The Psychology of Money

by Morgan Housel

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. And behavior is hard to teach, even to really smart people.

financial success is not a hard science. It’s a soft skill, where how you behave is more important than what you know.

Two topics impact everyone, whether you are interested in them or not: health and money. The health care industry is a triumph of modern science, with rising life expectancy across the world. Scientific discoveries have replaced doctors’ old ideas about how the human body works, and virtually everyone is healthier because of it. The money industry—investing, personal finance, business planning—is another story.

I love Voltaire’s observation that “History never repeats itself; man always does.” It applies so well to how we behave with money.

Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.

Spreadsheets can model the historic frequency of big stock market declines. But they can’t model the feeling of coming home, looking at your kids, and wondering if you’ve made a mistake that will impact their lives.

Take a simple example: lottery tickets. Americans spend more on them than movies, video games, music, sporting events, and books combined. And who buys them? Mostly poor people. The lowest-income households in the U.S. on average spend $412 a year on lotto tickets, four times the amount of those in the highest income groups. Forty percent of Americans cannot come up with $400 in an emergency. Which is to say: Those buying $400 in lottery tickets are by and large the same people who say they couldn’t come up with $400 in an emergency. They are blowing their safety nets on something with a one-in-millions chance of hitting it big. That seems crazy to me. It probably seems crazy to you, too. But I’m not in the lowest income group. You’re likely not, either. So it’s hard for many of us to intuitively grasp the subconscious reasoning of low-income lottery ticket buyers. But strain a little, and you can imagine it going something like this: We live paycheck-to-paycheck and saving seems out of reach. Our prospects for much higher wages seem out of reach. We can’t afford nice vacations, new cars, health insurance, or homes in safe neighborhoods. We can’t put our kids through college without crippling debt. Much of the stuff you people who read finance books either have now, or have a good chance of getting, we don’t. Buying a lottery ticket is the only time in our lives we can hold a tangible dream of getting the good stuff that you already have and take for granted. We are paying for a dream, and you may not understand that because you are already living a dream. That’s why we buy more tickets than you do.

Economist Bhashkar Mazumder has shown that incomes among brothers are more correlated than height or weight.

Benjamin Graham is known as one of the greatest investors of all time, the father of value investing and the early mentor of Warren Buffett. But the majority of Benjamin Graham’s investing success was due to owning an enormous chunk of GEICO stock which, by his own admission, broke nearly every diversification rule that Graham himself laid out in his famous texts.

We similarly think Mark Zuckerberg is a genius for turning down Yahoo!’s 2006 $1 billion offer to buy his company. He saw the future and stuck to his guns. But people criticize Yahoo! with as much passion for turning down its own big buyout offer from Microsoft—those fools should have cashed out while they could! What is the lesson for entrepreneurs here? I have no idea, because risk and luck are so hard to pin down.

Bill Gates once said, “Success is a lousy teacher. It seduces smart people into thinking they can’t lose.”

At a party given by a billionaire on Shelter Island, Kurt Vonnegut informs his pal, Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, “Yes, but I have something he will never have … enough.”

1. The hardest financial skill is getting the goalpost to stop moving.

2. Social comparison is the problem here.

3. “Enough” is not too little.

4. There are many things never worth risking, no matter the potential gain.

Reputation is invaluable. Freedom and independence are invaluable. Family and friends are invaluable. Being loved by those who you want to love you is invaluable. Happiness is invaluable. And your best shot at keeping these things is knowing when it’s time to stop taking risks that might harm them. Knowing when you have enough.

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.”

Applying the survival mindset to the real world comes down to appreciating three things. 1. 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.

Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.

A barbelled personality—optimistic about the future, but paranoid about what will prevent you from getting to the future—is vital.

To give a more recent example: How you behaved as an investor during a few months in late 2008 and early 2009 will likely have more impact on your lifetime returns than everything you did from 2000 to 2008.

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 highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want today.”

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.

The hardest thing about this was that I loved the work. And I wanted to work hard. But doing something you love on a schedule you can’t control can feel the same as doing something you hate. There is a name for this feeling. Psychologists call it reactance. Jonah Berger, a marketing professor at the University of Pennsylvania, summed it up well: People like to feel like they’re in control—in the drivers’ seat. When we try to get them to do something, they feel disempowered. Rather than feeling like they made the choice, they feel like we made it for them. So they say no or do something else, even when they might have originally been happy to go along.25

A wise old owl lived in an oak, The more he saw the less he spoke, The less he spoke, the more he heard, Why aren’t we all like that wise old bird?

The letter I wrote after my son was born said, “You might think you want an expensive car, a fancy watch, and a huge house. But I’m telling you, you don’t. What you want is respect and admiration from other people, and you think having expensive stuff will bring it. It almost never does—especially from the people you want to respect and admire you.”

Someone driving a $100,000 car might be wealthy. But the only data point you have about their wealth is that they have $100,000 less than they did before they bought the car (or $100,000 more in debt). That’s all you know about them.

When you define savings as the gap between your ego and your income you realize why many people with decent incomes save so little.

That flexibility and control over your time is an unseen return on wealth.

What’s often overlooked in finance is that something can be technically true but contextually nonsense.

Stanford professor Scott Sagan once said something everyone who follows the economy or investment markets should hang on their wall: “Things that have never happened before happen all the time.”

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.

2. 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.

There’s a common phrase in investing, usually used mockingly, that “It’s different this time.”

The further back in history you look, the more general your takeaways should be. General things like people’s relationship to greed and fear, how they behave under stress, and how they respond to incentives tend to be stable in time. The history of money is useful for that kind of stuff.

Benjamin Graham is known for his concept of margin of safety. He wrote about it extensively and in mathematical detail. 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.”

Nassim Taleb says, “You can be risk loving and yet completely averse to ruin.” And indeed, you should. The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking. The odds are in your favor when playing Russian roulette. But the downside is not worth the potential upside. There is no margin of safety that can compensate for the risk.

Jason Zweig, the Wall Street Journal investment columnist, worked with psychologist Daniel Kahneman on writing Kahneman’s book Thinking, Fast and Slow. Zweig once told a story about a personality quirk of Kahneman’s that served him well: “Nothing amazed me more about Danny than his ability to detonate what we had just done,” Zweig wrote. He and Kahneman could work endlessly on a chapter, but: The next thing you know, [Kahneman] sends a version so utterly transformed that it is unrecognizable: It begins differently, it ends differently, it incorporates anecdotes and evidence you never would have thought of, it draws on research that you’ve never heard of. “When I asked Danny how he could start again as if we had never written an earlier draft,” Zweig continued, “he said the words I’ve never forgotten: ‘I have no sunk costs.’”49 Sunk costs—anchoring decisions to past efforts that can’t be refunded—are a devil in a world where people change over time. They make our future selves prisoners to our past, different, selves. It’s the equivalent of a stranger making major life decisions for you.

Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term. That process feeds on itself. As traders push up short-term returns, they attract even more traders. Before long—and it often doesn’t take long—the dominant market price-setters with the most authority are those with shorter time horizons.

By the mid-nineties, the press had replaced annual scorecards with reports that appeared every three months. The change spurred investors to chase performance, rushing to buy the funds at the top of the charts, just when they were most expensive.

What you don’t realize is that the traders who were setting the marginal price of the stock were playing a different game than you were. Sixty dollars a share was a reasonable price for the traders, because they planned on selling the stock before the end of the day, when its price would probably be higher. But sixty dollars was a disaster in the making for you, because you planned on holding shares for the long run.

The main thing I can recommend is going out of your way to identify what game you’re playing.

It’s surprising how few of us do. We call everyone investing money “investors” like they’re basketball players, all playing the same game with the same rules. When you realize how wrong that notion is you see how vital it is to simply 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.” This might seem quaint, but once you write that mission statement down you realize everything that’s unrelated to it—what the market did this year, or whether we’ll have a recession next year—is part of a game I’m not playing. So I don’t pay attention to it, and am in no danger of being persuaded by it.

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.

Expecting things to be great means a best-case scenario that feels flat. Pessimism reduces expectations, narrowing the gap between possible outcomes and outcomes you feel great about. Maybe that’s why it’s so seductive. Expecting things to be bad is the best way to be pleasantly surprised when they’re not. Which, ironically, is something to be optimistic about.