of the S&P 500's returns, and Apple drove another 7%. If you owned an S&P 500 index fund in that year, almost 1/7th of your returns came from just two companies. If the number one rule of investing is compounding returns, then the number two rule has to be those tail events create the returns that get compounded.
Good investors will cast a sufficiently large net that they are sure to have some tails in it. They won't panic at one bad year, one bad earnings report, or one lousy product and sell before they have a chance to find those magic returns. They'll accept that most of their decisions will not be big winners but that if they make enough, they'll find ones that are.
Room for error
There has never been a battle larger than that for the city of Stalingrad during World War II. Having lasted almost half a year, that single battle saw more casualties than the total military dead of the United States, Great Britain, Italy, France, and Yugoslavia combined. In 1942 a unit of 104 German tanks was outside of the city in reserve. But when it was needed most, its officers were shocked to discover that only twenty of their tanks were operational.
Engineers investigated and soon discovered that during the weeks the tanks spent unused, outside the city to be called upon, field mice had nested inside of them and eaten the wires and insulation of the electrical systems the tanks needed to run their engines.
These tanks were not poorly designed. Many have made the argument that German armored units were so well engineered that they were impractically expensive. But no engineer would think to plan for a 20-gram field mouse to disable a 25-ton steel machine. It wasn't the engineer's responsibility to plan for freak events like field mice. It was the commander's responsibility to plan that they may not be able to use those tanks for some reason.
Freak events happen all the time. Things that have never happened before happen all the time. Even when someone thinks that they have planned for every possibility, they haven't. That's why it's so essential that margin for error is built into every plan and strategy. Investors always need to account for the ever-present reality of risk in their investments. They should never bet everything on a single strategy. They should always maintain a reserve in case their investments go wrong. They should always be aware that the returns they expect may never materialize. Loss will always come eventually, risk will always appear. The job of a competent investor is to make sure that when that happens, it is not catastrophic.
Margin for error is pretty hard to achieve without savings. Savings are a margin of error in a way, and building margin of error into a strategy – at least in investing – usually requires extra money (read: savings). Past a certain level of income, people fall into three groups.
Past a certain income level, people tend to fall into three groups: 1) Those who save. 2) Those who don't think they can save. 3) Those who don't think they need to save. Group one can stop. This isn't for them. But what should groups two and three understand?
First, wealth has more to do with your savings rate than your income and investments. Wealth is accumulated money. You need to save to get that. Secondly, the value of wealth is relative to what you need. It's a lot easier to use money more efficiently than find new sources of money. Thirdly, past a certain level of income, what you need is just what sits below your ego. Once comfortable basics are covered, everything after that is a want, and often those wants treat the display of money as more important than having money.
Fourth, people's ability to save is more in their control than they might think. You can spend less if you desire less, and you can desire less if you don't care what others think. Fifth, there's no need to have a specific reason to save. Something that's going to need money is seldom going to be anticipated. Sixth, flexibility and control over your time is an unseen return on wealth. Savings give the ability to control your own time. Lastly, that return is more and more important. Being able to be flexible and control time makes it easier to compete in an increasingly competitive market.
If someone wants a $30,000 car, they have three options. They can pay for it, they can find a different car, or they can steal it. Most people would not opt for the third option. They know that if they steal that car, it's not really free. It's just a different price. Investment returns are not free either. They all come with some kind of price.
From 2002 to 2018 Netflix returned 35,000%. But the price of success for someone invested in Netflix through that time was high. Netflix traded below its previous all-time high on 94% of days during that period. Monster Beverage, similarly, returned 319,000% from 1995 to 2018, but traded below its previous all-time high on 95% of all days.
Like the car, investors have three options. They can either A) accept this volatility as the price of those returns, B) accept lower returns with less volatility, or C) try to game the system and get those returns without the volatility. Like with the car, some car thieves will get away, many of them will not.
In 2008 GE, one of the biggest companies in the world, almost collapsed. Their stock price went from $40 in 2007 to only $7 by 2018. One of the problems was that under their CEO, Jack Welch, their extremely lucrative financing division would always beat Wall Street estimates. They'd always return higher, no matter what. They gamed the system, massaged numbers, pulled returns from future quarters to current quarters.
But that caught up with them, and when the stock market collapsed, so did their game. Volatility, risk, and uncertainty are a part of investing. They have to be accepted because they will always appear, and to think they can be avoided, often just exacerbates their effects.