Psychology of Money – Wealth is Unspent!

Psychology of Money, written by Morgan Housel, is a simple yet effective book of financial education. It is so simple, that the reader might feel it is common sense. But this common sense definitely needs a reinforcement. It emphasises on the fact that finance is more Behaviour than Stats. If you take care of behaviour, stats take care of themselves.

Ok, to begin with, let’s understand the basics of behaviour –

1. 1. Physics isn’t controversial. It’s guided by laws. Finance is different. It’s guided by people’s behaviours. And how I behave might make sense to me but look crazy to you
   2. Few people make financial decisions purely with a spreadsheet. They make them at the dinner table, or in a company meeting. Places where personal history, your unique world view, ego, pride, marketing, and odd incentives are scrambled together into a narrative that works for you
2. Now we’ll look at some concepts that will help us think about money from various perspectives –
3. Luck and risk. Equal forces, working in opposite direction. They both happen because the world is too complex to allow 100% of your actions to dictate 100% of your outcomes. There are infinite moving parts and the accidental impact of something outside your control can be more consequential than the actions you consciously take
4. Where’s your enough? The hardest financial skill is getting the goalpost to stop moving. Rajat gupta had everything, yet, in the pursuit of more, he risked it (check out our video on his story here). Modern capitalism generates wealth and generates envy. Happiness, as it is said, is just results minus expectations. “Enough” doesn’t mean leaving opportunity and potential on the table. It is realising the opposite – an insatiable appetite for more – will push you to the point of regret. It’s like food. You try & eat until you’re sick. Do it enough times and you know vomiting is going to hurt more than any meal is good
5. Compounding – how ice ages occurred? It wasn’t about a lot of snow. Minor tilting made summers a little less warmer and last winter’s snow did not melt. Accumulation over years lands us in an ice age. It is not necessarily the amount of snow that causes ice sheets but the fact that snow, however little, lasts. The same is with money. A lot of us would’ve seen Warren Buffett’s net worth increasing drastically after 60 (81.5bn out of the approx 90bn). His skill is investing, but his secret is time. That’s how compounding works
6. Getting wealthy vs staying wealthy – Now let’s get this straight. These are 2 very different skills! Getting money required taking risks, being optimistic, and putting yourself out there. 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. It requires frugality and an acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely
7. Tail events. Not all bets have to fire. Out of more than 21000 venture financing from 2004 to 2014: 65% lost money, 2.5% made 10x-20x, 1% made more than 20x and half a percent (about 100 companies) earned 50x or more. That’s where majority returns lie. Reed Hastings once announced his company (Netflix) was cancelling several big budget productions. He responded : our hit ratio is way too high right now. I’m always pushing the content team. We have to take more risk. You have to try more crazy things, because we should have a higher cancel rate overall
8. Freedom – the highest form of wealth is the ability to wake up every morning and say, I can do whatever I want today. 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. So, are you free?
9. Man in the Car Paradox – no is is impressed with your possessions as much as you are. Fancy cars send a strong signal to others that you made it. You’re smart. You’re rich. You have taste. You’re important. Look at me. The irony is that people rarely look at the drivers of such cars. They simply use it as a benchmark if they achieved that car, they’ll be cool. You don’t think, wow the guy driving that car is so cool. You always think, wow if I had that car, people would think I’m cool
10. Wealth is what you don’t see. Someone driving a $100,000 car in front of you. The only information you can get it that the owner is a $100,000 poorer or in debt. Wealth, if converted into things, reduces. The only way to accumulate wealth is by not spending it. Rich is a current income. Someone driving a fancy car to afford monthly EMI is rich. Wealth is hidden. It’s income not spent. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you can right now
11. Save money – building wealth has little to do with your income or investment returns, and lots to do with your savings rate. You have a better chance of building wealth without high income, but have no chance of building wealth without a high savings rate. More importantly, the value of wealth is relative to what you need. Past a certain level of income, what you need is just what sits below your ego
12. Reasonable > Rational : you’re not a spreadsheet. You’re a person. A screwed up emotional person. Do not aim to be coldly rational when making financial decisions. Reasonable is more realistic and you have a better chance of sticking with it for the long run
13. Do not underestimate surprise and overestimate history. You’ll likely miss the outlier events that move the needle the most. History can be a misleading guide to the future of the economy and stock market because it doesn’t account for structural changes that are relevant to today’s world
14. Room for error. You have to plan on your plan not going according to plan. As Benjamin graham puts it, the purpose of the margin of safety is to render the forecast unnecessary. Having a gap between what you can technically ensure versus what’s emotionally possible is an overlooked version of room for error. Can you survive a 30% crash? Not just on a spreadsheet but mentally?
15. You’ll change – as a kid you want to be a tractor driver, then perhaps lawyer, then you realise working such long hours isn’t worth it. And you find a more flexible job. The point is, our priorities change. We change. Long term financial planning is essential. But things change – both the world around you, and your own goals and desires. Thus, as Charlie Munger puts it, the first rule of compounding is to never interrupt it unnecessarily.
16. You and me. We’re different. Investors often take cues from other investors who are playing a different game than they are. How much should you pay for an asset class? It all depends on your time horizon – 30 years, 10 years, 1 year or 1 day? Your parameter will change drastically. And bubbles form when investors in an asset class shift from mostly long term to mostly short term
17. The seduction of pessimism – the simple idea that most people wake up in the morning trying to make things a little better and more productive than wake up looking to cause trouble is the foundation of optimism. Pessimism just sounds smarter and more plausible than optimism. If someone had forecasted right after WW2 that Japan would be a leading economy with almost double life expectancy and unemployment never topping 6%, people would’ve simply laughed. Our dramatisation instinct as mentioned in factfulness is what drives it. Assuming that something ugly will stay ugly is an easy forecast to make. And it’s persuasive, because it doesn’t require imagining the world changing. But nothing extremely good or bad stays that way in the long term as supply and demand adapt in hard to predict ways. Pessimism lowers our expectations and any good adds to pleasure
18. Basic summary – I can’t tell you what to do with your money, because I don’t know you. I don’t know what you want. I don’t know when you want it. I don’t know why you want it. Financial advisors can only lay out options in front of you. You need to choose your plan!