I Read It so You Don’t Have To: The Psychology of Money
Your brain is bad with money, but you don’t have to be
Economists make terrible financial advisors.
I should know, in my day job I advise on economic policy and at night I write about personal finance.
It’s not that economists don’t understand how money should be managed; the problem is they assume humans are perfectly rational creatures that will make the optimal decision when presented with perfect information.
Anyone who’s interacted with another human for more than five minutes knows that our species is the furthest thing from rational. We often make emotional, impulsive, and self-destructive decisions, which is especially true for money.
Morgan Housel’s “The Psychology of Money” seeks to understand how human psychology influences how we manage money and how we can use that knowledge to be better with money.
Here are the most important lessons from the book.
For some, it’s the roaring 20s. For others, it’s the great depression
I often write that personal finance is personal.
What I mean by that is that what might be a good financial decision for me may not be a good financial decision for you. It depends on your personal circumstances, goals, and risk tolerance.
Housel does a masterful job of reminding us that economics is also personal.
In every booming economy, there are still millions of people who are living in poverty. If you have to choose between putting food on the table or paying the electricity bill, what do you care if we have a low unemployment rate?
On the flip side of that coin, many people during the great depression and the 2008 financial crisis became wealthier during these painful recessions.
If you double your net worth during a depression, how does that impact how you view risk? If the economy is booming and you can’t make ends meet, what does that do to your confidence and ability to manage money?
Economic shocks at a young age impact how we manage money as adults
Our personal experience with money, particularly at a young age, can dramatically impact how we manage money later in life.
The term “depression babies” refers to the generation who grew up during the great depression. Many in this generation have a reputation for penny-pinching in response to the emotional trauma of coming of age during the great depression.
A 2009 paper by Ulrike Malmendier & Stefan Nagel reveals that macroeconomic events early in life impact our financial decisions as adults.
Young households in the 1980s were less likely to invest in the stock market in response to the poor market returns of the 1970s. As a result, these young adults missed one of the best times to invest. The S&P 500 returned an average of 14.89% (including dividends) from 1980–1990.
Young households in the late 1990s were more likely to hold a high percentage of their net worth in the stock market. They were informed by a hot market in the 80s and 90s. Many of them piled into stocks right before the dot com crash and the so-called “lost decade” during the 2000s.
This is why we need financial advisors. Having professional advice from an unbiased 3rd party can add some much-needed perspective that our past financial traumas prevent us from seeing on our own.
If you can’t afford a financial advisor, then at least start talking about financial problems with other people you trust.
Modern financial concepts are brand new relative to human history
The world’s first currency was introduced in 600 BC. If that seems like a long time, consider that the modern form of humans has been around for more than 200,000 years.
Our brains are still hard-wired to focus on surviving today. Hunting and avoiding being hunted are what consumed humanity’s thoughts for most of its existence. The brain isn’t designed to think about depositing money into a 401k today so that we can enjoy retirement in 40 years.
The very concept of retirement was not an option for the average person before World War 2. After the war Social Security, workplace pensions, and other retirement plans became mainstream. These concepts are less than a century old, so your prehistoric brain can be forgiven for not responding to them rationally.
Was it skill, or was it luck?
It’s impossible to know the exact role that luck plays in financial success.
If an investor makes a big bet on a stock pick and makes millions of dollars, what led to that outcome; was it skill, or was it luck?
It depends on who you ask:
If you ask the investor, they would probably put a much greater emphasis on all the time they spent researching the company and their skills in executing the perfect trade. “I made this money because I am smarter and work harder than everyone else.”
If you ask somebody else about the investor’s success, they would be much more likely to chalk it up to luck.
Humans are more likely to attribute their own financial success to skill and other people’s financial success to luck.
The opposite is also true.
Humans are more likely to attribute their own financial failures to luck and other people’s financial failures to poor choices.
We really can be arrogant and petty.
The lesson here is to realize that the truth is almost always somewhere in between. Every financial success story and every financial failure can be attributed to some combination of skill and luck. You need to be confident in your financial decision-making without losing sight of the risks involved in each decision.
Don’t try and copy someone else’s financial success
If you want to build more luck into your financial outcomes, never try and copy other people’s approaches.
Take Warren Buffett, for example. Many people look at his investing success and try and copy his value-style strategy to picking stocks. This is the wrong lesson to learn from Warren Buffett. You will never be as good at picking stocks as Warren Buffett, so don’t bother trying.
If you want to try and emulate Warren Buffett’s success in investing or any famous person’s success, you need to adopt the broad strokes of what made them successful rather than trying to do it the exact same way they did it.
In Buffett’s case, the lesson we can learn from him and actually apply to our own lives is that the key to building wealth is staying invested for decades and allowing compound interest to do its work.
Here’s Buffett saying exactly that in his own words.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
If you want to build generational wealth, here’s what you can learn from Warren Buffett: Invest early and often as possible and let compound interest do its work over the course of your life. The data and Warren Buffett would agree that when it comes to investing, most of us are better off investing in passive index funds than trying to become the next Warren Buffett.
In this article, I briefly touched on the most important concepts from The Psychology of Money. If you are at all interested in personal finance, I recommend reading this book cover to cover.
CONTRIBUTED BY Ben Le Fort
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