Recommended Reading: The Psychology Of Money

Summary

• Housel’s book is exceptionally well written, using stories and personal experiences to explore the strange ways people think about money, demonstrating that they are not economically rational - they're psychologically rational.
• Through his stories, he teaches us how to make better sense of many important issues, including how to think about saving, spending and investing.
• Among the important lessons are unexpected events and random luck can lead to good decisions having bad outcomes and poor decisions having good outcomes.
• Success is a lousy teacher because it can seduce us into thinking we cannot lose. Thus, we should not become overconfident in our judgments when things turn out well.
• Similarly, failure is a lousy teacher because it can seduce smart people into thinking their decisions were poor, when failure was just the unforgiving reality of risk showing up.

Behavioral finance is the study of human behavior and how that behavior leads to investment errors, including the mispricing of assets. The field has gained an increasing amount of attention in academia over the past several decades as pricing anomalies have been discovered. It being my favorite subject, I read everything I can get my hands on. Thus, I was excited to receive Morgan Housel’s new book, “ The Psychology of Money,” and read it in one sitting.

Housel’s book is exceptionally well written, using stories and personal experiences to explore the strange ways people think about money, demonstrating that they are not economically rational. Instead, they are psychologically rational. Through his stories, he teaches us how to make better sense of many important issues, including how to think about saving, spending and investing.

Among the invaluable lessons are:

While planning is important, the most important part of planning is to plan on things not going according to plan. It must be able to survive reality - the unknown unknowns that are everyone’s reality. While history is mostly the study of surprising events, it is too often used by investors as unassailable guides to the future (see above). A financial plan is like a good diet: You must stay disciplined, adhering to it. You need a strategy whose goal is not to maximize your expected wealth but to maximize your ability to sleep well at night, so you can enjoy your life. Good investing is not necessarily about making good decisions. It’s about consistently not screwing up. While getting money is about taking risks and being optimistic, keeping money requires humility (accepting that at least some of what you have accumulated is attributed to luck) and frugality, as the past cannot be relied upon to repeat itself indefinitely. Unexpected events and random luck can lead to good decisions having bad outcomes and poor decisions having good outcomes. Success is a lousy teacher because it can seduce us into thinking we cannot lose. Thus, we should not become overconfident in our judgments when things turn out well. Similarly, failure is a lousy teacher because it can seduce smart people into thinking their decisions were poor, when failure was just the unforgiving reality of risk showing up. Most things are harder in reality than in theory, sometimes because of overconfidence in our abilities. Some lessons must be experienced before they can be understood. For example, bear markets are much more difficult to live through than to observe in a backtest. The trick with failure is arranging your financial life in such 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 your way. Poor people irrationally buy most of the lottery tickets, despite having little savings. The psychological explanation is that they are “investing in a dream.” Having enough is realizing that an insatiable appetite for more will push you to the point of regret. Less ego equals more wealth as you save more. Comfortably living below what you can afford, without much desire for more, removes an immense amount of social pressure that many people in the modern First World subject themselves to. Use your money to gain more control over your time - the ability to do what you want, when you want, and with whom you want, for as long as you want, pays the highest dividend in finance. The simplest way to be a better investor is to increase your time horizon, putting the odds in your favor and allowing compounding to work for you.

Perhaps the most important lesson Housel teaches is that the highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want to today.” That is priceless. Once you have achieved that level of wealth, there is no longer a need to take risk. Yet so many have lost their fortunes trying to grow them beyond their need. Housel provided several examples, including that of legendary investor Jesse Livermore. At one time, he was one of the richest people in the world; however, at the time of his suicide, his liabilities exceeded his assets. The lesson is that, past a certain level of income, what you need is what sits just below your ego (keeping up with the Joneses and showing off your ability to spend).

Housel’s book is a must-read. I’ve added it to my list of the best behavioral finance books:

“The Honest Truth About Dishonesty” – Ariely “Predictably Irrational” – Ariely “Why Smart People Make Big Money Mistakes” – Belsky and Gilovich “The Psychology of Money” – Housel “Thinking, Fast and Slow” – Kahneman “The Drunkard’s Walk” – Mlodinow “Behavioural Finance” – Montier “Behavioral Finance and Wealth Management” – Pompian “Beyond Greed and Fear” – Shefrin “Finance for Normal People” – Statman “What Investors Really Want” – Statman “Misbehaving” – Thaler “Nudge” – Thaler and Sunstein “Your Money and Your Brain” – Zweig

I also recommend “Investment Mistakes Even Smart People Make and How to Avoid Them," my own book on behavioral finance, which covers 77 mistakes investors make.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.