6 Actionable Tips to Make Better Financial Decisions in Life- The Psychology of Money, Morgan Housel
Have you ever bought an asset, a stock, or a piece of real estate, because you thought thats the next big thing, and then within a few months, the price falls drastically? Do you have to sacrifice the happiest moments in life to advance in your career? Do you feel that none of the common investment strategies work for you? The answers to all these and a lot more financial wisdom can be found in the book "The Psychology of Money" by Morgan Housel. And in this blog, we will learn six ways to make better financial decisions in life.
Fundamental
1. Time & Freedom
When was the last time you were totally happy? This is such a complicated topic because everyone's idea of happiness is different. But if we can find a common denominator in happiness—a universal fuel of joy—it's when people have more control of their lives. Freedom to sleep until Monday afternoon and not have to go to work, that's happiness. Being able to spend time with family during Christmas is happiness. But even though we think we have free will to decide what to do with our lives, we keep missing the important events in life. Because we have to be somewhere else at that same time. We lack options. There is an interesting study about human psychology related to this.
When people feel that they don't have much control or a choice in doing something, they will refuse to do it, even if they enjoy doing the activity. For example, you are doing some interesting work on a Friday evening in your office. You are about to crack the problem, and you decide to do some overtime and come on Saturday to finish the work. But then suddenly your boss comes in, and he says everyone must work on weekends to finish the work. Suddenly you would feel less inclined to come the next day if you were okay with it initially.
We have heard the saying money can't bring happiness. That's because the way we use money is totally wrong. Earn and use the money to bring this control back in your life instead of buying more luxury items. When older people were asked about their happiest moments or what they valued the most, most of them said they valued things they had the luxury to do because they controlled their time. Think of reducing your working hours to spend time with your family and kids, even if that means you earn less.
2. Magic of Compounding
I first learned about compound interest In 8th grade. My math teacher passionately explained it to my class, but I couldn't care less. Then at 22, one of my friends spoke to me in detail about it. He passionately implored me to invest, at the very least, to try and see the results. Again I didn't care. After almost a decade, I see the wisdom in both of their advice. If I had invested at 22 over these years, there is a strong likelihood I would have been more financially sound.
Housel explains that the single most important factor that determines how much money you make is how long you invest. 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.
James Simons and Warren Buffet are among the world's best investors. The annual returns of Simons have compounded at a rate of 66% since 1988. And this rate for Buffet is 22%. That's 3 times that of Buffet's investment. So ideally, Simons should have more wealth than Buffet. No, Buffet is 75% wealthier than Simons. Simons got to this 66% rate when he was 50. While Buffet started his investment when he was 10 and has been earning 22% since then.
There are over 2,000 books picking apart how Warren Buffett built his fortune. But none are called "This Guy Has Been Investing Consistently for Three-Quarters of a Century." But we know that's the key to the majority of his success. Few people would have ever heard of him if he started investing in his 30s and retired in his 60s. His skill is investing, but his secret is time.
His current net worth is $84.5 billion, but $84.2 billion was accumulated after his 50th birthday. It's hard to wrap your head around that math because it's not intuitive. People often underestimate or ignore the power of compounding. Even if we logically know that the time of investment matters more, we struggle to act on this information. Because we are not good at looking or conceptualizing so far into the future. The best time to invest was 10 years ago. The second best time is now.
3. Reasonable vs. Rational
I admire facts or thoughts that change or alter how I see the world. And this is one such thing from the book. It always surprised me to see people rushing to close their home loans by paying off the mortgages on their houses before the term period. Interest rates on home loans are so low nowadays. So if you have some extra cash lying around, the logical thing to do is invest in the stock market, where you can get around 8% returns. So by paying off the mortgage faster, you are losing money. It didn't make any sense to me.
What I failed to understand is that owning a home is not always a logical decision for most people. We are emotional creatures with emotional needs, not rational decision-making machines.
We have to consider this emotional part when we make any financial decision, for that matter. For example, if you decide one day to quit your job to work on your passion. You have saved enough money to support yourself for another 2 years. You may think you can weather any storm when you start such a journey because you are well prepared.
But then, once you start spending from your reserves, as you see the numbers getting reduced in your bank account, consider the emotional side will kick in. Only when you experience such a downturn you'll know what you'll do and how you will behave. So be mindful of this emotional side and develop a sensible strategy.
Harry Markowitz won the Nobel Prize in economics for creating formulas that tell you exactly how much of your portfolio should be in stocks vs. bonds, depending on your ideal level of risk. A few years ago, the Wall Street Journal asked him how, given his work, he invests his own money. He replied:
I visualized my grief if the stock market went way up and I wasn't in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.
Make money decisions that let you sleep peacefully at night, even if that doesn't bring you the best returns.
4. Past & Future
Take a look into the past. Think for a moment about how you were 10 years ago. The most important people in your life, the viewpoints, and opinions you had, the dreams you wanted to achieve. There is a good possibility that they have considerably changed in the last few years. And we understand and recognize this change. But what we fail to consider is how much you will change in the next 10 years from who you are now. There is called the end of history illusion.
For example, when you were in your college, you may have wanted to travel around the world, have new experiences, and never thought about buying a house or settling down. But probably now, you would want to buy a house, have family and kids, and settle down. And if you are thinking now that there might not be any major changes coming in your life, think again.
It's always possible that you might want different things from life in the next 5-10 years. But we always underestimate the future changes so much. Because change is scary when it's not yet happened. So it's okay to look at the past and see the change rather than look and prepare for changes that will come in the future.
So, according to the author, when you make financial decisions, it's always better not to go to extremes to avoid bigger regrets. For example, suppose one day you decide to sell everything you own and use that money to travel around the world for the rest of your life. But maybe after 4 years you will be bored of this lifestyle and want to settle. And in this case, it might be difficult for you, and you might regret the decision to sell your house. I am not saying you shouldn't go with the lifestyle you want. But the more you understand that your needs and views could change in the future, the fewer regrets you will have.
But suppose we ended up making a financial decision that we happen to regret in the future. In that case, it's better to accept this mistake as soon as possible and then adjust our strategy accordingly instead of sticking to it. People do the opposite normally, and this is called sunk cost fallacy. That's our tendency to stick to our choices, thinking of the effort we have invested in them.
So a restaurant owner might keep the restaurant open even if it's not making any profits or is not enjoying his work, thinking about the initial investment and effort they put into it. This can only ultimately lead to more loss of money and more unhappiness. So the faster you admit your mistake and move on, the less miserable you will be.
5. Pay the Price
If you want something, You have to pay the price. You walk into an apple store to buy a new iPhone. you need to give the price on the label unless you plan to take the phone and run away with it. And the concept is the same for the stock market. But the price you have to pay is not the stock price, broker fees, or other charges associated with your investment. The biggest price you have to pay to make profits from the stock market is something you cannot see and measure.
It's the emotional price that's demanded by markets. There will be down periods during your investment journey where you will lose 50 or 60% of your portfolio in a day. But if you panic and quit, you won't be able to reap the benefits the stock market has to offer in the long term. But if you can stay put and prepare for these lifetime opportunities, you can make a fortune.
Napoleon's definition of a military genius was, "The man who can do the average thing when all around him are going crazy.
The general tendency is to overreact when failures in our investment strategy happen. But what we have to realize is that failure is very common; it's just that the failure stories are not that interesting, so we don't hear them much.
In a shareholder's annual meeting, Warren Buffett once mentioned that many of his investments didn't work out. However, the few that did well paid for all the bad assets, so he kept investing.
It's the same in investing. Just focus on the impact and not on the count of how many times we failed. If you invest, for example, in 100 penny stocks, it might be that you have 1 stock that will grow by 40% annually for over a decade, which will compensate for the loss of others. It's like the Pareto's Principle, that often, 20% of the events cause 80% of the results. Even if you fail most of the time, you can still be successful
6. Play Your Game
You cant win a football match by hitting the ball out of the park. Like every game has its own rules, every person has their own goals and plans. So their activities and strategy will be based on their personal goals. So if you don't know exactly what your goals are, you might get caught up chasing other people's goals.
Investors often innocently take cues from other investors who are playing a different game than they are.
You need to know what you want from your investments. Are you looking for some quick returns, or are you saving for your retirement?
In this age of information overload, you are bombarded with information from all directions. Once you discover your financial goals, you will have a far easier time ignoring advice that's irrelevant to your needs. For example, buying an overvalued stock may make sense for short-term day-traders as they will close the position at the end of the day. If you are an investor who buys and holds stocks, buying a richly valued stock won't do any favor to your investment portfolio in the long run.
Invest in an asset because you know the opportunities and how they align with our plan, not because everyone else is doing the same.
Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games.
As important as it is to make sound financial decisions, you also need to be aware of why we make bad ones. For that, you can revisit this blog. If you liked the content, do think of sharing it with the people who need it. see you in my next blog, happy reading.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.
