The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel

Hello investors, welcome to my Substack, where I study the best Investors and businesses from around the world. In this week’s article, we’ll go over the book The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel.

We will be taking a look at these four key topics from the book:

1. The story of the Great Depression

2. How the economic concepts we use today are still historical concepts

3. How envy can only lead to recklessness

4. How amassing a fortune is easier than keeping it

So what is the stock market and how does it work? When is it best to buy or sell assets? And, if you want to retire by a certain age, how much do you need to save each year?

These are the kinds of questions that come up frequently in personal finance discussions. However, something important is frequently left out of the equation. This is the human factor, or the relationship that exists between real people and their money.

This factor, according to Morgan Housel, is critical to comprehending financial decision-making. You don't need to study interest rates to understand why people get into debt or waste their fortunes; you just need to look into the all-too-human history of envy, greed, and optimism. 

First, we will take a look at the Great Depression.

The economic crash of 1929 is a well-known story.

The global economy entered a decade of sustained decline and the "roaring twenties" in the United States came to an abrupt end. Businesses went bankrupt, families lost their farms and homes, and hard-earned savings vanished. Poverty and unemployment rose sharply, while confidence in the prospect of a better tomorrow plummeted.

This version of events has since become the accepted narrative. That makes sense - after all, it does describe the experience of millions of Americans. It does, however, leave something crucial out of the picture. 

In 1960, when John F. Kennedy was running for president, he was asked about his experiences during the Great Depression. Many voters were taken aback by his response. He claimed that the Kennedys were already wealthy in 1929. And their fortune didn't vanish over the next ten years; in fact, it grew. The family had more servants and a larger home by 1939 than it had at the start of the decade. He only realized how badly many of his fellow citizens had suffered when he went to Harvard and read about the Depression.

It turned out that not all Americans had been in the same boat. Kennedy wanted to change that, which is one of the reasons he was able to persuade voters that he wasn't just an out-of-touch elitist, but also a worthy president. But it's not just the rich and poor who have different economic experiences; we all do.

The son of an unemployed farmhand and the son of a successful Manhattan stockbroker come from very different backgrounds and learn very different lessons about risk and reward when it comes to money. However, the same holds true for equally well-off people, depending on their individual life experiences.

A wealthy person who grew up during periods of high inflation, for example, will have a different financial worldview than someone who has only ever experienced stable prices. What we do with money is shaped by the lessons learned from these various perspectives. We all like to think we understand how the world works, but we usually only get a glimpse of it. And that's the first thing to realize about money psychology: we don't know as much as we'd like to believe.

When economists model financial behavior, they frequently fall back on a convenient fiction: rational individuals making self-interested decisions that maximize their returns. Of course, reality is a little more complicated than this neat concept. Take the lottery, for example. Every year, the average low-income family in the United States spends $411 on lottery tickets. At the same time, roughly 40% of all households are unable to come up with $400 in an emergency. This 40% is made up of the same low-income households that spend just over $400 on lottery tickets, which is unsurprising.

Is this a rational response? Hardly. But it's also not illogical. You're unlikely to have enough money for essentials, let alone luxuries like vacations, if you're living paycheck to paycheck. Playing the lottery is a long shot, but it's better than not having a chance at the good things that wealthier people take for granted.

These irrational decisions are more common than you might believe. Take economists Ulrike Malmendier and Stefan Nagel's study from 2006. They combed through fifty years of data from the Survey of Consumer Finances, a long-running study that looks at how Americans spend their money. Malmendier and Nagel wanted to know what factors influence people's financial decisions.

When the investors were young adults, the economy was doing well. In other words, our attitude toward risk is determined by our personal history. This isn't the kind of rationality found in economics textbooks, but it is intuitively logical, like buying lottery tickets. If inflation was high between late adolescence and early adulthood, for example, investors were less likely to invest in bonds later in life. When inflation was low during these formative years, however, investors were content to keep their money in bonds as they grew older, regardless of whether inflation increased.

Stocks follow a similar pattern. If the stock market was performing well when they were young adults, they continued to invest in it; if it was underperforming at the same time, they avoided it.

Assume you were born in the year 1970. The S&P 500 increased tenfold between your mid-teens and early twenties. Anyone who invested in the companies represented by that stock made a fortune. People born in 1950 had a very different perspective on the market, which was largely dormant during this time period. Importantly, decisions to invest or not invest remained unchanged even when the market changed, implying that real-world evidence failed to influence early-life gut decisions. 

A toy poodle does not resemble its wild ancestors, which were not all that dissimilar to wolves. This isn't surprising given the fact that today's dog breeds have a ten-thousand-year history of domestication. Even so, dog owners are frequently surprised by their pets' instinctive, bloodthirsty responses when they see a squirrel or a cat. It turns out that ten millennia haven't completely eradicated these deep-rooted wild traits.

But how does the domestication of dogs relate to the psychology of money? Actually, quite a bit.

This brings us onto our second topic: the notion that today’s current economic concepts are still historical concepts.

Why do so many of us struggle with money? One answer is that, in the grand scheme of things, it's fairly new.

Around 600 BC, King Alyattes of Lydia – an Iron-Age kingdom in modern-day Turkey – minted his own coins, which became the first currency. And that pales in comparison to more complicated economic concepts.

Consider the concept of retiring. Prior to WWII, the majority of Americans worked until they died. Of course, life expectancy was lower back then – and even so, in the 1940s, half of all men over the age of sixty-five were still working.Things began to change after World War II with the introduction of Social Security, but retirement remained an unattainable dream for most Americans until the 1980s, when the average monthly Social Security check surpassed $1,000 after inflation. Only a privileged few could previously afford to retire in their mid-sixties.

That means one of the most fundamental economic concepts we use today is only two generations old. The 401(k) – the most common way to save for retirement – didn't exist until 1978, and the Roth IRA retirement plan wasn't introduced until 1998!

Other important concepts and practices also aren't that old. Hedge funds have only been around for a quarter of a century, and index funds have only been around for fifty years. Consumer debt, such as mortgages, car loans, and credit cards, which is one of the primary drivers of economic growth in the United States, only became widespread after the GI Bill made it easier for average Americans to borrow money in 1944.

It's not that we're crazy - it's just that we're brand noobs when it comes to financial planning and decision-making. Nobel Laureate economist, Robert Schiller, was asked a few years ago what he'd like to know about investing that can't be fully understood. He answered: the "exact role of luck in successful outcomes".

The subject of luck is a difficult one. Few investors and entrepreneurs would deny that it plays a role in theory, but it's difficult to quantify how much it contributes to one company's success – and another's failure. We also think it's impolite to attribute other people's success to luck. As a result, we frequently overlook the importance of luck in financial decision-making. That's a blunder.

The main point is that luck plays a larger role in financial success than you might think. 

The income of two siblings is more closely correlated than either height or weight, according to economist Bhashkar Mazumder. To put it another way, if your brother is wealthy and tall, you're more likely to be wealthy than tall. This relationship is simple to explain. Siblings from the same family are more likely to share the same advantages and opportunities. Parents who send one child to a good school usually send his brother to the same school. However, if you find a pair of wealthy brothers, you'll find two people who don't believe Mazumder's research applies to their family.

It's all due to human psychology. We frequently undervalue or exaggerate the importance of luck in determining outcomes. If we succeed, it is due to our efforts; if we fail, it is due to bad luck. However, if others fail, we aren't nearly as generous. In those cases, we attribute failure to character flaws such as laziness or shortsightedness rather than bad luck.

Unfortunately, our success-obsessed culture isn't much of a help here. Forbes does not honor brilliant investors who lost money because they were unlucky and the market crashed. It does, however, honor second-rate or rash investors who struck it rich. That puts us in a bind. We don't just need to figure out what works and what doesn't when it comes to money; we also need a way to incorporate randomness into our models. We may not be able to realize Schiller's dream of accounting for the "exact role" of chance, but we can get a handle on it.

So, how should you incorporate luck and chance into your financial strategy? So, here's what you shouldn't do: obsess over specific examples of people. We often pick outliers – billionaires who have changed the way the world works – when studying highly successful people, and this can lead us astray.

Take, for example, John D. Rockefeller, one of history's most successful businessmen. He ran into a problem when he first started building his petroleum industry. The laws of the United States prevented him from doing what he desired. His solution was straightforward: ignore them. His disregard for legal etiquette was so blatant that one judge described his company as acting "no better than a common thief."

The success of Rockefeller has influenced how we think about this behavior. Looking back, it's easy to laud his foresight and claim that he refused to let outdated laws stifle progress. But what if he didn't succeed? Would we still think we should follow Rockefeller's lead? Most likely not. At best, we'd think of him as a failed criminal who taught us not to do things. But, when it comes down to it, the only thing that separates these two outcomes is chance. Rockefeller's fortunes could have been changed by a few different verdicts here and there, or perhaps a shift in the political climate.

More importantly, it's nearly impossible to duplicate good fortune. Even if you follow Warren Buffett's every career move, you can't guarantee the dice will fall the same way for you as they did for him.

So here's an alternative: stick to analyzing success and failure patterns. The more common a pattern is, the more likely it is to apply to your life and finances. People who have control over the structure of their days, for example, are happier with their jobs than those who don't. 

Thirdly, we will look at how envy can only lead to recklessness.

Capitalism excels at two things: creating wealth and instilling envy.

Consider a $500,000-a-year rookie baseball player. He's wealthy by any reasonable measure. However, if he is on the same team as a superstar like Mike Trout, who earns $36 million per year, he will be dissatisfied with his pay. He aspires to have what others have. Meanwhile, high-earning individuals such as Trout compare themselves to those who earn even more. To make the top ten highest-paid hedge fund managers in America in 2018, for example, you needed to earn at least $340 million in that year. By that standard, even Trout is a small fry.

Envy has no moral ramifications in a capitalist society. However, there is a practical issue. When does enough become enough? 

Rajat Gupta can attest to this. Gupta, who grew up in a slum in Kolkata, India, rose through the ranks of management consulting firm McKinsey to become its CEO. He was worth $100 million when he retired in 2007. He had the ability to do anything. Gupta, on the other hand, was envious. He aspired to become a multi-billionaire.

Gupta, a member of Goldman Sachs' board of directors, learned in 2008 that Warren Buffett was planning to invest $5 billion to keep the company afloat during the financial crisis. Gupta dialed the number of a hedge fund manager and bought 175,000 shares of Goldman Sachs 16 seconds after hearing the news on a conference call, long before it was made public. This was insider trading, and it was against the law. Gupta couldn't care less because he'd just made a quick $1 million. He'd amassed $17 million in a series of shady deals by the time prosecutors caught up with him. It didn't make him a billionaire, but it was enough to land him in prison for a long time.

What is the moral of the story? Envy leads to poor decisions, and the cost of those decisions is far greater than the benefits you stand to gain. Consider this: If you have an insatiable appetite, you will eat until you become ill. However, throwing up is a lot worse than eating a good meal, so you don't do it. Leaving opportunities on the table does not always imply that you are missing out; rather, it is a recognition that trying to eat everything will lead to regret.

To put it another way, don't be Rajat Gupta!

Finally, we will look at how amassing a fortune is easier than keeping it.

Jesse Livermore was one of the best stock market traders in early twentieth-century America. He was born in 1877 and was instrumental in the development of Wall Street. In today's money, he was worth $100 million at the age of thirty.

Livermore made the best decision of his life just before the 1929 stock market crash: he took a short position and bet that stocks would fall. The market, indeed, lost a third of its total value. Livermore returned home to his family with good news while fortunes were liquidated and news of bankrupt investors leaping from office windows spread. He'd just made the equivalent of $3 billion in today's money.

Is there a happily ever after? Not quite.

Remember what we said about being a good student but a bad teacher? Livermore believed he was untouchable after his big win in 1929. He kept placing larger and larger bets and losing big – until his fortune was gone. He committed suicide in a Manhattan club in 1940, broke and in debt.

It turns out that getting rich is sometimes a lot easier than staying rich. It's understandable that people who excel at the former struggle with the latter. Making money is all about taking chances, being optimistic, and being brave. Keeping money is a completely different mental challenge. It's about the fear of losing everything you've worked hard for. Being wealthy also entails remaining humble. After 1929, Livermore believed he was a genius who never made a mistake. He would have been better off accepting that luck had played a role in his success – and that it couldn't be repeated indefinitely.

There are many Livermores in the world, though their stories aren't always as tragic. Approximately 40% of all publicly traded companies lose all of their value over time. And, excluding cases of death and intra-family transfers, the ‘Forbes 400 list of America's Wealthiest People’ has a 20% turnover every decade.

So, what are your options for preserving what you already have? Perseverance, in a nutshell. The most successful entrepreneurs are those who can stay in business for a long time without going bankrupt. Fear is the one thing that they all have in common. When you're afraid of losing, as multi-billionaire venture capitalist Michael Moritz puts it, you look at potential wins through a different lens. Few gains are significant enough to justify risking everything you own. And when you approach things from that perspective, you're much more likely to make better decisions.

Heinz Berggruen, according to his own account, didn't show much promise in his youth. He had no idea what he wanted to do with his life when he was forced to flee Nazi Germany in 1936. He worked as a journalist with a sideline in art criticism after studying literature at the University of California, Berkeley. He paid $100 for a small watercolor by an artist named Paul Klee in 1940. It was the start of a lifelong love affair with modern art.

By the 1990s, Berggruen had established himself as one of the most successful art collectors of all time. He sold his collection for 100 million euros to the German government in 2000. Given the large number of Picassos, Klees, Matisses, and Braques in the collection, that figure was nowhere near its true value, which was estimated at $1 billion. It was one of the world's most important collections.

How did Berggruen amass such an impressive collection of artists from the twentieth century? Was it a matter of skill or pure luck? Horizon Research, an investment firm, has a more intriguing response. According to the firm's research, all great collectors buy large quantities of art. Some purchases turn out to be excellent investments, particularly if the collector keeps them for a long time. The vast majority, on the other hand, are failures.

The key, according to Horizon's report, is to keep the former until the portfolio return – the total value of the collection – "converges upon the return of the portfolio's best elements." Berggruen's portfolio was similar to an index fund in that his risks were evenly distributed across a variety of investments. Instead of buying only what he liked or admired, he bought everything he could get his hands on and waited for a few winners to emerge.

This strategy is applicable to all types of investments. The tendency for a small number of events to account for the majority of outcomes is known as the long tail. This principle is based on a lot of complicated math, but when you boil it down to the essentials, it's quite simple. In other words, if you get a few things right, you can afford to make more mistakes. Failure is unavoidable; what matters is the quality of your victories. To put it another way, when you have one Picasso, you don't have to worry about the other 99 in your collection.

This brings us to the conclusion of today’s article.

In the real world, financial decision-making is a lot messier than it is in economics textbooks. Many decisions aren't rational, such as buying lottery tickets when you're broke, but they make sense in their own way. The same can be said for investment decisions, which are frequently influenced by people's early adulthood economic experiences rather than cold assessments of current market conditions. Simply put, financial decisions are influenced by psychological factors. So, what's the best course of action? Accept that luck plays a part in success, learn to be afraid of losing what you have, and hedge your bets.

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