Psychology of Money
Timeless lessons on Wealth, Greed & Happiness
Wealth is the nice cars not purchased. The diamonds not bought. The watches not worn, the clothes forgone and the first-class upgrade declined. Spending money to show people how much money you have is the fastest way to have less money.
~ 22 min read
“A genius is the man who can do the average thing when everyone else around him is losing his mind.” —Napoleon
“The world is full of obvious things which nobody by any chance ever observes.” —Sherlock Holmes
The premise of this book is that doing well with money has a little to do with how smart you are and a lot to do with how you behave. And behaviour is hard to teach, even to really smart people.
Genius who loses control of their emotions can be a financial disaster. The opposite is also true. Ordinary folks with no financial education can be wealthy if they have a handful of behavioural skills that have nothing to do with formal measures of intelligence.
Two topics impact everyone, whether you are interested in them or not: health and money.
Here's the thing: People from different generations, raised by different parents who earned different incomes and held different values, in different parts of the world, born into different economies, experiencing different job markets with different incentives and different degrees of luck, learn very different lessons.
History makes you feel like you understand something. But until you've lived through it and personally felt its consequences, you may not understand it enough to change your behaviour.
We all think we know how the world works. But we've all only experienced a tiny sliver of it.
Some lessons have to be experienced before they can be understood.
Luck and risk are both the reality that every outcome in life is guided by forces other than individual effort. They are so similar that you can't believe in one without equally respecting the other. They both happen because the world is too complex to allow 100% of your actions to dictate 100% of your outcomes. They are driven by the same thing: You are one person in a game with seven billion other people and infinite moving parts. The accidental impact of actions outside of your control can be more consequential than the ones you consciously take.
Be careful who you praise and admire. Be careful who you look down upon and wish to avoid becoming.
Some people are born into families that encourage education; others are against it. Some are born into flourishing economies encouraging of entrepreneurship; others are born into war and destitution. I want you to be successful, and I want you to earn it. But realise that not all success is due to hard work, and not all poverty is due to laziness. Keep this in mind when judging people, including yourself.
Therefore, focus less on specific individuals and case studies and more on broad patterns.
Studying a specific person can be dangerous because we tend to study extreme examples—the billionaires, the CEOs, or the massive failures that dominate the news—and extreme examples are often the least applicable to other situations, given their complexity. The more extreme the outcome, the less likely you can apply its lessons to your own life, because the more likely the outcome was influenced by extreme ends of luck or risk.
The trick when dealing with failure is arranging your financial life in a way that a bad investment here and a missed financial goal there won't wipe you out so you can keep playing until the odds fall in your favour.
Warren Buffett once put it: To make money they didn't have and didn't need, they risked what they did have and did need. And that's foolish. It is just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.
There is no reason to risk what you have and need for what you don't have and don't need.
The hardest financial skill is getting the goalpost to stop moving and know when is enough.
If expectations rise with results there is no logic in striving for more because you'll feel the same after putting in extra effort. It gets dangerous when the taste of having more—more money, more power, more prestige— increases ambition faster than satisfaction. In that case one step forward pushes the goalpost two steps ahead. You feel as if you're falling behind, and the only way to catch up is to take greater and greater amounts of risk.
Modern capitalism is a pro at two things: generating wealth and generating envy. Perhaps they go hand in hand; wanting to surpass your peers can be the fuel of hard work. But life isn't any fun without a sense of enough. Happiness, as it's said, is just results minus expectations.
Social comparison is the problem here. The point is that the ceiling of social comparison is so high that virtually no one will ever hit it. Which means it's a battle that can never be won, or that the only way to win is to not fight to begin with—to accept that you might have enough, even if it's less than those around you.
“Enough” is not too little.
There are many things never worth risking, no matter the potential gain.
Reputation is invaluable. Freedom and independence are invaluable. Family and friends are invaluable. Being loved by those who you want to love you is invaluable. Happiness is invaluable. And your best shot at keeping these things is knowing when it's time to stop taking risks that might harm them. Knowing when you have enough.
If something compounds - if a little growth serves as the fuel for future growth - a small starting base can lead to results so extraordinary they seem to defy logic. It can be so logic-defying that you underestimate what's possible, where growth comes from, and what it can lead to. And so it is with money.
Good investing is not necessarily about making good decisions. It's about consistently not screwing up.
Getting money and keeping money are two different skills. Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility, and fear that what you've made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you've made is attributable to luck, so past success can't be relied upon to repeat indefinitely.
We can spend years trying to figure out how Buffett achieved his investment returns: how he found the best companies, the cheapest stocks, the best managers. That's hard. Less hard but equally important is pointing out what he didn't do. He didn't get carried away with debt. He didn't panic and sell during the 14 recessions he's lived through. He didn't sully his business reputation. He didn't attach himself to one strategy, one world view, or one passing trend. He didn't rely on others' money (managing investments through a public company meant investors couldn't withdraw their capital). He didn't burn himself out and quit or retire. He survived. Survival gave him longevity. And longevity—investing consistently from age 10 to at least age 89—is what made compounding work wonders. That single point is what matters most when describing his success.
Nassim Taleb put it this way: “Having an 'edge' and surviving are two different things: the first requires the second. You need to avoid ruin. At all costs.”
More than I want big returns, I want to be financially unbreakable. And if I'm unbreakable I actually think I'll get the biggest returns, because I'll be able to stick around long enough for compounding to work wonders.
Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.
Some tail-driven industries are obvious. Take venture capital. If a VC makes 50 investments they likely expect half of them to fail, 10 to do pretty well, and one or two to be bonanzas that drive 100% of the fund's returns. Investment firm Correlation Ventures once crunched the numbers.
Controlling your time is the highest dividend money pays.
Having a strong sense of controlling one's life is a more dependable predictor of positive feelings of wellbeing than any of the objective conditions of life we have considered.
More than your salary. More than the size of your house. More than the prestige of your job. Control over doing what you want, when you want to, with the people you want to, is the broadest lifestyle variable that makes people happy.
But doing something you love on a schedule you can't control can feel the same as doing something you hate. There is a name for this feeling. Psychologists call it reactance.
People like to feel like they're in control—in the drivers' seat. When we try to get them to do something, they feel disempowered. Rather than feeling like they made the choice, they feel like we made it for them. So they say no or do something else, even when they might have originally been happy to go along.
No one—not a single person out of a thousand—said that to be happy you should try to work as hard as you can to make money to buy the things you want. No one—not a single person—said it's important to be at least as wealthy as the people around you, and if you have more than they do it's real success. No one—not a single person—said you should choose your work based on your desired future earning power.
No one is impressed with your possessions as much as you are.
When you see someone driving a nice car, you rarely think, “Wow, the guy driving that car is cool.” Instead, you think, “Wow, if I had that car people would think I'm cool.” Subconscious or not, this is how people think.
“You might think you want an expensive car, a fancy watch, and a huge house. But I'm telling you, you don't. What you want is respect and admiration from other people, and you think having expensive stuff will bring it. It almost never does—especially from the people you want to respect and admire you.”
Wealth is What You Don't See
Spending money to show people how much money you have is the fastest way to have less money.
Someone driving a $100,000 car might be wealthy. But the only data point you have about their wealth is that they have $100,000 less than they did before they bought the car (or $100,000 more in debt). That's all you know about them.
We tend to judge wealth by what we see, because that's the information we have in front of us. We can't see people's bank accounts or brokerage statements. So we rely on outward appearances to gauge financial success. Cars. Homes. Instagram photos. But the truth is that wealth is what you don't see.
Wealth is the nice cars not purchased. The diamonds not bought. The watches not worn, the clothes forgone and the first-class upgrade declined.
Wealth is financial assets that haven't yet been converted into the stuff you see.
When most people say they want to be a millionaire, what they might actually mean is “I'd like to spend a million dollars.” And that is literally the opposite of being a millionaire.
Bill Mann once wrote: “There is no faster way to feel rich than to spend lots of money on really nice things. But the way to be rich is to spend money you have, and to not spend money you don't have. It's really that simple.”
Exercise is like being rich. You think, “I did the work and I now deserve to treat myself to a big meal.” Wealth is turning down that treat meal and actually burning net calories. It's hard, and requires self-control. But it creates a gap between what you could do and what you choose to do that accrues to you over time.
The problem for many of us is that it is easy to find rich role models. It's harder to find wealthy ones because by definition their success is more hidden.
If wealth is what you don't spend, what good is it? Well, let me convince you to save money.
Do people need to be convinced to save money? My observation is that, yes, many do.
Past a certain level of income people fall into three groups: Those who save, those who don't think they can save, and those who don't think they need to save.
This is for the latter two.
The first idea—simple, but easy to overlook—is that building wealth has little to do with your income or investment returns, and lots to do with your savings rate.
Wealth is just the accumulated leftovers after you spend what you take in. And since you can build wealth without a high income, but have no chance of building wealth without a high savings rate, it's clear which one matters more.
More importantly, the value of wealth is relative to what you need.
Past a certain level of income, what you need is just what sits below your ego.
People's ability to save is more in their control than they might think.
Savings can be created by spending less.
You can spend less if you desire less.
And you don't need a specific reason to save. Some people save money for a downpayment on a house, or a new car, or for retirement. That's great, of course. But saving does not require a goal of purchasing something specific.
You can save just for saving's sake. And indeed you should. Everyone should.
Savings without a spending goal gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. It lets you change course on your own terms.
That flexibility and control over your time is an unseen return on wealth.
What is the return on cash in the bank that gives you the option of changing careers, or retiring early, or freedom from worry? I'd say it's incalculable.
When you don't have control over your time, you're forced to accept whatever bad luck is thrown your way. But if you have flexibility you have the time to wait for no-brainer opportunities to fall in your lap. This is a hidden return on your savings.
Savings in the bank that earn 0% interest might actually generate an extraordinary return if they give you the flexibility to take a job with a lower salary but more purpose, or wait for investment opportunities that come when those without flexibility turn desperate.
And that hidden return is becoming more important.
A question you should ask as the range of your competition expands is, “How do I stand out?”
Intelligence is not a reliable advantage in a world that's become as connected as ours has. But flexibility is.
Having more control over your time and options is becoming one of the most valuable currencies in the world.
History is the study of change, ironically used as a map of the future. But, “Things that have never happened before happen all the time.” It is smart to have a deep appreciation for economic and investing history. History helps us calibrate our expectations, study where people tend to go wrong, and offers a rough guide of what tends to work. But it is not, in any way, a map of the future.
Whenever we are surprised by something, even if we admit that we made a mistake, we say, 'Oh I'll never make that mistake again.' But, in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That's the correct lesson to learn from surprises: that the world is surprising.
You have to plan on your plan not going according to plan.
Use room for error when estimating your future returns. This is more art than science. 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. A one-third buffer is enough to allow me to sleep well at night. And if the future does resemble the past, I'll be pleasantly surprised. “The best way to achieve felicity is to aim low,” says Charlie Munger. Wonderful.
Long-term planning is harder than it seems because people's goals and desires change over time.
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.
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.
We should avoid the extreme ends of financial planning.
We should also come to accept the reality of changing our minds. Some of the most miserable workers I've met are people who stay loyal to a career only because it's the field they picked when deciding on a college major at age 18. The trick is to accept the reality of change and move on as soon as possible.
Everything has a price, but not all prices appear on labels.
“Every job looks easy when you're not the one doing it.”
Beware taking financial cues from people playing a different game than you are.
When a commentator on CNBC says, “You should buy this stock,” keep in mind that they do not know who you are. Are you a teenager trading for fun? An elderly widow on a limited budget? A hedge fund manager trying to shore up your books before the quarter ends? Are we supposed to think those three people have the same priorities, and that whatever level a particular stock is trading at is right for all three of them?
But while we can see how much money other people spend on cars, homes, clothes, and vacations, we don't get to see their goals, worries, and aspirations. 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.
There is an iron law in economics: extremely good and extremely bad circumstances rarely stay that way for long because supply and demand adapt in hard-to-predict ways.
Third is that progress happens too slowly to notice, but setbacks happen too quickly to ignore.
Stories are, by far, the most powerful force in the economy. They are the fuel that can let the tangible parts of the economy work, or the brake that holds our capabilities back.
At the personal level, there are two things to keep in mind about a story-driven world when managing your money.
The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.
“When you have no money, and your son is sick, you'll believe anything.”
Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
Take history. It's just the recounting of stuff that already happened. It should be clear and objective. But as B. H. Liddell Hart writes in the book Why Don't We Learn From History?
[History] cannot be interpreted without the aid of imagination and intuition. The sheer quantity of evidence is so overwhelming that selection is inevitable. Where there is selection there is art. Those who read history tend to look for what proves them right and confirms their personal opinions. They defend loyalties. They read with a purpose to affirm or to attack. They resist inconvenient truth since everyone wants to be on the side of the angels. Just as we start wars to end all wars.
Daniel Kahneman once told me about the stories people tell themselves to make sense of the past. He said:
Hindsight, the ability to explain the past, gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn't make sense. That's a big deal in producing mistakes in many fields.
We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.
What these stories do to us financially can be both fascinating and terrifying.
When I'm blind to parts of how the world works I might completely misunderstand why the stock market is behaving like it is, in a way that gives me too much confidence in my ability to know what it might do next. Part of the reason forecasting the stock market and the economy is so hard is because you are the only person in the world who thinks the world operates the way you do. When you make decisions for reasons that I can't even comprehend, I might follow you blindly into a decision that's right for you and disastrous to me. This, as we saw in chapter 16, is how bubbles form.
Kahneman once laid out the path these stories take:
When planning we focus on what we want to do and can do, neglecting the plans and skills of others whose decisions might affect our outcomes. Both in explaining the past and in predicting the future, we focus on the causal role of skill and neglect the role of luck. We focus on what we know and neglect what we do not know, which makes us overly confident in our beliefs.
Can't tell you what to do with your money, because I don't know you. I don't know what you want. I don't know when you want it. I don't know why you want it.
- Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong.
- Less ego, more wealth.
- Manage your money in a way that helps you sleep at night.
- If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon.
- Become OK with a lot of things going wrong. You can be wrong half the time and still make a fortune.
- Use money to gain control over your time.
- Be nicer and less flashy.
- Save. Just save. You don't need a specific reason to save.
- Define the cost of success and be ready to pay it.
- Worship room for error.
- Avoid the extreme ends of financial decisions.
- You should like risk because it pays off over time.
- Define the game you're playing, and make sure your actions are not being influenced by people playing a different game.
Charlie Munger once said “I did not intend to get rich. I just wanted to get independent.”
We can leave aside rich, but independence has always been my personal financial goal.
Being able to wake up one morning and change what you're doing, on your own terms, whenever you're ready, seems like the grandmother of all financial goals. Independence, to me, doesn't mean you'll stop working. It means you only do the work you like with people you like at the times you want for as long as you want.
And achieving some level of independence does not rely on earning a doctor's income. It's mostly a matter of keeping your expectations in check and living below your means. Independence, at any income level, is driven by your savings rate. And past a certain level of income your savings rate is driven by your ability to keep your lifestyle expectations from running away.
A secondary benefit of maintaining a lifestyle below what you can afford is avoiding the psychological treadmill of keeping up with the Joneses.
Nassim Taleb explained: “True success is exiting some rat race to modulate one's activities for peace of mind.”
Good decisions aren't always rational. At some point you have to choose between being happy or being “
Charlie Munger put it well: “The first rule of compounding is to never interrupt it unnecessarily.”
Over the years I came around to the view that we'll have a high chance of meeting all of our family's financial goals if we consistently invest money into a low-cost index fund for decades on end, leaving the money alone to compound.
No matter how we save or invest I'm sure we'll always have the goal of independence, and we'll always do whatever maximises for sleeping well at night.
Do you have any questions, or simply wish to contact me privately? Don't hesitate to shoot me a DM on Twitter.
Have a wonderful day.