The Psychology of Money by Morgan Housel is comfortably the best personal finance and investing book I’ve read. Morgan Housel is a partner at the Collaborative Fund where he writes a regular blog; previously he was a columnist for the Wall Street Journal and the Motley Fool.
What’s refreshing is that Morgan is one of few writers who is conscious of reader’s time; the book is concise (less than 250 pages) and to the point. This is a break from the convention of a typical book, which is to make a few good points and then waffle on endlessly for over 300 pages — it’s understandable why most readers don’t finish books.
The psychology of money is one of the few books you’ll read back to front, multiple times. It’s been said that “Most books should be articles, most articles should be blog posts, and most blog posts should be tweets.” I couldn’t agree more.
The book consists of 20 short chapters, consisting of stories and anecdotes conveying financial and investing lessons. The underlying the premise of the book is that doing well with money has little to do with how smart you are and everything to do with how you behave.
Morgan is a big advocate of multi-disciplinary learning, he frequently reads outside of the topic of finance, on subjects such as Biology, Physics and history — therefore his lessons and observations are applicable to multiple fields.
Below is a summary and compilation of my favorite bits from the book:
Role of Luck and risk
In this chapter Morgan identifies the reality that every outcome in life is guided by forces other than individual effort — and these are luck and risk, which he describes as close siblings.
Why is this?
The world is too ‘complex to allow 100% of your actions to determine 100% of your outcomes’. You are one person out of more than seven billion people and almost infinite moving parts, the accidental impact of actions outside of your control can be more impactful than the ones you consciously take.
He rightly points out that luck is something we tend to ignore, despite it being as powerful and prevalent as risk. And I can perfectly understand why it’s impact is downplayed. To identify your success not as the product of hard work, but the result of a fickle and random force, reduces the celebratory feeling and satisfaction of achievement. Alternatively to accuse others success as being the product of luck makes you seem rude and jealous.
While luck is undoubtedly a big factor in life, its impact on successful outcomes is something we can’t measure. Therefore we can’t know for sure how much of someone’s success or misfortune is due to this invisible force.
He therefore urges us to be careful when assuming that 100% of outcomes can be attributed to individual effort and personal decisions. After Morgan’s son was born he wrote a letter which said “Not all success is due to hard work and not all poverty is due to laziness. Keep this is mind when judging people, including yourself.”
Focus on Broad patterns
In conclusion to the chapter, he believes we should focus less on specific individuals and case studies when studying success and failure, and more on broad patterns. The more broader and common the pattern, the more applicable it is to your life.
By contrast, studying a specific person can be dangerous because these are often extreme examples, the billionaires and enormous failures that dominate the news. They are often the least applicable to other situations given their uniqueness and complexity.
As a general rule Morgan says “The more extreme the outcome, the less likely you can apply its lessons to your own life, because the more likely the outcomes was influenced by the extreme ends of luck and risk.”
Getting wealthy vs. staying wealthy
There are plenty of ways to get wealthy; the self-help industry bombards with ways to do so. But there is only a few ways to stay wealthy, and that is a combination of ‘frugality and paranoia’.
He uses the example of Jessie Livermore, one of greatest stock traders of all time. Jessie shorted the stock market crash of 1929, making $100 million in the process. After this he was brimming with confidence and made larger and larger bets. He found himself over his head, getting deeper into debt and lost everything in the stock market. He committed suicide in 1940; Jessie was very good at getting wealthy, but terrible at staying wealthy.
Part of the reason getting money and keeping it is so hard is that it requires a different set of skills. Getting wealthy requires risk taking, optimism and shooting for the fences, where as staying rich requires frugality and a healthy dose of paranoia.
Morgan summarizes money success in a single word, ‘survival’. Surviving long enough and not getting wiped out is critical to allow compounding to work its wonders. I believe having a decent cash reserves is key to this as it prevents you from being forced to sell stocks during a down market, and enables compounding to earn good returns for the longest period of time.
Tail events drive outcomes
Tail events are outlying one in a million events that drive the majority of outcomes. Anything that is hugely profitable, influential and famous is a result of a tail event — tails drive everything in business and investing. I have no doubt this idea was inspired from the ‘Pareto Principle’, where 80% of outcomes are the result of 20% of inputs.
In the stock market, most companies are duds; and only a small minority generate all of the market returns.
In the case of business, Amazon for example generates most of their revenue from Amazon Web Services and Prime.
Another example is Apple, where the iPhone is responsible for the overwhelming majority of their success. In the third quarter of this fiscal year, the iPhone accounted for 44% of the company’s overall revenue.
Even the great investor Warren Buffett’s returns are due to tails. In a 2013 Berkshire Hathaway meeting, Buffett said he owned 400–500 stocks during his life and made most of his money on 10 of them. Remove the top investments and his returns are pretty average.
The power of compounding
He points to the fascinating fact that $81.5 of Warren Buffett’s $84.5 billion net worth came after his 65th birthday.
Warren Buffett’s fortune is due to him being a good investor since he was a child. His secret in investing is time, he has been investing for three quarters of a century.
He observes that good investing isn’t about necessarily earnings the highest return but about earning moderately good returns for the longest period of time. This is where compounding really works wonders.
Charlie Munger once said — “the first rule of compounding: Never interrupt it unnecessarily.”
Wealth gives you control over your time
Money’s greatest intrinsic value is the ability to give you control over your time.
It gives you the freedom to wake up in the morning and do whatever you want — this is the highest dividend money pays.
He believes that building wealth is mainly about spending less than you earn, your savings rate is more important than your investment returns and your income.
This is short chapter but demonstration of his ability to write succinctly.
The role surprises and unknowns
Stanford Professor Scott Sagan: “Things that have never happened before happen all the time.”
History is a study of surprising events and therefore relying on past data as a guide to future conditions is futile, economics is a field where change happens all the time.
If there’s one thing history has taught us is that outlier events move the needle the most. These outliers, such as the great depression and September 11th are unknown unknowns, despite having no ability to forecast them, they have an enormous role in shaping the global economic and political landscape.
And what is underappreciated is that events compound — For example 9/11 caused the Federal Reserve to slash interest rates, fueling the housing bubble, which led to the financial crisis of 2008, causing a weak labor market, driving people to seek college education, leading to student loans crisis.
The takeaway from this chapter is that a tiny number of unprecedented events account for the majority of what is happening in the global economy.
Folly of forecasters
If surprises are the common plot of history, then using record-setting events like the Great Depression and World Wars to guide our view of the worst case scenarios when thinking about the future is deeply misguided.
When forecasters assume the worst and best events of the past will match the worst and best events of the future, you’re making the mistake of assuming the history of unpredictable events doesn’t apply to the future.
Morgan describes this as a failure of imagination — he highlights the example of the Fukushima nuclear reactor, which experienced a meltdown in 2011 when a tsunami struck. It was built to withstand the worst past earthquake, the builders had not imagined much worse. They hadn’t thought that the worst past event would have been a surprise and therefore have no precedent.
Instead of using the past as a guide to future scenarios, we should just use the history of surprises as an admission that we have no idea of what will happen next. As a result of this, Morgan says that we don’t need a particular reason to save; savings can just be a “hedge against life’s inevitable ability to surprise the hell out of you at the worst possible time.”
Structural changes in the economy makes history a poor guide to the future
Finally there is another problem with using history as a guide to the future. That is history doesn’t account for the structural changes which are relevant today. For example the S&P 500 didn’t include financials until 1977 and technology was existent 50 years ago. Moreover there are differences in accounting and market liquidity.
To show how these changes affect investing, he uses the example of the classic investment book, ‘The Intelligent Investor’ by Benjamin Graham. As a young teenager learning about investing, Morgan read this book, and it laid out the formulas on how to make money in the stock market. The problem was that few of them actually worked. Each time Graham updated the book; he discarded the old formulas and replaced them with new ones, it was an admission that the old techniques didn’t work anymore.
The reason is that information has become more accessible thanks to greater technology, which leads to an anomaly or discrepancy getting rapidly competed away. Therefore a formula which delivers high market returns will only work only for a short period of time, before investors catch onto it and crowd out the excess returns.
Economies, businesses and stock markets evolve, things are constantly changing.What works in one period won’t work in another. As a rule he shows that the further back in history you look, the more likely you are examining a world that no longer applies today.
Everything in life comes with a price; the problem is that for a lot of things the price isn’t obvious, especially from the outside. When we experience them first-hand, then the price becomes apparent. For success it is long hours, hard-work, sacrificing your social life and even compromising your health.
We’ve all instinctively know this, but in this chapter Morgan brings this to light. He uses the statistic that the S&P 500 increased 119-fold in the 50 years ending 2018. Invest a lump sum, sit back and watch your money compound.
In this example, there is a ‘fee’ for these incredible returns — which are volatility, fear, uncertainty, regret, and panic as stocks markets exhibit huge and regular drawdowns. Nothing in life is free, and not seeing the price seduces us into believing that we can get something for nothing. Trying to avoid the price leads to paying more, and even fall victim to scams.
Another example is Netflix, since going went public in 2002; the stock has delivered a 39,000% return. The fee for these returns is three 70% drawdowns and about eleven falls of 30% or more. Very few people were willing to pay this price.
My Favorite insights from the book:
-There are plenty of ways to get wealthy, but only a few ways to stay wealthy
- Tail events (rare outlying events) drive the majority of outcomes
- The power of compounding: $81.5 of Warren Buffett’s $84.5 billion net worth came after his 65th birthday. His secret is time; he’s been investing for three quarters of a century.
- Wealth gives you control over your time, it gives you the freedom to wake up in the morning and do whatever you want.
- History is a study of surprising events. Things which have never happened before happen all the time.
-Nothing in life and investing is free, there is a price, but it isn’t always obvious. Identify the price, see it as a fee and decide if you want to pay it.
This is the best investing and psychology book that I’ve read. If I apply Sturgeons Law to the investment industry, then ‘90% of everything is crap’. Wading through the sea of garbage to find golden nuggets of information is exhausting, but finding them is immensely rewarding, this book is one of them: The Psychology of Money by Morgan Housel