The Psychology of Money

Introduction

• Soft skills are far more important than hard skills in finance
• Treating finance as if it’s like math or physics is not wise, because finance is driven more by emotion than simple formulas

No-one’s Crazy

Your personal experiences with money make up a small fraction of what’s happened in the world, but it makes up 80% of how you think the world works

• Everyone has different experiences, and that anchors their perception of money differently

Luck & Risk

Nothing is as good or as bad as it seems

• Ex:// Bill Gates was extremely lucky that his school had access to a computer. His friend was just as unlucky and died in an accident
• Money is also subject to luck and risk and the effects are often out of our control
• The problem is that we often choose financial strategies without factoring the large role of luck and risk
• Be careful who you praise and admire and those you wish to avoid becoming
  • Likely, luck and risk played huge factors in their outcomes
• Focus more on broad patterns rather than specific case studies

Never Enough

Rich people can do crazy things

• Ex:// Bernie Madoff and Rajat Gupta (CEO of McKinsey who did insider trading) are examples of individuals that took greed so far that they paid for it
• There’s no reason to risk what you have and need for what you don’t have and don’t need
• When you reach a state where your finances can cover everything you need, remember the following
  • The hardest financial skill is to stop moving the goal post: if expectations keep rising with results, then you will make foolish decisions and never feel satisfied.
    • Capitalism is really good at generating wealth and envy. Avoid envy and rising expectations as much as possible
  • Social comparison is a huge problem: comparing your wealth to others is a losing game, because there’s always someone who is wealthier than you
  • ”Enough” is not too little: it’s actually wise because over-reaching is far more painful
  • There are many things never worth risking, no matter the gain: there are so many things in life that are invaluable (eg. family, friends, reputation). Knowing when you have enough is the key to prevent losing

Confounding Compounding

$81.5BofBuffe{t}^{\prime }s$84.5B net worth came after his 65th birthday. Our minds cannot handle this exponential growth

• Ex:// Compounding caused cycles of ice ages: a cool summer allowed accumulation in winter, which compounded again to form glaciers. Same thing happens with intense heat cycles
• Buffet’s main driver for success is compounding. He has been investing since he was a child and that gave him a huge runway
• Jim Simons, founder of RenTech has a much higher annual return rate than Buffet at 66%, but he started way later in his 50s. Because of this he is 75% less rich than Buffet
• Our minds are not good at exponential thinking and we make mistakes because of this. Mainly, we don’t consider compounding and start to mess with it
• Good investing is not making the highest returns. It’s making good returns for the longest period of time

Getting Wealthy vs. Staying Wealthy

Good investing is not all about making good decisions. It’s about consistently not screwing up

• Ex:// During the 1929 crash, Jesse Livermore shorted and made a huge profit, while Abraham Germansky bet on surging markets and lost everything. A few years later, Livermore went too deep into debt and lost everything as well
• Getting money and keeping money are two different skills.
  • Getting money requires taking risk
  • Keep money requires humility, frugality and acceptance of luck & risk
• Never assume tomorrow will be like yesterday. Survival mentality if key with money
• There are two reasons why survival mentality is important
  • There’s no gains that are so great that it’s worth losing everything
  • Compounding results require you to stay in the game for a long period of time, despite ups and downs and avoid mistakes
• We need to appreciate three things in the world to develop a survival mindset
  • More than big returns, you want to be financially unbreakable, which allows you to exercise the magic of compounding
  • Plan on your plan not going to plan: build in room for things to go awry. You don’t want your plan to be dependent on a specific future event
    • Most bets fail because they were mostly right in moments when they needed to be precisely right
  • A barbelled personality (optimistic about future yet paranoid about what would prevent you from achieving that future) is vital

Tails, You Win

You can be wrong half the time and still make a fortune

• Ex:// Heinz Berggruen became an extremely successful art dealer, not because he had a great eye for art but because he bought so much that a few were worth far more than all his duds
• Long tails have huge influence on outcomes
• In fact, most of the index fund performances are driven by very few companies that just performed extremely well
• Even during recessions, by just keeping cool and not worrying about anything, you would have made a far greater return than if you just cut short the compounding
• Even Buffet invested in hundreds of companies, but only ~10 really made his company something incredible

Freedom

Controlling your time is the highest dividend money pays

• Really, the biggest factor in someone being happy is they have control over their life. Money helps people with this, but it must be a good relationship
• People in the most high-paying jobs are not always the most happy: their time is tightly controlled and they don’t feel very empowered
• America is the richest nation in history, and yet so many people are unhappy. Most people simply use their money to buy better stuff, but they give up more control
• Quality relationships are more important and control over time is more important

Man in the Car Paradox

No one is impressed with your possessions as much as you are

• People tend to want wealth to flex, but most people are using your wealth as a benchmark. It won’t get you the admiration that you want
• Humility, kindness and empathy bring more respect than horsepower ever will

Wealth is What You Don’t See

Spending money to show how much you have made is the fastest way to have less money

• We tend to judge people on their outward appearances and possessions, but they don’t reflect reality that well
• Wealth is about not spending on frivolous things. It’s more hidden
• To feel rich, you can spend lots of money on nice things. To be rich, you spend what you have and don’t spend what you don’t have
• A problem is that we don’t have role models of truly wealthy people because by nature their wealth is hidden
• Just remember, appearances don’t reflect reality. A modest person might be extremely wealthy, but a rich person might be near insolvency

Save Money

The only factor you can control generates one of the only things that matters

• Building wealth has little to do with your income or investment returns and lots to do with your savings rate
• Ex:// In the 1970’s, the US overcame the energy crisis by decreasing the energy it needed rather than increasing energy supply. This was a good strategy because decreasing energy need is in US control, but increasing supply is far more uncertain
• Similarly, money returns are far more unpredictable on our finances than just simply consuming less (which is under our control)
• The value of wealth is relative to what you need
  • Even if someone can generate higher returns, if they are spending a huge amount, they don’t feel wealthy
  • The bigger the gap between your earnings and spend, the more wealthy you are
• Recognize that so much time and effort is spent on increasing returns but if the same amount of effort was used to decrease spend, you can get wealthy much more quickly
• Past a certain level of income, you you need sits below your ego
  • Don’t let your ego expand as your wealth expand as it will cause increase spend
  • Rather than focusing on increasing income, focus on increasing humility so that the ego-income gap increases
• To spend less, desire less. To desire less, stop caring what others think of you
• You don’t need a goal to save. Save for saving’s sake should be the goal, as it helps you develop a hedge against uncertainty and gives you flexibility over your future (which is invaluable)

Reasonable > Rational

Aiming to be mostly reasonable works better than trying to be coldly rational

• Consistency is the key in personal finance. Being rational negates our emotional side, which can cause us to make poor decisions. If we are reasonable and account for emotions, we have a better chance with sticking with our decisions
• Ex:// Julius Wagner-Jauregg treated his syphillis patients with malaria with pretty good success (won Nobel Prize in 1927). He recognized fever is useful in fighting disease. However, we still use Tylenol and other medication to reduce fevers. Why do we continue to manufacture fever treatment even though fevers are useful? Because it hurts. Doctors are being reasonable when prescribing medication, not entirely rational
• We try to invest without taking into account of our emotions
• It’s ok to be reasonable and allow some emotion into investing. If anything, it can help you be more consistent

Surprise!

History is the study of change used as a map of the future

• ”Things that have never happened before happen all the time” - Scott Sagan
• We can’t really predict the future just from past behaviour
• Even having the experience of going through a particular event doesn’t mean you will be marginally more experienced than others. It’s more likely that it will manifest in overconfidence
• 2 dangerous things happen if you rely on history as a guide of what’s next
  • You’ll miss outlier events that move the needle most: these outlier events are likely to compound to create huge impact and they don’t usually follow the patterns of past
    • Eg:// People in Egypt used to write down the high water levels for future indicators of flood, but they always underestimated because of a lack of imagination
  • History doesn’t account for sturctural changes in the world

Room for Error

The most important part of any plan is planning on your plan not going to plan

• You want to develop a margin of safety, such that forecasts of the future don’t really matter too much because you can also start right back after setback
• How comfortable are you with volatility, like a 30% decline? Especially your confidence?
  • You can create as many spreadsheets as you want to crunch the numbers, but none will tell you how you will feel during the decline and what you would do
  • You turn fearful precisely when it’s your greatest opportunity
• Author does financial planning based on notion that market will underperform 1/3 compared to actual rate ⇒ saves more
• Recognize that when taking risks, note that it’s never worth taking if the downside is realized and you cannot escape out of it
  • Eg:// Russian roulette’s downside is never worth it
• How do you avoid these huge risks? Avoid single points of failure

You’ll Change

Long-term planning is harder than it seems because people’s goals and desires change over time

• A major underpinning in psychology is that humans are bad predictors of the future
  • We can imagine goals all we want, but it is completely different from reality, especially when life’s stresses grow with our ambitions
• End of history illusion: people are aware of how much they’ve changed in the past, but cannot use that to predict accurately how much they will change in the future
• Charlie Munger often says the number one rule of compounding is to never interrupt it unnecessarily, but this is hard when goals and desires change
• As we plan our finances, we have to be willing to create balance. Not austere, not luxurious. This gives us the room for compounding to take effect
• We must be wary of sunk cost fallacy, as that often prevents us from accepting change

Nothing’s Free

Everything has a price, but not all prices appear on labels

• The key to a lot of things with money is to figure out the price and your willingness to pay
• Problem: we often realize the price of things when the bill is overdue
• Successful investment has the price of volatility, fear, doubt, uncertainty and regret, which makes long-term holding hard
  • Some people try to invest while avoiding the volatility by buying and selling before booms and busts. This rarely works and it often ends up worse than just accepting the volatility
• Think of market volatility as a fee rather than a fine. The trick is to accept this

You & Me

Beware taking financial cues from people playing a different game than you are

• Bubbles and crashes often happen because people are taking cues from others who have different goals
• Some prices that you might think look ridiculous are normal for others, because goals and time horizons are different
• Not only do differnet goals throw off investment, but also spending
• Take some time to figure out what game your trying to play with finances

The Seduction of Pessimism

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

• Optimism is the best bet for most people because the world tends to get better for most people most of the time
  • This is not to be blindly optimistic but rather knowing that odds are in your favor over time
• Pessimism sounds smarter and hence more attractive
• This is partially because of our asymmetric aversion to loss compared to gain
• Pessimistic outlooks often seem more systemic and seem to affect more people
• Pessimists often extrapolate present trends without accounting for market adaption
  • Eg:// In 2008, people thought that oil would run out due to China’s consumption trends, but the crazy high prices spurred greater exploration and we didn’t run out of reserves
  • Threats incentivize solutions in equal magnitude
• Progress happens too slowly to notice but setbacks happen too quickly to ignore
  • Growth is from compounding, which requires time. Destruction comes from single points of failures, which can happen instantaneously

When You’ll Believe Anything

Appealing fictions and why stories are more powerful than statistics

• 2008 was a narrative damage year which led to tangible (and huge) economic loss
  • The narrative that was damaged was the security of mortgages and houses, which was a bedrock of the economy
• Stories are the most powerful force in the economy, because they color the data
• Two things about stories:
  • The more you want someting to be true, the more likely you are to believe a story that overestimates the odds of it being true
    • Your forecast of the future, while already bad, gets messed up even more
    • With finance, there’s a huge stake, so whatever confirms our belief is often given far more credit than deserved
  • Everyone has an incomplete view of the world, but we form a complete narrative to fill the gaps
    • This can be dangerous because we become overconfident and make mistakes
    • We start to develop a mindset that we are in control of most things, but we’re not!

All Together Now

What we’ve learned about psychology of your own money

• Find humility when things go right and forgiveness when things go wrong
  • A large portion of our success is due to factors out of our control
• Less ego, more wealth
  • Saving is the gap between income and ego
  • Wealth is something you don’t see. You need to be able to limit your fun today to create wealth tomorrow
• Manage your money so you can sleep well at night
• If you want to be a better investor, the most important thing is to increase your time horizon, as time is the biggest force in investment
• Remember a small minority make a majority of outcomes, so be comfortable with lots of things go wrong and a few going right
• Use money to gain control over time
• Be nicer and less flashy
• Save without reason
• Define the fees of success (eg. uncertainty is a fee for stock markets)
• Keep a room for error to allow for compounding to occur
• Avoid extreme financial decisions
• Risk is good but ruinous risk can be terrible. Avoid and be paranoid about it
• Define the game you’re playing and make sure your role models are playing the same