Book Review - The Psychology of Money
I do not do book reviews on the regular, but given that that was one of the aims with which I started this newsletter with - I’m starting with the review of a widely read and famous book - The Psychology of money by Morgan Housel. I intend the review to be less of a regular review and more of a record of notes from the book that I found pretty useful. I hope you benefit from it.
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Record and Review
To me the best part of the book is that it is simple. No complex graphs, no statistics, no formulae and most importantly - no high sounding claims like ‘read this book to become a millionaire’. To Morgan’s credit, he writes the book with a deep sense of intellectual humility which is embodied not just in the financial principles he sets but also how he looks at his own advice. He is honest about the fact that these are not universal principles, and that there are many caveats and background conditions that need to be in place for these rules and principles to work. It also helps that it is a short read.
The premise as Morgan explains in just the starting few pages is ‘Doing well with money has little to do with how smart you are and a lot to do with how you behave. And behavior is really hard to teach, even to smart people’. This is the central tenet of the book - the idea that it is your habits, consistent and long term habits, that make you good with money, and not conventional smartness. The second and a deeper premise of the book is his idea that Financial success is not a hard science. He argues that it is not data analytics, spreadsheets, crunching numbers and complicated machine learning software that generates favorable financial outcome, but equal parts luck and equal parts good financial habits. This is deep rooted in the unpredictability of financial markets, which despite seeming something that can be predicted - is in the end mystical to a large extent.
I now will go through the book and talk about the relevant and interesting portions in each chapter. The portions in bold and italics are direct excerpts from the book.
One: No one’s crazy
This chapter is the perfect example of the intellectual humility that I was talking about earlier. Morgan’s main argument is that it is incorrect to first, think of certain financial decisions as correct and incorrect, and second, that a lot of people’s financial decisions are driven by their own unique experiences. Just because we do not or can not understand them does not mean that their decision are inaccurate. He gives an example of how the risk taking appetite of two individual’s - one born during the great depression and other after the 80s in USA can differ extremely. It is simply because they have experienced different things. He quotes investor Michael Batnick who said ‘some lessons have to be experienced before they can be understood’. Morgan’s own explanation for why individual’s are not spreadsheets and thus cannot be expected to be cold hard calculating machines is, ‘Few people make financial decisions based purely on a spreadsheet. They make them at dinner tables, or in a company meeting. Places where personal history, your own unique view of the world, ego, pride, marketing, and odd incentives are scrambled together into a narrative that works for you’.
Two: Luck and Risk
Morgan uses the story of Bill Gates to prove how success is equal parts luck and equal parts risk. Bill Gates was lucky enough to go to a school which had a computer when it was exceedingly rare to have one at schools. So, would you say that Bill gates got lucky?
The idea behind understanding risk is to first realize that everything runs on probabilities. There is a x% chance of success and (100-x)% chance of failure with everything. When someone or something does fail, it is not always because ‘the team or individual didn’t try hard enough. Sometimes you are just exposed to the naked odds of risk. The second idea flowing from this is the idea (which Morgan wrote in a letter to his new born son) ‘Realize that not all success is due to hard work, and not all poverty is due to laziness’. That to me is a deeply humble statement. As Morgan says in the end of the chapter ‘nothing is as good or as bad as it seems’.
Three: Never Enough
One of my personal favorite chapters and the one which contains the most important financial lesson in my opinion - understanding what and when is enough. Morgan tells a story about an individual who despite being very rich still risked everything to get even richer by indulging in extra legal activities. He ended up going to jail. The central lesson as he gives out later is ‘There is no reason to risk what you have and need for what you don’t have and don’t need’. Greed ruins. And as Naseem Taleb says, one needs to take risks, but not ruinous risks - risks whose downside is so bad, that if the odds were not in your favor, you’d be ruined.
The only way you can develop a definition of enough is if you get the goalpost to stop moving. The idea of the goalpost is the idea of what do you want to achieve with money. If you idea is always to have more, then it will lead you to ruins. For nothing is enough. Therefore you need to develop a sense of enough. For me, at this point in life, enough would look like a comfortable and simple house in a city of my choice, a mid range car, a job that pays me moderately well and also gives me time to do other things etc. If I am lucky to get the goalpost to stop moving, what will happen is that my earnings will keep increasing but my expenditure will remain more or less the same - since I already have enough. And that will in turn increase my savings. But as Morgan says, it is one of the hardest things to do because most individuals upscale as a result of social comparison. It is hard to exit the game of social comparison. ‘It is a battle that can never be won, or that the only way to win is to not fight to begin with - to accept that you might have enough, even if it is less that those around you’.
Four: Confounding Compounding
Warren Buffet’s 81.5 billion dollars out of 84.5 billion dollar net worth came after his 65th birthday. He has been investing since he was 10. Compounding is the only way to get wealthy.
Five: Getting wealthy vs. staying wealthy
Getting rich and staying rich are two separate skills. You can get rich by a million ways, but whatever skill helped you become rich is not the same skill that will keep you rich. Morgan argues that mostly money is made by taking bets and risks, but keeping money requires the opposite of risk - ‘It requires humility, and fear that what you’ve made can be taken away from you just as fast’. He quotes the head of legendary VC firm Sequoia Capital Michael Moritz when he talks about how the culture at Sequoia is that of paranoia - the understanding that tomorrow’s success is not given just because they have had success in the past. Which is a pattern displayed by a lot of successful companies and individuals - paranoia in the short term, optimism in the long term. Keeping money has all to do with being patient and not consistently screwing up.
That chapter offers two more valuable advices.
First, ‘planning is important but plan on the plan not going according to the plan’. My whole life is an example to this statement except like most else, I did not plan accordingly. This is the larger epistemological humility that is required when planning anything. The realization that there are so many variables that are out of our control and that we possible cannot look back at what has happened till now to predict what will happen from now on.
Second - Margin of safety. The following is one of the most foundational lessons in probabilistic thinking - ‘Most bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right’. The idea behind this is that we plan according to information we have till now, and irrespective of how accurate that information may be, future is never a linear projection of the past. Things happen, trends change and that spoils those plans that run on certain number of things going exactly right. So Morgan’s suggestion is to keep a margin of safety when planning financially. For example - if you hope that investing x amount of money is likely to give you y amount of returns based on return pattern of the financial instrument and after adjusting for inflation, it is always better to invest more than just x to create the margin of safety such that even if the financial instrument doesn’t perform as per expectation, your returns are not likely to change significantly.
Six: Tails, you win
A very small number of events drive the maximum number of outcomes. I think it is very similar to the power law as explained by Peter Theil in his book Zero to One, or the more conventional Pareto Principle. This means that it can very well happen that the most correct investor may not be the richest, and that an investor who is wrong the most time is the richest because he was right only one time that repaid him obscenely well. This helps you understand the value of luck. Tail events drive the world.
Seven: Freedom
Only two things I would like to reproduce from the book that gave me immense insight into the real leverage of money.
Money’s greatest intrinsic value - and this can’t be overstated - is its ability to give you control over your time.
Doing something that you love on a schedule that you cannot control is an awful lot like doing something that you hate doing.
Eight: Man in the car Paradox
Buying things to earn the admiration and respect of others is the quickest way to earn neither and lose money.
Nine: Wealth is what you don’t see
Connected to the previous lesson, Morgan argues that wealth is the fact that you can afford to buy x number of things but you do not. Mostly because you’ve made the goalpost to stop moving and you realize that you do not actually need those things. That what you have is enough. Wealth is the understanding that if you wanted to, you could, but you won’t. As Morgan says, wealth offers you options, flexibility, leverage etc. Buying things from money cannot offer you any of this. Only money can.
Ten: Save Money
Two important lessons in this chapter:
The only way to build wealth is not to earn more money, it is to save more money irrespective of your income.
Learn to save just for saving’s sake. Even though saving for something particular also works.
As Morgan puts it - ‘Saving is a hedge against life’s inevitable ability to surprise the living hell out of you at the worst possible moment’.
Eleven to Fifteen: Excerpts
Aiming to be reasonable instead of coldly rational is more important when making financial decisions
History is not a map of the future
The correct lesson to learn from surprises is that life is full of surprises and not to use them are planning devices for future
Good ideas taken too far are indistinguishable from bad ideas
You have to take the risk to go ahead, but no risk that can wipe you out is worth taking
Few financial plans that only prepare for known risks have enough margin of safety to survive the real world
When we say that '“we don’t know what the future holds” we are admitting that we ourselves do not know what we will want in the future
Sixteen: You & me
I absolutely love this chapter. It talks about how (not just in investing but life) different people are playing different games. They have different priorities, different time horizons, different aims. Judging all of them on the same scale does not make any sense. But this means two more things. First, is that there is no correct or rational investment decision. And second, there is no correct investment advice that applies to everyone. So when someone says ‘buy this stock’ that is incomplete advice. It all depends upon if the person wants to invest short term or long term, what this financial priorities are in life etc. This can be extrapolated to everything in life. General advice is wrong advice.
In the end Morgan gives a summary of all the lessons he speaks about. This is the list:
Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong.
Less ego, more wealth
Manage your money in a way that helps you sleep at night
If you want to do better as an investor, the single biggest thing you can do is to increase your time horizon
Become OK with a lot of things going wrong. You can be wrong half of the time and still make a fortune
Use money to gain control over your time
Be nicer and less flashy
Save. Just save.
Define the cost of success and be ready to pay it
Worship room of error
Avoid the extreme ends of financial decisions
We should like risks because it pays off over time
Define the game you’re playing1
Respect the mess
Of course this post is not meant to be a replacement for reading the book itself. I’d really recommend you to get a copy. It is a brilliant book and I believe that every 18 year old (even younger) should read this. I plan to buy and gift copies of this book to people I care about. It is simply that good.
I would also recommend following Morgan’s writing on his blog. Morgan is on twitter as @morganhousel.
Naval Ravikant says two things. First, only play games you care to win. Second, the only reason to win the game is to become free of it. This advice has single handedly made things more clear to me than any other advice.