On "The Psychology of Money" by Morgan Housel

The Psychology of Money is a guide to becoming better with money. The author argues that in the end, it isn’t the hard skills which matter (what specific type of index funds you go after, complicated trading theories, etc) but rather the soft skills which will make the most significant impact on your finances. Humans aren’t super great at following the most rational and well-thought out of investing strategies because emotion, greed, and ego come into the picture. By better understanding our psychology and decision making, we can learn to curtail these harmful impulses stopping the goalpost from moving, and creating long-lasting wealth.

I listened to the audiobook version of this book, and one thing I noticed right off the bat was how accessible the content was. Enjoyable to both novices and experts alike, Housel has packed the book with short stories of wealthy CEOs who lost it all, janitors who became millionaires through diligent financial action, and everything in between. The stories kept the book’s content practical, ensuring we never diverged into hypothetical space, but stayed rooted to practical advice one could apply to daily life.

A few lessons I took away:

Know the game you’re playing. I often see stock analysts on TV or in the news making future stock price predictions and I’ve always been a little dubious. For one thing, (as Housel points out), your rational for interpreting a stock price is different depending on your time scale (day trader, short term, or long term). A day trader only really cares about micro trends in a stock price, because he might be dumping the shares by lunch time. In contrast, for the long term trader with a 30 year time horizon, the metrics for evaluating a stock are completely different. The long term trader couldn’t care less about a difference in 2-3% in stock price (something which is extremely consequential for the short term trader). The issue arises when traders get influenced by people playing a different game than they are. This is a major contributing factor toward bubbles. As soon as the price of stock moves marginally up, a flush of short-term traders rush in hoping to make a quick buck, (in the process fooling some long term traders into jumping in as well). Then, when the price has been pushed up enough, all the short term traders pull out, causing a crash and wiping out the long term investors who simply didn’t know the game they were really in.

Tail Events. Housel’s introduction of the term tail events was perfect, because I’ve been skirting around this concept in my mind for a while now, but just never had the language to effectively communicate what I meant. Tails (or tail events) are events with low statistical probability which yield a disproportionate return. The concept of Tails can be seen all around us:

Source: https://upload.wikimedia.org/wikipedia/commons/thumb/8/8a/Long_tail.svg/1200px-Long_tail.svg.png

As mentioned in the book:

• The COVID-19 pandemic is said to be a once in 100 year event which has fueled tech stocks such as zoom.
• World War 2, led to rapid industrialization, access to cheap debt, culture of consumerism, etc
• Disney lost money on 400+ movies/animations before hitting the gold mine of Snow White and the Seven Dwarves. This 83 minute movie made all the difference, causing an inflection point in Disney’s prospects (allowing them to expand, hire more, etc)
• Apple and Amazon account for a disproportionate share in the S&P500’s growth. These companies themselves have seen success come from tail events (Amazon experimented with tons of products and services like the Fire Phone before discovering the big winners which are AWS and Amazon Prime)
• Google has a 0.67% acceptance rate: they have so few engineers relative to their user base, but those engineers are able to pump out a disproportionate amount of return due to their skill (they are at the top of their field). Tail engineers (brilliant) work on tail projects (wildly profitable, innovative, unique), which drive tail (extremely high) returns.

In terms of investing - the way you behaved when markets dropped ~30% in March 2020 probably will have more impact on your long term return compared with everything you did for the previous 5 years. Tail events drive returns.

People often discount the probability of tail events happening, however the probability that any one arbitrary tail event will happen in a given year is actually quite high (since there are so many possible tail events). As an investor, knowing that most of the returns will come from these positive tail events, your goal should be to try to encapsulate and capture the returns from as many tail events as possible (by investing in a low-cost broad index fund for example)

Stop the Goalpost from Moving. One of my favorite quotes from the book is that

Savings is the difference between your ego and your income.

Your ego (your metaphorical “goalpost”) dictates a lot about how you spend your money (lifestyle, views about money, etc). Do you need to be “keeping up with the Joneses”, or are you content with your current style of living. Housel also points out that many times, your savings rate is far more important than your income. Take the case study of Janitor Ronald Reid who, through simple indexing & regular saving, managed to amass a net worth of over 8 million by the time he died.

A key concept here is the different between being “rich” and being “wealthy”. Being rich is more akin to being flashy, it’s the hotshot at the bar, with the $120,000 luxury car. Most people would look at this guy and see the flashy car, but what they won’t see is the insurmountable debt he’s placed himself in, the monthly payments he needs to make, the mortgage he’s at risk of not being able to pay. With the average household in the US having a debt/income ratio of over 1, this is a real problem. Wealth is what you don’t see. As Housel writes in the book, wealth encapsulates the vacations forfeited, the fancy cars not bought, and the luxury restaurants not frequented.