Top 6 Lessons from The Psychology of Money

Introduction

Psychology of Money is a best selling book that was written by Morgan Housel. It has been a popular book since its release in 2020 spending several months on the New York Times Bestsellers List. This book doesn’t necessarily address the x’s and o’s of investing. Rather it is focused on, what in our opinion, are the most important subjects that you need to learn in investing. These include our relationship with money, and how that influences our money decisions. The subtitle of the book is aptly named “timeless lessons on wealth, greed and happiness”. In today's post we are going to break down our Top 6 Lessons from the Psychology of Money.

1. Margin of Safety

   • Quotes

     • “Margin of safety 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” - Morgan Housel

     • “The purpose of the margin of safety is to render the forecast unnecessary” - Warren Buffet

When you start your journey into personal finance the focus is solely on numbers. We ask ourselves questions such as?

• What percentage of my income should I save or invest?

• What is my retirement savings target?

• How much should I invest in stocks or bonds?

This is for a good reason. If you don’t have guidelines to follow in a complex world your default is to avoid the subject entirely. However, this over emphasis on numbers becomes an issue when we fail to consider factors that couldn’t been forecasted. The problem with the classic Nathan Rothschild quote “The time to buy is when there is blood in the streets” is that when this happens you are likely one of those people bleeding.

There are many things in our life we can predict, and plan for. These include things such as a car repair, house purchase, vacations, utility bills, food costs, and even kids. But there will inevitable be events in our lifetime that will be hard, if not impossible, to predict. Very few people predicted the Covid-19 pandemic, and were able to shield themselves financially from it. The same can be said of other tragedies such as 911, World War 2, and many more.

Considering that unpredictable events can occur, or prepare for then some investments that appear good on paper may turn out to be catastrophic. This is particularly true if a large percentage of your net worth is invested when you need the money the most. Just imagine purchasing a house right before losing your job.

The only way to protect yourself from the things you can’t predict is to have room for error. This comes in several forms:

• Avoid investing all of your money into any single investment. This is the benefit of index ETFs

• Hold a mix of different asset classes (ie. stocks, bonds, real estate, gold)

• Consider keeping a larger percentage of money in cash to protect yourself from the things you can’t predict.

• Under project future returns when planning for retirement. If your retirement nest egg depends on you getting the S&P 500 average of 10%, and it underperforms you won’t be prepared. Plan to earn a smaller return.

2. Know The Game You Are Playing

• Quotes

  • “Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviours of people playing different games than you are” - Morgan Housel

We are constantly bombarded with “investing” advice that sounds something like this:

• “Invest in Nvidia it is going to the moon”

• “Our currency is being devalued you should invest in gold”

• “Clean energy is the future, invest in xyz EV company”

Amongst all of this information we never stop to ask ourselves what game am I actually playing?

I can tell you the game I am playing is to increase my income, maintain my expenses, and invest the difference. I would like to reach my freedom goal of 1.5 million dollars. This would allow me to live on 50-60k/ year provided that I follow the 4% rule. I know I can achieve this within 20-30 years by investing strictly in a low cost index ETF. Most importantly though I would like to avoid financial ruin. I am playing the long game. Everything else is irrelevant.

Most of the advice you will hear focuses on the short to medium term. It is directed at stock traders not investors. These are people that focus solely on the immediate direction, and momentum of the stock

• If it is increasing rapidly then they buy it and ride the wave.

• If it is decreasing rapidly then they short it and ride the wave.

The goal is to get in just in time to ride the wave, and get out before the tide goes out.

Investors on the other hand focus on valuation of a company. They look at the financials to determine if the company is growing its profits, decreasing its expenses, has good growth potential, and is undervalued. If so then they buy with the intention of holding the stock forever, or at least until the narrative changes.

People get burned, and bubbles form when long term investors take advice from short term traders. They apply a long term mindset of buy and hold, at the wrong time…when the stock has been driven up by people that plan to get out before the chips fall. Unfortunately, when they do the only ones left to pick up the pieces are those that forget what game they were playing.

3. Rich vs Wealthy

• Quotes

  • “The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. Keep this in mind when quickly judging others success and setting your own goals” - Morgan Housel

Think of the richest people in the world (Elon Musk, Mark Zuckerberg, Warren Buffet). If you seen these individuals on the street but didn’t know who they were would you think they had a lot of money? My default would be that they live a modest lifestyle with an average income. Now on the other hand if we see someone driving a Ferrari, living in a big house, or wearing designer clothes our default thoughts is that they must have money.

The problem in both of these scenarios is that we never actually get to look at their pay stub, brokerage accounts, and credit card statements to get an idea of their finances. Rather our default mode is to think that the possession of expensive things must mean someone is wealthy.

To the contrary wealth is often what isn’t seen. It is the accumulation of assets through saving. Someone who is wealthy saves money today in order to:

• Buy more or better experiences later.

• Have the flexibility to leave a job, retire, or reduce their hours.

• Etc.

Those that outwardly appear wealthy are more then likely what we can define as rich. They are rich because they have a high current income which allows them to pay for expensive things. Or at least it allows them to get access to the credit to buy those things. The unfortunate thing is many of those individuals have not established the appropriate saving’s muscle. Consequently, their burn rate is just as high as there earn rate. The result is when the income tap slows the facade comes crumbling down.

4. The Cost of Admission

• Quotes

  • “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 deal with them in real time” - Morgan Housel

Invariably the most successful asset class over the last 50 years has been stocks, particularly US based stocks. By all available information the smartest thing you can do is buy a S&P 500 index ETF, and hold it until you retire. In reality though, few people ever follow this advice.

Instead what they do is:

• Trade in and out of stocks, trying to buy the dip.

• Invest in lower return asset classes such as bonds and GICs or worse keep all their money in cash out of fear of losing it all.

Surprisingly, even people we consider financial experts fall prey to the same mistake. This is why many active mutual funds consistently underperform the S&P 500 index..

The problem is that the average investor views a decrease in their stock portfolio as a form of punishment. When we experience a 30% drop in our portfolio we think we have lost 30% of our money. The truth is you only ever lose the 30% if you decide to sell.

Stocks have a high degree of volatility which means there is a wide variance in their market price. The market price in many cases is completely unrelated to the quality of the underlying business. Instead things such as news, investor psychology, short term growth prospects, and market headwinds/tailwinds all impact the stock price on a day to day basis.

In order to profit off the growth potential of stocks we have to except that these price variations exist. We have to view them as the cost we must pay in order to get the returns we desire. If we don’t have the mental fortitude or stomach to deal with it that is fine… but accept that you will be earning lower returns investing in safer assets.

5. Shut up and Wait

• Quotes

  • “There are books on economic cycles, trading strategies, and sector bets. But the most powerful and important book should be called Shut Up and Wait. It’s just one page with a long term chart of economic growth” - Morgan Housel

  • “81.5 billion of Warren Buffett’s $84.5 billion net worth came after his 65th birthday. Our minds are not built to handle such absurdities” - Morgan Housel

Our brain is build to comprehend simple mathematic equations:

• If I buy a chocolate bar for $2 and give the cashier $5, I will get $3 back.

• If I invest $1000 into a stock, and it goes up by 50% I know that I now have $1500.

• If I save $100 a month for the next 20 years, I will have $24,000.

The impact of compounding is much more complicated for us to wrap our head around. Compounding is when the money you invest earns interest, and then that interest also earns interest.

Example: Imagine I invest $1000 today in a index ETF that earns 7% per year.

• After Year 1, I should have $1070. This includes $1000 principle, and $70 of interest.

• After Year 2, I should have $1144,90. This includes $1000 principle, $70 of interest I made in year 1, and the $74.90 of interest I earned in year 2. Of which $4.90 was interest earned on the $70 of interest I had earned in year 1.

Although this sounds good….it is by no means mind blowing. The hard to comprehend part of this process comes when you increase the size of the numbers, and the time period over which compounding occurs.

For example: Imagine you invested $1,000 on your 20th birthday. Each month you contributed an additional $500 until you retired at 65 years old.

• On your 21st birthday you should have $7,260.15 ($7,000 of which is contributions, $260.15 is interest)

• By 30 you will have $87,493.02 ($61,000 is contributions, $26,493.02 is interest)

• By 40 you will have $257,637.87 ($121,000 is contributions, $136,637.87 is interest)

• By 65 I will have $1,789,833.14 (only $271,000 is contributions, the $1,518,833.14 is interest)

In this example at the 20 year mark you will have earned more in interest then you actually contributed. By the time you retire you will have earned >5x your contribution in interest. In other words, a simple slow approach produces returns that we can’t comprehend.

Because this is so hard to believe, we instead resort to short term strategies (ie. options, trading stocks, gambling, etc) hoping to hit the lottery. The result is we burn ourselves. When instead we should have just continued to buy the index, lived our lives, and waited for compound interest to do its work.

6. Stop Moving the Goalpost

• Quotes

  • “The hardest financial skill is getting the goalpost to stop moving” - Morgan Housel

One of the most challenging financial skills to learn is saving. Our natural inclination is to spend all of the money we make. Once we’ve maxed out what we can spend on our current income, we seek a higher one. Unfortunately, in many cases this cycle repeats after every subsequent pay increase. This is because our “wants” also increase in alignment with our wage. We want a bigger house, a newer or nicer car, to go on more vacations, to go out for dinner more, and the list goes on. This is what is referred to as lifestyle creep.

At first this can be the desire that pushes you to improve your life circumstances. Up until a certain point increases in income do result in improved happiness. However, eventually we will reach a point that any subsequent increase in income is likely to produce no supplemental benefit to our happiness.

Worse yet we create a “keeping up with the Joneses” effect in our life whereby we are never satisfied regardless of what we achieve. Regardless of your income there is always someone who has more. Someone who has bigger, and better things then you. The guy who owns a pontoon boat wants a sport boat, the guy who owns the sport boat wants a yacht, the guy who owns a yacht wants a super yacht.

If we never develop a savings muscle we trap ourselves into a constant cycle of wanting more, and never ever meeting that desire. Being wealthy isn’t about having a lot of money, although that is part of the equation, its more about having enough. And when you constantly desire more, nothing is ever enough.

Our goal as we increase our income should be to learn how to create a gap between our income, and our spending so that we can start to accumulate wealth. It should be to stop moving the goalpost and realize when enough, is enough.

Final Thoughts: Why You Should Read The Psychology of Money

The Psychology of Money by Morgan Housel is one of our favourite books on how emotions and behavior shape our financial decisions.

Whether you’re just starting your financial journey or looking to refine your money habits, this book offers timeless lessons that can help you build long-term wealth.

👉 Interested in reading it yourself? You can grab a copy here:
📖 Buy The Psychology of Money on Amazon

If you liked this post you may also like:

• [The Hidden Tax of Inflation: How Cash Shrinks Your Wealth]

• [The Best Investment You Can Make is in Yourself]

Disclaimer: The information discussed in this blog is not financial advice, and is meant for educational purposes only. Please consult a personal financial expert before making any financial decisions

Citations

• Buffett, W. (n.d.). The purpose of the margin of safety is to render the forecast unnecessary. [Quote]. Retrieved from various sources.

• Housel, M. (2020). The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviours of people playing different games than you are. [Quote]. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. Keep this in mind when quickly judging others' success and setting your own goals. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). 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. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). There are books on economic cycles, trading strategies, and sector bets. But the most powerful and important book should be called Shut Up and Wait. It’s just one page with a long-term chart of economic growth. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). 81.5 billion of Warren Buffett’s $84.5 billion net worth came after his 65th birthday. Our minds are not built to handle such absurdities. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Housel, M. (2020). The hardest financial skill is getting the goalpost to stop moving. The psychology of money: Timeless lessons on wealth, greed, and happiness. Harriman House.

• Rothschild, N. (n.d.). The time to buy is when there is blood in the streets. [Quote]. Retrieved from various sources.