The Psychology of Money

by Morgan Housel

But investing is not a hard science. It’s a massive group of people making imperfect decisions with limited information about things that will have a massive impact on their wellbeing, which can make even smart people nervous, greedy and paranoid.

Richard Feynman, the great physicist, once said, “Imagine how much harder physics would be if electrons had feelings.” Well, investors have feelings. Quite a few of them. That’s why it’s hard to predict what they’ll do next based solely on what they did in the past.

It’s not intuitive to link 19 hijackers to the current weight of student loans, but that’s what happens in a world driven by a few outlier tail events.

In Pharaonic Egypt … scribes tracked the high-water mark of the Nile and used it as an estimate for a future worst-case scenario. The same can be seen in the Fukushima nuclear reactor, which experienced a catastrophic failure in 2011 when a tsunami struck. It had been built to withstand the worst past historical earthquake, with the builders not imagining much worse—and not thinking that the worst past event had to be a surprise, as it had no precedent.

The most important economic events of the future—things that will move the needle the most—are things that history gives us little to no guide about. They will be unprecedented events. Their unprecedented nature means we won’t be prepared for them, which is part of what makes them so impactful. This is true for both scary events like recessions and wars, and great events like innovation.

Or take public markets. The S&P 500 did not include financial stocks until 1976; today, financials make up 16% of the index. Technology stocks were virtually nonexistent 50 years ago. Today, they’re more than a fifth of the index. Accounting rules have changed over time. So have disclosures, auditing, and the amount of market liquidity. Things changed.

Not among all players, of course. But a tiny group of blackjack players who practice card counting can teach ordinary people something extraordinarily important about managing money: the importance of room for error.

There is never a moment when you’re so right that you can bet every chip in front of you. The world isn’t that kind to anyone— not consistently, anyways. You have to give yourself room for error.

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.”

Room for error lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low-probability outcome fall in your favor. The biggest gains occur infrequently, either because they don’t happen often or because they take time to compound. So the person with enough room for error in part of their strategy (cash) to let them endure hardship in another (stocks) has an edge over the person who gets wiped out, game over, insert more tokens, when they’re wrong.

Having a gap between what you can technically endure versus what’s emotionally possible is an overlooked version of room for error.

Another is saving for retirement. We can look at history and see, for example, that the U.S. stock market has returned an annual average of 6.8% after inflation since the 1870s. It’s a reasonable first approximation to use that as an estimate of what to expect on your own diversified portfolio when saving for retirement. You can use those return assumptions to back into the amount of money you’ll need to save each month to achieve your target nestegg.

For my own investments, which I’ll describe more in chapter 20, I assume the future returns I’ll earn in my lifetime will be ⅓ lower than the historic average. So I save more than I would if I assumed the future will resemble the past. It’s my margin of safety. The future may be worse than ⅓ lower than the past, but no margin of safety offers a 100% guarantee.

“The best way to achieve felicity is to aim low,” says Charlie Munger. Wonderful.

Same with money. The odds of many lucrative things are in your favor. Real estate prices go up most years, and during most years you’ll get a paycheck every other week. But if something has 95% odds of being right, the 5% odds of being wrong means you will almost certainly experience the downside at some point in your life. And if the cost of the downside is ruin, the upside the other 95% of the time likely isn’t worth the risk, no matter how appealing it looks.

To get around this, I think of my own money as barbelled. I take risks with one portion and am terrified with the other. This is not inconsistent, but the psychology of money would lead you to believe that it is. I just want to ensure I can remain standing long enough for my risks to pay off. You have to survive to succeed. To repeat a point we’ve made a few times in this book: The ability to do what you want, when you want, for as long as you want, has an infinite ROI.

“During the weeks of inactivity behind the front lines, field mice had nested inside the vehicles and eaten away insulation covering the electrical systems.” The Germans had the most sophisticated equipment in the world. Yet there they were, defeated by mice. You can imagine their disbelief. This almost certainly never crossed their minds. What kind of tank designer thinks about mouse protection? Not a reasonable one. And not one who studied tank history.

A good rule of thumb for a lot of things in life is that everything that can break will eventually break. So if many things rely on one thing working, and that thing breaks, you are counting the days to catastrophe. That’s a single point of failure.

The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.

The trick that often goes overlooked—even by the wealthiest— is what we saw in chapter 10: realizing that you don’t need a specific reason to save. It’s fine to save for a car, or a home, or for retirement. But it’s equally important to save for things you can’t possibly predict or even comprehend—the financial equivalent of field mice.

I GREW UP WITH a friend who came from neither privilege nor natural intellect, but was the hardest-working guy I knew. These people have a lot to teach because they have an unfiltered understanding of every inch of the road to success. His life’s mission and dream as a teenager was to be a doctor. To say the odds were stacked against him is being charitable. No reasonable person at the time would consider it a possibility. But he pushed. And—a decade older than his classmates—he eventually became a doctor. How much fulfillment comes from starting from nothing, bulldozing your way to the top of medical school, and achieving one of the most noble professions against all odds?

Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is something entirely different. This has a big impact on our ability to plan for future financial goals.

The End of History Illusion is what psychologists call the tendency for people to be keenly aware of how much they’ve changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future. Harvard psychologist Daniel Gilbert once said: At every stage of our lives we make decisions that will profoundly influence the lives of the people we’re going to become, and then when we become those people, we’re not always thrilled with the decisions we made. So young people pay good money to get tattoos removed that teenagers paid good money to get. Middle-aged people rushed to divorce people who young adults rushed to marry. Older adults work hard to lose what middle-aged adults worked hard to gain. On and on and on.

The fuel of the End of History Illusion is that people adapt to most circumstances, so the benefits of an extreme plan—the simplicity of having hardly anything, or the thrill of having almost everything—wear off.

Compounding works best when you can give a plan years or decades to grow. This is true for not only savings but careers and relationships. Endurance is key. And when you consider our tendency to change who we are over time, balance at every point in your life becomes a strategy to avoid future regret and encourage endurance.

Aiming, at every point in your working life, to have moderate annual savings, moderate free time, no more than a moderate commute, and at least moderate time with your family, increases the odds of being able to stick with a plan and avoid regret than if any one of those things fall to the extreme sides of the spectrum.

“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.’”

Rightly so: those rewarded with dynastic wealth when times are good hold the burden of responsibility when the tide goes out. He stepped down in 2017.

“Every job looks easy when you’re not the one doing it.”

Dealing with the conflicting demands of sprawling bloat, short-term investors, regulators, unions, and entrenched bureaucracy is not only hard to do, but it’s hard to even recognize the severity of the problems until you’re the one dealing with them. Immelt’s successor, who lasted 14 months, learned this as well.

Like most products, the bigger the returns, the higher the price. Netflix stock returned more than 35,000% from 2002 to 2018, but traded below its previous all-time high on 94% of days. Monster Beverage returned 319,000% from 1995 to 2018—among the highest returns in history—but traded below its previous high 95% of the time during that period.

Individual investors fall for this when making their own investments, too. The average equity fund investor underperformed the funds they invested in by half a percent per year, according to Morningstar—the result of buying and selling when they should have just bought and held.

The result was that under Welch’s leadership, stockholders didn’t have to pay the price. They got consistency and predictability—a stock that surged year after year without the surprises of uncertainty. Then the bill came due, like it always does. GE shareholders have suffered through a decade of mammoth losses that were previously shielded by accounting maneuvers. The penny gains of Welch’s era became dime losses today.

The price of investing success is not immediately obvious. It’s not a price tag you can see, so when the bill comes due it doesn’t feel like a fee for getting something good. It feels like a fine for doing something wrong. And while people are generally fine with paying fees, fines are supposed to be avoided. You’re supposed to make decisions that preempt and avoid fines. Traffic fines and IRS fines mean you did something wrong and deserve to be punished. The natural response for anyone who watches their wealth decline and views that drop as a fine is to avoid future fines. It sounds trivial, but thinking of market volatility as a fee rather than a fine is an important part of developing the kind of mindset that lets you stick around long enough for investing gains to work in your favor.

Few investors have the disposition to say, “I’m actually fine if I lose 20% of my money.” This is doubly true for new investors who have never experienced a 20% decline.

The trick is convincing yourself that the market’s fee is worth it. That’s the only way to properly deal with volatility and uncertainty—not just putting up with it, but realizing that it’s an admission fee worth paying.

Find the price, then pay it.

Competition for investment returns is fierce, and someone has to own every asset at every point in time. That means the mere idea of bubbles will always be controversial, because no one wants to think they own an overvalued asset. In hindsight we’re more likely to point cynical fingers than to learn lessons.

An iron rule of finance is that money chases returns to the greatest extent that it can. If an asset has momentum—it’s been moving consistently up for a period of time—it’s not crazy for a group of short-term traders to assume it will keep moving up. Not indefinitely; just for the short period of time they need it to. Momentum attracts short-term traders in a reasonable way.

But if you were a long-term investor in 1999, $60 was the only price available to buy. And many people were buying it at that price. So you may have looked around and said to yourself, “Wow, maybe these other investors know something I don’t.” Maybe you went along with it. You even felt smart about it.

Rising prices persuade all investors in ways the best marketers envy. They are a drug that can turn value-conscious investors into dewy-eyed optimists, detached from their own reality by the actions of someone playing a different game than they are.

A young lawyer aiming to be a partner at a prestigious law firm might need to maintain an appearance that I, a writer who can work in sweatpants, have no need for. But when his purchases set my own expectations, I’m wandering down a path of potential disappointment because I’m spending the money without the career boost he’s getting. We might not even have different styles. We’re just playing a different game. It took me years to figure this out.

Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.

“For reasons I have never understood, people like to hear that the world is going to hell.” —Historian Deirdre McCloskey

But pessimism holds a special place in our hearts. Pessimism isn’t just more common than optimism. It also sounds smarter. It’s intellectually captivating, and it’s paid more attention than optimism, which is often viewed as being oblivious to risk.

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.

“Every group of people I ask thinks the world is more frightening, more violent, and more hopeless—in short, more dramatic—than it really is,” Hans Rosling wrote in his book Factfulness.

When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.

There are two topics that will affect your life whether you are interested in them or not: money and health. While health issues tend to be individual, money issues are more systemic. In a connected system where one person’s decisions can affect everyone else, it’s understandable why financial risks gain a spotlight and capture attention in a way few other topics can.

Another is that pessimists often extrapolate present trends without accounting for how markets adapt.