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The Psychology of Money – Book Review

The Psychology of Money - Book Review
Categories Investing books

The psychology of money, by Morgan Housel, is one of the greatest and most comprehensive books that dives deeply into the emotional side of managing personal finances and investing.

The book explores how financial decisions are rarely based solely on facts, spreadsheets, and financial knowledge, but rather on past financial experiences, learned behaviors, underlying beliefs and the emotions that arise in an individual when it comes to money.

Besides Richer, Wiser, Happier: How the World’s Greatest Investors Win in Markets and Life, The Psychology of Money is one of our favorite books when it comes to general advice on how to improve your mindset in money and investing (by the way, here’s the list of the 190 best investment books).

That’s why we decided to write a short book review, emphasizing the six lessons we found the most valuable in the text and adding a few of our own nuggets.

The book provides many great investing and money-management insights, explained through 19 “strange” life stories, which make the financial lessons even more memorable.

This is a book we strongly encourage you to buy and read. Now let’s look at what thoughts from the book resonated with our experiences the most.

Table of contents

1. Complex personal finances are something relatively new, that’s why it’s important to understand the psychology of money

The modern financial system, with pension funds, thousands of investing products, budgeting, saving and investing, not to mention all the money apps and books, is relatively new.

The first stock exchange was established a few hundred years ago, nevertheless, before World War II most people worked until they died, and money management was much simpler. Pension plans (like a 401k) were formed 40 years ago, and the first ETF 30 years ago. That’s relatively new, not counting for even one generation.

Thus, it’s hard to expect from people to learn and master their personal finances (from their parents or peers for example), and even more so to learn how to manage their emotions when it comes to money.

Thriving in the complex financial world is not easy, and even more importantly, not all success is the result of smart work, and not all poverty is result of poor decisions and laziness. We must keep that in mind when judging ourselves and others.

“You’re not a spreadsheet, you’re a person, a screwed up, emotional person. Do not try to be coldly rational when making financial decisions, aim to be pretty reasonable.”

– Morgan Housel

People can make bad financial decisions by simply being:

  • misinformed or having bad information
  • bad at math
  • persuaded by bad marketing
  • naïve or having no idea what they are doing
  • negatively influenced by their past experiences and learned behaviors

Not to mention that the financial world is only becoming more complex, each and every year. That’s what we’re trying to change with Equito Academy, by equipping people with knowledge and emotion-management techniques when it comes to money and investing.

When learning how personal finance works and who to model, we must be careful to distinguish what is luck, what is skill, and what is taking smart risk. Rarely, 100 % of outcomes can be attributed to decisions and effort, if ever. Thus, rather than focusing on individuals, it makes sense to focus on general patterns when studying money management.

This is all important to understand for a few reasons. The first being that in a complex financial world you simply must invest in your financial education. As well as that, you must find and trust the right sources. In addition, you must learn how to manage your emotions when it comes to money.

And finally, you must be aware that there are rare people who are extremely good at earning, keeping, and investing money. You must be able to distinguish between the ones who got lucky and the ones that have the right money-mindset. Find the ones with the right money-mindset and learn from them.

2. Money decisions are driven by our past experiences, learned behavior, and emotions, not by logic

In general, we try to approach money management from a scientific and logical point of view, and consider rules, laws, and spreadsheets. By doing so, we neglect the psychological point of view, as well as emotions and nuance.

Nevertheless, the worst money decisions are made based on emotions like greed, insecurity, fear, and excessive optimism. Intelligence, education, and sophistication are not the main driving factors of successful investing, as it might often seem.

Knowing how to manage your emotions when it comes to money is the foundation of making smart financial decisions. Money always arouses certain emotions and many times we must be able to act against our emotions if we want to be smart with our money.

The emotions that arise when it comes to money, and the decisions we make when handling money, are based on our past experiences, including those from when we were young.

As the book nicely suggests, a child of a rich banker will acquire vastly different psychological schemas regarding money than a person who grew up in poverty. In the same way, a person going through a financial recession, high inflation, or an extreme lack of goods will take different money decisions than a person who has never experienced these situations.

Thus, when analyzing your own or someone else’s money decisions, you must always consider the context – the fact that everyone is from a different generation, has been raised in a different family, has a different background, has experienced different business cycle stages, and has learned completely different things about money.

And all this dictates not only what opportunities are presented to a person, but also how a person thinks about them. This can also lead to a better understanding of yourself and your mindset when it comes to money. Understanding the context of your money decisions can guide you to where to make corrections in your mindset.

“Some financial lessons must be experienced before they can be understood.”

Michael Batnick

3. Pave your strategy based on the outliers or even better long-term steady investing

Many (financially) successful people are the result of an outlying event. They were at the right place at the right time, invested in the right few companies or sectors, joined the right company as early employees etc.

Long tails, which are a small number of events that account for the majority of outcomes, have a very big influence in finance. People’s successes can be a consequence of periods of extreme risk and luck.

But the more extreme the outcome, the harder the lessons are to replicate, since the success was the result of a rare opportunity. That’s the bad news, because long-tails are hard to replicate.

Things that are super profitable, famous, and influential are most often a result of an outlying one-in-a-million event. And it’s easy to underestimate the rareness and power of such events.

The good news is, being a successful investor doesn’t necessarily mean you must earn the highest yields, outperform everyone else or find an outlying event. If you have such an edge, great, but most people don’t.

Thanks to the compounding effect, you can be financially successful by earning good (but not superior) investment returns over a longer period of time. Compounding can do miracles when you give it decades to grow. Endurance in this sense is the key.

Morgan Housel’s investment strategy thus doesn’t rely on investing in the right sector at the right time, timing the recession, or picking a few winning stocks. The authors strategy relies on:

  • a high rate of savings,
  • a long-term view,
  • patience,
  • having enough cash not to be thrown out of the game,
  • diversifying investments,
  • and staying optimistic that the global economy will go up in the next several decades, despite hurdles on the way.

It’s also something we encourage you to do on the Equito platform – to be patient long-term patient and a diligent investor, but also to find your own investment edge and not be a completely passive investor. Active investing drives you to get even more educated, and to become sharp, better in business, and a better decision maker.

To get back to the lessons from the book, it’s definitely true, in our experience, that in personal finance you must learn how to:

You earn money by taking smart risks, being optimistic and open to opportunities, and putting yourself out there in the business world. keeping money is about being frugal.

And successfully investing money means knowing what you’re investing in, learning to manage your emotions when it comes to money, and staying in the market as long as possible.

“Growth is driven by compounding, which takes time. Destruction is driven by a single point of failure that can happen in an instant.”

Morgan Housel
The Psychology of Money

4. Stay humble, learn to keep as much money as possible and always have enough to survive bouts of bad luck

Now let’s get to the pieces of advice from the book on saving and surviving. Knowing how to keep as much money as possible is as important a skill as earning and investing money.

Keeping your money requires frugality, humility, dealing with the fear that the money can be taken away from you, and acceptance that past successes with money can’t always be easily replicated.

To take a step further regarding frugality, money is also nice cars and diamonds not bought, fancy watches and suits not worn, and first-class upgrades declined. Less ego means more wealth. That’s definitely something that struck a chord with us.

Being a successful investor can make you a lot of money. But to be honest, whether your investment strategy will work or not, and for how long, is always in doubt to a certain extent. On the other hand, frugality, humility, and conservation of money is where you have much more control of the outcome.

Just as you can learn from Warren Buffet how to invest cleverly, you can also learn many valuable lessons from him on how to keep money. For example, Warrant didn’t panic during the 14 recessions he lived through; he never overleveraged his portfolio, followed only one general investment strategy (value investing), and regularly adapted to new circumstances.

He also never risked his reputation or took such a high risk that he could be kicked out of the game. He was never in a hurry to get wealthy and, most importantly, he survived the investing game by being smart, patient, and diligent.

“Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One.”

Warren Buffet

In finance, as in life, it’s thus important to have a sufficiently big margin of safety. You need enough liquid reserves to never get pushed out of the game by a swing of bad luck. Having enough savings is a hedge against the high possibility that bad luck will surprise you at the worst possible moment.

We like the author’s thought that an investing genius is also a person who can do the smart thing when everyone else is going crazy. In other words, someone who can keep a cool head when a recession comes. Such a behavior can also be described as a long-tail event.

Here’s an exercise to illustrate this point – ask yourself what would happen if your assets declined by 30 %?

  • Could you financially survive?
  • Could you be keep paying the bills and have positive cashflow?
  • How would you hold up mentally?
  • Would you stay confident?
  • Would that physically and mentally exhaust you?
  • How would that influence your spouse or your family?
  • What if you also lost your job?

And swings of bad luck do happen. It’s normal for things to go wrong, fail, and break, and there’s no way you can be right all the time.

So, you must be careful not to be a naïve optimist in life, but you should be a sensible or real optimist in life, meaning you believe that the long-term odds are in your favor, even though the road between now and then is filled with hiccups, challenges, bad luck, and misery.

Sensible optimists don’t believe everything will always be great, because it won’t. They believe that the odds of good outcomes are in their favor over time, while being sure to have a financial margin and competencies to face the setbacks that occur along the way. Being a sensible optimist also means you should be okay with a lot of things going wrong, because that’s the natural course of life.

After reading this book, we are definitely categorizing ourselves as sensible optimists (besides being stoics).

“To get ahead in life you have to take some risks, but never take risks so big that they can wipe you out. You have to survive to succeed. Stand long enough to see your risks pay off. And remember, risk is what’s left when you think you’ve thought of everything.”

Also keep in mind, that successful investing has its price. The price you have to pay to be a successful investor is volatility, fear, uncertainty, doubt, greed management, and so on. This price is not small when you have to deal with it in in real-time.

No success comes without a price, and thus you should define what success means in your terms and then be prepared to pay for it. Now you know what the price is when it comes to investing (short-term volatility, not being thrown out of the game, managing your emotions, staying frugal…), and we definitely agree that the price is very well defined in this excellent book.

5. Flexibility is as important advantage as intelligence and emotional management when it comes to investing

Intelligence, knowledge, experience, and knowing what you’re doing are important advantages in investing. The book emphasizes that they are less and less important in our hyper-connected world, where many things are automated and bots are trading; nevertheless, in our view, knowing what you’re doing and having an edge in investing is of the utmost importance.

But we definitely agree that flexibility is as important as intelligence, if not more so. Flexibility in the context of investing means that you can patiently wait for a good opportunity. It’s an ability to easily adapt to your investment strategy and the macro circumstances, and patiently wait for the right moment.

Being flexible should enable you to learn new things when necessary, feel less urgency to chase the competition when you don’t have an edge, and explore new niches where you could actually have an edge.

Flexibility means you can do all that at a slower pace that enables you to forge the optimal career and make the right investment moves for you as an individual.

“You can afford not to be the greatest investor in the world, but you can’t afford to be a bad one.”

Morgan Housel

6. Be aware of the endless drive to have more, cultivate sense of having enough

In our view, the most mesmerizing piece of advice from the book is: “There is no reason to risk what you have for what you don’t have and don’t need.”

In other words, don’t take unnecessary and stupid risks based on greed, fear, envy, and similar emotions. Always wanting more money, more power, and more status rarely ends well; especially because it’s never enough.

“Karl Pillemer interviewed thousands of elderly people, asking them the most important lessons of their life. Not even one person said that to live a fulfilling life, you should try to work as hard as you can to make more money to buy stuff.”

It’s impossible to live a happy life without a sense of having enough, because risking your health, relationships, time, and everything you already have for more money can be a big downgrade in your quality of life, not to mention it can end up as a life wasted.

An insatiable appetite for more many times pushes us to the point of regret. Know when you have enough and make sure you manage your money in a way that enables you to sleep at night.

That’s the final thought from the book to leave you with. Now it’s up to you to buy and read it.