Lessons from “Psychology of Money”
Psychology of Money (PoM) by Morgan Housel is a phenomenal book. It shows us
How we think about money
How our mindset can decide about our financial decisions
Though it’s not money management guide of any sort, in hindsight it teaches some lessons about financial literacy. In this post, I am going to share some of the lessons I have learned from this book.
Lesson 1: Nobody is crazy
People do crazy things with their money, but nobody is crazy. It’s all about their induvial experiences with life and money.
Let’s take example of my father. My dad was Government of India employee, first from our family. Before 5th and 6th Pay Commission happens, he used to get meagre salary. In his younger days financial opportunities were limited. Lottery was way to get sizable chunk of money. Investing in share market or realty was next to impossible as there was no corpus. Convenient way to invest and grow your money was Fixed Deposits (with interest rate up to 14% PA).
On contrary, I grew up in post-Liberalized India. There are so many opportunities in Education and Investment. Mutual Funds, ETFs, Stocks (Indian and Foreign), Gold, even Crypto. I do regular investments in all these instruments. My dad thinks that I am gambling with my hard-earned money; Instead, I should do FDs.
Earlier I used to think that how can be my otherwise rational dad can say such irrational thing. After all if I need to build a corpus for future (that to considering inflation), I have to invest in various instruments. But after reading PoM, I realized that he is not crazy. He has seen poverty and he want me to have financial security. He has seen Scammers like Harshad Mehta, Ketan Parekh eradicated Billions of rupees of retail stock market investors. For safety of money, he insists upon investing in FDs. And I have learned to respond more mindfully respecting his opinions. 😊
Lesson 2: Luck & Risk
Luck and Risk can impact your life more than we think of, that too in unexpected way. It is really, really hard to predict/quantify risks and luck in anything. That is why even with 100% individual efforts we cannot dictate 100% of the outcome. Accepting this will help us understand that situations (own and others’) are as not as good or as bad they seem.
There are billions of investors in world. Everybody takes risks and we can say that some of them by chance can become billionaire; but we cannot say for sure how much role is played by hard work or luck for sure. It might happen that I buy some stocks which may not move for next 10 years or maybe it will go up and up to make me millionaire in couple of days. No matter how much research I put while selecting stock, I cannot predict market.
For third person, my decision can be “Masterstroke” or “Moronic” depending on the outcome. Same is true for vice-versa. This because of human tendency to mark other’s decision as “Lucky” or” Unlucky”. But for own decisions (Good or Bad), we say “It was because of risk involve in trade.” Another human trait of providing simple explanation to complex things.
In short, luck and risks are part of your financial decisions. Your lucks & risks are different from my lucks and risks. If we accept the role of Luck and Risks in financial decisions, we can have balance outlook towards our financial journey.
Lesson 3: Never Enough
With money comes one of the seven deadly Sins — Greed. We have seen many examples of greediness which led people to path of financial crimes.
Case 1: There is a district named Jamtara in state of Jharkhand, India. This district is known as Financial Scam hub of India. It is so (in)famous, that Netflix has produced a web series named “Jamtara”. #notsponsoredbynetflix. When we look at the situation in this area, there are very less chances of getting proper jobs to educated youth in this area. So they are turning towards getting easy money by scamming people.
Case 2: India has seen lots of renown people (and once reputed businessperson) duping various financial institutions in recent times. Some of the examples are Vijay Mallya of Kingfisher, Nirav Modi and Mehul Choksi of Gitanjali Group, Subrata Roy of Sahara Group and Ramlinga Raju of Satyam Computers. Interestingly Netflix has another series “Bad Boy Billionaires: India” for these guys. #notsponsorednetflix
Now if we look rationally at these two stories, scammer from Jamtara and scammer businessperson are criminals. They should be tried and punished as per law of land. But there is an obvious difference in these cases. Scammer from Jamtara doing it out of need, while scammers from case 2 are doing it out of greed. Until scam came out, all these businesspersons were respected, responsible citizens. Their greed to get more money quickly brought their worth to big-fat ZERO.
It is good to take quantified risks while taking financial decisions; but we should also mind that some things are never worth risking like your reputation, friends-Families, independence & freedom etc. Happiness is invaluable against Greed. Lesson is that we should know when it is enough and when to stop. Tool explained in next lesson will help use determine our “Enough”
Lesson 4: Confounding Compounding
Compounding is as interesting phenomena. You might have learned Compounding formula in Math class at school. It goes like this.
A = Final Amount
P = Initial principle (base) amount
r = Rate of Interest
n = Number of times interest applied per time period
t = number of time periods elapsed
This seems dry in Mathematical formula. But when we put it a graph against Simple interest, it starts making sense.
To put in words, if we keep some amount invested say 1000 USD for considerable time, for first 3 years you will observe same returns as that of simple interest. But post that you’ll exponential returns over next couple of years. Now this is what for one time investment. Now suppose you keep on investing 1000USD every month over long period of time, it will make wonders in terms of returns.
This is what made Warren Buffet billionaire. Of course, Warren Buffet did lots of research over period of time while making investments, but at its core Buffet keep on investing over long period of his life to become one of the most wealthiest person in world. As explained PoM, around 81.5B USD of his fortune came after his 60s with average 22% annual returns. But if he had stopped investing at his 60s, his net worth would have been mere 11.9M USD. That is power of compounding.
It is similar to growing a tree. We need to sow a good seed, take care of it over long period of time and when it grows well, tree will give you fruit on its own. Similarly investing money, patiently over long period of time, irrespective of market conditions will rip you great yield.
Lesson 5: Getting Wealthy v/s Staying Healthy
It easy to become wealthy than staying wealthy. This is universally proven fact. There are people who won lottery and became rich overnight, but then became poor again due to lack of “surviving the wealthiness” skill. Let’s take an example of Sushil Kumar. Sushil Kumar won INR 5 Cr (50M INR) in 2011 on Reality TV Show Kaun Banega Crorepati (KBC). In couple of days, he went bankrupt. He told local media that after winning gameshow, he became local celebrity. This caused drift from his core teaching profession. Many people cheated him in name of philanthropy. He became addicted to Smoking and Alcohol and left house to become filmmaker, only to fail. (Reference: India Today)
This trait can be found in many hedge fund managers, intra-day traders and even in crypto enthusiasts. One fine day they get good return. Believing that same trade will give them amazing returns, they take more and more risks and loose most of their wealth.
As wise investor, we should understand that there is no legal instrument which will give you extravagant returns over short period of time. Consistent investment, not panicking during market dips and patience is a key of staying wealthy.
Lesson 6: Tails, You Win
We cannot predict exact outcomes of our investments. We can predict that 20% of invests can yield losses. 40% may give average profit the investment, 35% may give above average profits and 5% may give you extra-ordinary returns. But since we cannot accurately predict which investment will fall in which category, what can be logical thing to do? We should keep investing anyways. Tailing investments will define the profitability of portfolio.
Let’s take example of Microsoft. Microsoft, as told earlier, was an extremely successful company in OS market and their Office Suite is one of the most used commercial software in the world till date. Then they came with many failed products such as Zune, Windows Vista and Windows Mobile OS. These were major losses in terms of money, research and reputation etc. But in hindsight, Microsoft was working on bit lesser-known product — Azure Cloud. Today Azure is world’s second biggest cloud infra (after Amazon AWS). Azure is very popular for its reliability and being easy to use and became large revenue generator for Microsoft.
We can find similar story with Amazon, who has similar failed products such as Fire phone, Amazon Appstore etc. and stream of extremely successful products such as AWS, Prime, Kindle and Echo products, which are bringing tonnes of money for company. There are countless stories like these among whole lot of companies.
Lesson for us is to keep investing no matter if market is bearish or bullish. Tail will always define outcome.
Lesson 7: Freedom
Having control on your time is the biggest freedom you can have. This freedom can be different for different people. For daily wage worker, taking few day-offs without sleeping hungry. For salaried person like me, waiting for good job after leaving current job.
Freedom can also be attributed to sense of being in control. If I love my work, but my company try to make it time bound, then there is a chance that I am not going to love it anymore. This becomes more and more important in today’s knowledge economy, as having sense of control can help us to do better work.
Having enough money can give you that sense of control. If you have 6-months’ worth of emergency fund, you will not be afraid of your boss and look for new opportunities. If you have built sizable chunk of money, then you can retire at relatively your age or starting your own business too. This is the greatest dividend money can give you.
Lesson 8: Man in Car Paradox
This is interesting one. Suppose you are neo-rich person. To show your wealth and impress your friends and neighbours, you bought a luxury car; say Ferrari. People will get impressed, no doubt. But what they think is “If I had this car, people would think I am cool”. People will not admire you or your wealth, instead they will use your car as benchmark for their own desire of being liked and admired.
Same thing will be applied to big house, bikes, jewellery, cloths etc. Nobody will look at you but at items (which has price depreciation).
Lesson is showing of your wealth to get respect and admiration is fool’s errand.
Lesson 9: Wealth is what you don’t see
We think “Rich” and “Wealthy” are same things. But they are not… Rich is current income; Wealth is income not spent. Buying 50L Rs car is Rich, not buying that car is Wealth. This unspent amount, if invested properly, can give multiplied return to make us wealthier. Unfortunately, we think that spending unnecessarily on things we wanted (but not needed) is sign of wealthiness, where in reality by spending such money wealth get reduced.
Lesson is to spend money mindfully. Reduce expenses on Wants, build the wealth.
Lesson 10: Save Money
We can make wonders with things we can control. With respect to saving, we need to understand couple of things:
a. Rate of Saving: Building wealth has nothing to do how much income we have or what is return on invest is. But it depends upon how much we can save. Saving more can help you build wealth faster. To save more we need to understand our “Needs” and “Wants”. To live decent life, we shall not compromise on “Needs Expenditure”, but we can certainly reduce “Wants Expenditure”. Do bit less outing. Do less hotelling. No need to always take Uber or Ola, take Train sometimes. No need to bring out your two-wheeler while buying vegetables, instead go walking.
This approach can make us less materialistic, make us desire less and turn mindful spending into habit. That will help us build emergency funds and provide much needed financial freedom, faster.
b. Save without goal: World is full of uncertainties. We cannot predict many of them. We can face any emergency any time. So it is logical to save money without having any goals; which will help us in case of emergency. Plus, financial freedom is an added bonus.
Lesson 11: Reasonable > Rational
We are humans, not robot. We have emotions and we are messed up. We cannot be rational all the time, even if it is going to help us in long term. People take financial decision not always with logic and reason, but with gut feeling and previous experiences. And that is okay because nobody is crazy (Lesson 1). This is why Economy runs more on psychology than cold rationale.
Lesson is everybody has their own emotions with their investments and reasoning not always work. As a smart investor we should be mindful of this.
Lesson 12: Surprise
As mentioned in previous less, we are human with emotions. Emotions can get affected by many things like our experiences with world, current affairs, our beliefs etc. Millions of investors with infinite numbers of emotions make financial decisions and this moves economy in unexpected ways. Since we cannot predict emotions of millions of people, it is impossible to accurately predict outcome of your investments; no matter how much you plan.
Lesson is to expect the unexpected.
Lesson 13: Room for Error
As mentioned in previous lesson, our expectation about RoI cannot be 100% accurate. If we do not acknowledge the room for unexpected scenarios, we may end up taking unnecessary risks and evaporating hard earned money. We should always keep certain margin of safety, may be by having Backup fund or maybe by diversifying our investments across various instruments.
Lesson 14: You’ll change
We are living being. Every cell of our body gets replaced withing span of 7 years on average. It means we change, and it happens all the time. Not only physical properties, but our mental state such as desires, needs, wants, goals etc. get change all the time. So is our financial situation. No matter how much financial expert going to tell “Do not break investments”, but in case of financial emergency I will take out my investment and future RoI on my investment will change. This is exactly why everyone is not Warren Buffet.
Lesson is that we should acknowledge the fact that we will change and still keep investing.
Lesson 15: Nothing’s free
In order to gain something, we have to pay price. Thing is, not all prices come with tags. If you try to avoid those prices, yield will be lower.
Let’s consider a scenario. You want to double your investment in next 3 years.
Which investment option you’ll choose?
- Not Savings account or FD. They have shitty rate of return, and they cannot even beat inflation. It will take time to double your investment.
- How about stocks? Choosing good stock may give you 40% returns in year and 18% CAGR. But these returns come with high risk profile and you may loose your money.
- What about crypto? Crypto can you make prince, but it can also make you pauper. Highly volatile asset class.
From above example, we should understand, that to get yield we have to pay the price. It can be Time, Patience or ability to endure losses.
Lesson 16: You & Me
Normally in life, as per our passion, we have role models. They can be actors, singers, businessperson maybe. In our investment journey we will also have some role model. It can be famous personality like Rakesh Jhunjhunwala or your friend who is regularly doing investments.
It might seem tempting for you take cues from them and follow their exact path. But you should always remember that you are different than your role model, in terms of knowledge, experience and risk profile. Hence you are not playing same game as your role model. It is important to do your own study.