Despite studying and working in finance for years, I learned a lot more from this book than I expected. The central premise of the Psychology of Money is that our relationship with our finances is a lot more emotional than rational; and that people are better off trying to be reasonable about their approach to their finances rather than coldly calculative. By using principles of behavioral economics and reducing cognitive biases (e.g., sunk cost fallacy, end-of-history illusion, loss aversion, anchoring bias, endowment effect, recency bias, overconfidence bias), the book helps you form a better relationship with your financial wellbeing.
TL;DR Lessons:
Start your compounding journey as early as possible;
Save as much as you can by resisting social pressures on spending to fit a societal mold;
Tail events drive the majority of your portfolio returns and losses; you get exposure to them by diversifying your investments;
Be optimistic in the long-run (invest more) but pessimistic in the short-run (save more);
Beating the market consistently is hard and statistically improbable, you’re better off indexing rather than stock picking (your overconfidence bias will tell you otherwise); and,
Surprises happen, so leave room for error by not planning too rigidly — meaning be flexible with your time horizon, your budget, your salary and your expectations for the future.
Review: 5/5. Highly Recommended.
The main lessons from the book are summarized below:
People’s personal experiences with money color their expectations and assumptions about their finances: whether its growing up in an era of low inflation, high interest rates or stagflation, the circumstances in which you were brought up in make up your underlying assumptions for how you think about your wealth and your expectations of the future. Research findings suggest that individual investors’ willingness to bear risk mostly depends on personal history rather than rational calculations of risk adjusted returns.
The line between luck and risk is blurry and only visible with hindsight: in no circumstance can 100% of the outcome be attributed to effort and calculated decisions; therefore, less focus should be put on specific decisions and more on broad patterns. This will allow your decision making to be in the right direction rather than rely on specific facts to be absolutely correct.
As your financial wealth grows, make sure your lifestyle does not succumb to “preference inflation”: as social creatures, our material desires are pervasively impacted by societal pressures and expectations (these are mostly subconscious and implicit); setting a hard ceiling for those expectations will reduce your lifestyle inflation, increasing your ability to save, invest and grow your wealth.
Time + compounding allows your wealth to multiply: the most illustrative example of this lessons is that Warren Buffet made $81.5Bn of his $84.5Bn net worth after his 65th birthday. It is critical to start your compounding journey as early as possible.
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There is a big difference between earning money and keeping it: by reducing lifestyle inflation (i.e., maintaining a frugal lifestyle as your earnings grow), you ensure that you keep your incremental gains, rather than spend them frivolously. Plan your budget but make sure to leave room for error since plans are bound to result in surprises.
Similar to a pilot, your success (as an investor) will be determined by how you respond to punctuated moments of terror, not years spent on cruise control: given volatility and the vicissitudes of our world (think 9/11, GFC, CV19), the balance between how much money you make when you’re right and how much money you lose when you’re wrong determines your long-term success. Have a plan and stick to it, especially when things are going wrong.
Money can buy happiness, but it does it through increasing your free time, not material goods: controlling your time is the highest dividend money pays you. More than your salary, the size of your house and the prestige of your job, true freedom and wealth is having control over doing what you want, when you want, with the people you want.
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Credit: Vox Media
No one is impressed with your possessions as much as you are: spending money to show people how much money you have is the fastest way to have less money; true wealth is what people don’t see.
Building wealth has little to do with your income or investment returns and more to do with your saving rate: you spend less by desiring less, you desire less if you care less about what people think about you and your possessions. Investors try hard to increase their returns by 1% where they could increase their saving rate by multiples of that which would contribute more to their future net worth.
Outlier events drive the majority your portfolio’s returns, and you can’t plan for them because they tend to be unprecedented: the main lesson to take away from this is that surprises happen (e.g., fall of the Soviet Union, CV-19), and history cannot be a guide for those surprises. Diversify your investments so that you’re not overexposed to any sector or individual stock.
On a long enough time horizon, anything that can go wrong, will go wrong: the biggest point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future. Reduce your points of failure by diversifying your income streams.
Long-term planning is hard because people’s goals, desires and personalities change: people make career decisions in and around their time in college, thinking they are likely to stay in that profession for a long time. This is a form of cognitive dissonance called the End-of-History Illusion in which individuals believe that they have experienced significant personal growth and development up to the present moment, but will not substantially change in the future. Given this, people make extreme life-style and career decisions (e.g., becoming a forensic accountant) only to realize that their desires change once they achieve their previously desired goals. That in addition to Sunk Cost Fallacy pushes people to stay in careers and lifestyles they no longer desire but fear leaving behind.
Pessimism is seductive because it sounds intelligent; optimism sounds like a sales pitch: since progress happens too slowly to notice, but setbacks happen quickly, they capture a lot more attention. This coupled with Loss Aversion (the tendency to prefer avoiding losses to acquiring equivalent gains) makes people a lot more careful and pessimistic. Too much pessimism makes you myopic about future possibilities.
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Loss Aversion (credit: economicshelp.org)
Conclusion:
Manage your money in a way that lets you sleep at night. Be okay with a lot of things going wrong. Use money to gain control over your time. Avoid extreme career and financial decisions since your desires may change.
