The Psychology of Money

Timeless Lessons on Wealth, Greed and Happiness

By Morgan Housel

Overview:

The Psychology of Money explores how financial success is influenced more by behavior and luck than by intelligence alone. It emphasizes the importance of saving for unpredictable future needs and understanding that wealth can come and go quickly. The book also highlights that happiness often comes from controlling your time rather than just accumulating money.

Highlights:

“A genius is the man who can do the average thing when everyone else around him is losing his mind.”
—Napoleon
The premise of this book is that doing well with money has a little to do with how smart you are and a lot to do with how you behave.
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.
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.
Everything worth pursuing has less than 100% odds of succeeding, and risk is just what happens when you end up on the unfortunate side of that equation.
But realize that 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.
When things are going extremely well, realize it’s not as good as you think. You are not invincible, and if you acknowledge that luck brought you success then you have to believe in luck’s cousin, risk, which can turn your story around just as quickly.
Failure can be a lousy teacher, because it seduces smart people into thinking their decisions were terrible when sometimes they just reflect the unforgiving realities of risk. The trick when dealing with failure is arranging your financial life in a way that a bad investment here and a missed financial goal there won’t wipe you out so you can keep playing until the odds fall in your favor.
There is no reason to risk what you have and need for what you don’t have and don’t need.
The hardest financial skill is getting the goalpost to stop moving.
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. Nassim Taleb put it this way: “Having an ‘edge’ and surviving are two different things: the first requires the second. You need to avoid ruin. At all costs.”
More than I want big returns, I want to be financially unbreakable. And if I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able to stick around long enough for compounding to work wonders.
Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time—especially in times of chaos and havoc—will always win
Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error—often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline—anything that lets you live happily with a range of outcomes.
A barbelled personality—optimistic about the future, but paranoid about what will prevent you from getting to the future—is vital.
Destruction in the face of progress is not only possible, but an efficient way to get rid of excess.
A lot of things in business and investing work this way. Long tails—the farthest ends of a distribution of outcomes—have tremendous influence in finance, where a small number of events can account for the majority of outcomes. That can be hard to deal with, even if you understand the math. It is not intuitive that an investor can be wrong half the time and still make a fortune. It means we underestimate how normal it is for a lot of things to fail. Which causes us to overreact when they do.
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.
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.
The most powerful common denominator of happiness was simple. Campbell summed it up: Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing than any of the objective conditions of life we have considered.
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.
It’s a subtle recognition that people generally aspire to be respected and admired by others, and using money to buy fancy things may bring less of it than you imagine. 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.
But wealth is hidden. It’s income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now.
Personal savings and frugality—finance’s conservation and efficiency—are parts of the money equation that are more in your control and have a 100% chance of being as effective in the future as they are today.
Think of it like this, and one of the most powerful ways to increase your savings isn’t to raise your income. It’s to raise your humility.
Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.
Savings without a spending goal gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. It lets you change course on your own terms.
If you have flexibility you can wait for good opportunities, both in your career and for your investments. You’ll have a better chance of being able to learn a new skill when it’s necessary. You’ll feel less urgency to chase competitors who can do things you can’t, and have more leeway to find your passion and your niche at your own pace. You can find a new routine, a slower pace, and think about life with a different set of assumptions. The ability to do those things when most others can’t is one of the few things that will set you apart in a world where intelligence is no longer a sustainable advantage.
Having more control over your time and options is becoming one of the most valuable currencies in the world.
“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 mental trick we play on ourselves here is an over-admiration of people who have been there, done that, when it comes to money. Experiencing specific events does not necessarily qualify you to know what will happen next. In fact it rarely does, because experience leads to overconfidence more than forecasting ability.
The majority of what’s happening at any given moment in the global economy can be tied back to a handful of past events that were nearly impossible to predict.
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.
The most important economic events of the future—things that will move the needle the most—are things that history gives us little to no guide about. They will be unprecedented events. Their unprecedented nature means we won’t be prepared for them, which is part of what makes them so impactful. This is true for both scary events like recessions and wars, and great events like innovation.
But my favorite summary of the theory came when he mentioned in an interview that “the purpose of the margin of safety is to render the forecast unnecessary.” It’s hard to overstate how much power lies in that simple statement. Margin of safety—you can also call it room for error or redundancy—is the only effective way to safely navigate a world that is governed by odds, not certainties. And almost everything related to money exists in that kind of world.
Two things cause us to avoid room for error. One is the idea that somebody must know what the future holds, driven by the uncomfortable feeling that comes from admitting the opposite. The second is that you’re therefore doing yourself harm by not taking actions that fully exploit an accurate view of that future coming true.
Room for error lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low-probability outcome fall in your favor. The biggest gains occur infrequently, either because they don’t happen often or because they take time to compound. So the person with enough room for error in part of their strategy (cash) to let them endure hardship in another (stocks) has an edge over the person who gets wiped out, game over, insert more tokens, when they’re wrong.
An important cousin of room for error is what I call optimism bias in risk-taking, or “Russian roulette should statistically work” syndrome: An attachment to favorable odds when the downside is unacceptable in any circumstances. Nassim Taleb says, “You can be risk loving and yet completely averse to ruin.” And indeed, you should.
To get around this, I think of my own money as barbelled. I take risks with one portion and am terrified with the other. This is not inconsistent, but the psychology of money would lead you to believe that it is. I just want to ensure I can remain standing long enough for my risks to pay off. You have to survive to succeed. To repeat a point we’ve made a few times in this book: The ability to do what you want, when you want, for as long as you want, has an infinite ROI.
The trick that often goes overlooked—even by the wealthiest—is what we saw in chapter 10: realizing that you don’t need a specific reason to save. It’s fine to save for a car, or a home, or for retirement. But it’s equally important to save for things you can’t possibly predict or even comprehend—the financial equivalent of field mice.
An underpinning of psychology is that people are poor forecasters of their future selves. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is something entirely different.
We should also come to accept the reality of changing our minds. Some of the most miserable workers I’ve met are people who stay loyal to a career only because it’s the field they picked when deciding on a college major at age 18. When you accept the End of History Illusion, you realize that the odds of picking a job when you’re not old enough to drink that you will still enjoy when you’re old enough to qualify for Social Security are low. The trick is to accept the reality of change and move on as soon as possible.
Like everything else worthwhile, successful investing demands a price. But its currency is not dollars and cents. It’s volatility, fear, doubt, uncertainty, and regret—all of which are easy to overlook until you’re dealing with them in real time.
Competition for investment returns is fierce, and someone has to own every asset at every point in time. That means the mere idea of bubbles will always be controversial, because no one wants to think they own an overvalued asset. In hindsight we’re more likely to point cynical fingers than to learn lessons.
But let me propose one reason they happen that both goes overlooked and applies to you personally: Investors often innocently take cues from other investors who are playing a different game than they are.
An idea exists in finance that seems innocent but has done incalculable damage. It’s the notion that assets have one rational price in a world where investors have different goals and time horizons.
An iron rule of finance is that money chases returns to the greatest extent that it can.
A takeaway here is that few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are. The main thing I can recommend is going out of your way to identify what game you’re playing.
How I invest my own money is detailed in chapter 20, but years ago I wrote out “I am a passive investor optimistic in the world’s ability to generate real economic growth and I’m confident that over the next 30 years that growth will accrue to my investments.”
Real optimists don’t believe that everything will be great. That’s complacency. Optimism is a belief that the odds of a good outcome are in your favor over time, even when there will be setbacks along the way.
There is an iron law in economics: extremely good and extremely bad circumstances rarely stay that way for long because supply and demand adapt in hard-to-predict ways. Growth is driven by compounding, which always takes time. Destruction is driven by single points of failure, which can happen in seconds, and loss of confidence, which can happen in an instant.
In investing you must identify the price of success—volatility and loss amid the long backdrop of growth—and be willing to pay it.
This is different from, say, Germany in 1945, whose manufacturing base had been obliterated. Or Japan in the 2000s, whose working-age population was shrinking. That’s tangible economic damage. In 2009 we inflicted narrative damage on ourselves, and it was vicious. It’s one of the most potent economic forces that exists.
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.
An appealing fiction happens when you are smart, you want to find solutions, but face a combination of limited control and high stakes.
Investing is one of the only fields that offers daily opportunities for extreme rewards.
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. When thinking about room for error in a forecast it is tempting to think that potential outcomes range from you being just right enough to you being very, very right. But the biggest risk is that you want something to be true so badly that the range of your forecast isn’t even in the same ballpark as reality.
Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
Most people, when confronted with something they don’t understand, do not realize they don’t understand it because they’re able to come up with an explanation that makes sense based on their own unique perspective and experiences in the world, however limited those experiences are. We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.
Coming to terms with how much you don’t know means coming to terms with how much of what happens in the world is out of your control. And that can be hard to accept. 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.
We don’t wander around blind and confused. We have to think the world we operate in makes sense based on what we happen to know. It’d be too hard to get out of bed in the morning if you felt otherwise.
Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong. Because it’s never as good or as bad as it looks. The world is big and complex. Luck and risk are both real and hard to identify. Do so when judging both yourself and others. Respect the power of luck and risk and you’ll have a better chance of focusing on things you can actually control. You’ll also have a better chance of finding the right role models.
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.
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.
Use money to gain control over your time, because not having control of your time is such a powerful and universal drag on happiness. 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.
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.
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.
It’s mostly a matter of keeping your expectations in check and living below your means. Independence, at any income level, is driven by your savings rate. And past a certain level of income your savings rate is driven by your ability to keep your lifestyle expectations from running away.
Nassim Taleb explained: “True success is exiting some rat race to modulate one’s activities for peace of mind.” I like that.
Good decisions aren’t always rational. At some point you have to choose between being happy or being “right.”
While the top 1 percent have seen their incomes rise 18 percent over the past decade, those in the middle have actually seen their incomes fall. For men with only high-school degrees, the decline has been precipitous—12 percent in the last quarter-century alone.
The economy works better for some people than others. Success isn’t as meritocratic as it used to be and, when success is granted, it’s rewarded with higher gains than in previous eras.