The Psychology of Money

Question 1

What is the psychology of money?

Answer 1

It’s a soft skill where how you behave is more important than what you know.

When it comes to finance, soft skills are more important than the technical side of money.

Question 2

Finance is overwhelmingly taught as a math-based field, where you put data into a formula and the formula tells you what to do. What is missing from this approach to money?

Answer 2

Knowing what to do tells you nothing about what happens in your head when you try to do it.

We think about, and are taught about money in ways that are too much like physics (with rules and laws), and not enough like psychology (with emotions and nuance).

Physics isn’t controversial. It’s guided by laws. Finance is different. It’s guided by peoples behaviors.

Question 3

Which two lenses will help you understand finance better than most?

Answer 3

Psychology and history

To grasp why people bury themselves in debt, you don’t need to study interest rates; you need to study the history of greed, insecurity, and optimism.

To get why investors sell out at the bottom of a bear market, you don’t need to study the math of expected future returns; you need to think about the agony of looking at your family and wondering if your investments are imperilling their future.

Question 4

What is the largest contributor to how you think the world works?

Answer 4

Your personal experiences

Not intelligence, or education, or sophistication. Just the dumb lack of when and where you were born.

Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.

Question 5

What is that quote by investor Michael Batnick?

Answer 5

“Some lessons have to be experienced before they can be learned.”

We all think we know how the world works. But we’ve all only experienced a tiny sliver of it.

Question 6

What mix of personal factors go into many of the financial decisions that people make?

Answer 6

• Environment
• The people around you
• Personal history
• Your unique world view
• Ego / Pride
• Marketing
• Incentives

Question 7

Aside from personal history and worldview, why else do money decisions tend to be so messy?

Answer 7

People have only recently began to talk about money.

Money has been around a long time, but the modern foundation of money decisions—saving and investing—is based on concepts that are practically infants.

• The 401k didn’t exist until 1978
• The Roth IRA was introduced in 1998
• Index funds are less than 50 years old

Question 8

How does Morgan Housel define luck and risk?

Answer 8

Luck and risk are both the reality that every outcome in life is guided by forces other than individual effort.

You are one person in a game with 7 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.

Question 9

Psychologically, what’s the difference between my mistakes and your mistakes?

Answer 9

Other peoples’ mistakes are usually attributed to bad decisions, while your own failures are usually chalked up to the dark side of risk.

When judging someone else’s failures, you’re likely to prefer a simple story of cause-and-effect because you don’t know what’s going on inside their head. (“You had a bad outcome so you must have made a bad decision.”)

But when judging yourself, you can make up a wild narrative, justifying your past decisions and attributing bad outcomes to risk.

Question 10

What is one of the biggest problems we face when trying to learn about the best way to manage money?

Answer 10

Identifying what is luck, what is skill, and what is risk.

The line between “inspiringly bold” and “foolishly reckless” can be a millimetre thick, and only visible with hindsight.

Question 11

How can we get closer to finding actionable takeaways when it comes to learning from other people, (financial) successes and failures?

Answer 11

Focus less on specific individuals and case studies and more on broad patterns. Look for broad patterns of success and failure.

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.

Question 12

What is the hardest financial skill to learn?

Answer 12

Getting the goalpost to stop moving.

It gets dangerous when the taste of having more—more money, more power, more prestige—increases ambition, faster than satisfaction.

Question 13

What is two things is modern capitalism a pro at generating?

Answer 13

Wealth and 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.

Question 14

What is one of the key drivers of success (if not the key driver) in investing?

Answer 14

Time

Specifically: consistent investing over a long period of time.

Compound interest leads to exponential gains. The longer that math is at work, the more your gains and the more your gains accelerate.

Question 15

What is the first law of the survival mindset (as applied to money)?

Answer 15

More than wanting big returns, want to be financially unbreakable. If you’re unbreakable, you’ll get the biggest returns, because you’ll be able to stick around long enough for compounding to work wonders.

Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time, especially in times of chaos, will always win.

Question 16

What is the second law of the survival mindset (as applied to money)?

Answer 16

Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.

A plan is only useful if it can survive reality. And a future filled with unknowns is everyone’s reality. A good plan embraces this truth and emphasizes room for error.

Question 17

What is one of the most underappreciated forcesin finance?

Answer 17

Room for error, often called margin of safety.

It comes in many forms: a frugal budget, flexible thinking, and a loose timeline— anything that lets you live happily with a range of outcomes.

Question 18

What is the third law of the survival mindset (as applied to money)?

Answer 18

A barbelled (balanced) personality— optimistic about the future, but paranoid about what will prevent you from getting to the future—is vital.

You can be optimistic that the long-term growth trajectory is up and to the right, but equally sure that the road between now and then is filled with landmines, and always will be. Those two things are not mutually exclusive.

Question 19

What causes many people to overreact when it comes to volatility in the market?

Answer 19

They underestimate how normal it is for a lot of things to fail. Which causes them to overreact when they do.

Question 20

What are the highest dividends that money pays?

Answer 20

Freedom and control

The ability to do what you want, when you want, with who you want, for as long as you want, is the broadest lifestyle variable that makes people happy.

Question 21

What is the definition of wealth?

Answer 21

Wealth is the accumulated leftovers after you spend what you take in.

Wealth is also relative to what you need.

This means that you can build wealth without a high income. But you can’t build wealth without a high savings rate. So savings rate matters more than having a high income when it comes to building wealth.

Question 22

What is required for a high savings rate? And what is the knock-on benefit?

Answer 22

A high savings rate means having lower expenses than you otherwise could, and having lower expenses means your savings go farther than they would if you spent more.

There are professional investors who grind 80 hours a week to add a tenth of a percent to their returns when there are easily 2 or 3 full percentage points of lifestyle bloat in their finances that can be exploited with less effort.

Question 23

One of the most powerful ways to increase your savings isn’t to raise your income. It’s to raise your…?

Answer 23

Humility. Savings is the gap between your ego and your income.

Past a certain level of income, what you need is just what sits below your ego.

Spending beyond a pretty low level of materialism is mostly a reflection of ego approaching income, a way to spend money to show people that you have money.

Question 24

What is the relationship between reason and rationality when it comes to the way we handle our money?

Answer 24

In personal finance, merely reasonable is better than rational.

We are not spreadsheets, we are emotional people. We are set up to fail if we attempt to make boldly rational financial decisions. Reasonable is more realistic and you have a better chance of sticking with it in the long run, which is what matters most when managing money.

Question 25

What is the correct lesson to learn from surprises?

Answer 25

That the world is surprising.

Not that we should use past surprises as a guide to future boundaries; that we should use past surprises as an admission that we have no idea what might happen next.

Question 26

When it comes to investing, why do historical trends going back decades or longer carry less weight than one might think?

Answer 26

The further back you look, the more likely you are to be examining a world that no longer applies to today.

Many investors and economists take comfort in knowing their forecasts are backed up by decades, even centuries, of data. But since economies evolve, recent history is often the best guide to the future because it’s more likely to include important conditions that are relevant to the future.

Question 27

What should you keep in mind when using historical trends to make investment decisions?

Answer 27

The further back in history you look, the more general your takeaways should be.

Specific trends, specific trades, specific sectors, specific causal relationships about markets, and what people should do with their money are always an example of evolution in progress. Historians are not prophets.

Question 28

In which specific places should investors think about leaving healthy room for error

I.e. liquid assets (cash)

Answer 28

1. Volatility: can you survive your assets declining by 30%? (Physically and mentally?)
2. Saving for retirement: What if returns aren’t as good as history dictates? What if you retire during a bear market? What if you need to cash out for an emergency in your 40s?

Leaving room for error creates space for mishaps, preventing you from having to make suboptimal decisions that leave you poor off.

Question 29

What is leverage and why is it a terrible investment strategy?

Answer 29

Leverage is taking on debt to make your money go further, usually by investing it in stocks that produce a higher return than the cost of that debt.

It’s a bad investment strategy because it pushes routine risks (investing in the stock market) into something capable of producing financial ruin.

Question 30

What is the greatest thing that money can buy you?

Answer 30

Freedom: The ability to do what you want, when you want, for as long as you want.

Question 31

Aside from just widening the target around what you think might happen, what does leaving room for error achieve?

Answer 31

It also helps protect you from things you’d never imagine, which can be the most troublesome events we face.

Think: pandemic, natural disasters, critical illness, job loss, etc.

Question 32

What is the biggest single point of failure with money?

Answer 32

Sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.

Question 33

Should you still save if you don’t have a reason to save? (If, for example, you already have a house, car, emergency fund, etc.)

Answer 33

Yes.

You don’t need a specific reason to save. It’s great to save for a car, a home, or for retirement, but it’s equally important to save for things you can’t possibly predict or even comprehend.

Question 34

What is the “end of history illusion?”

Answer 34

It’s what psychologist call the tendency for people to be keenly aware of how much they’ve changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future.

Question 35

What is the sunk-cost fallacy and why is it so damaging to change?

Answer 35

Sun costs are anchoring decisions to past efforts that can’t be refunded.

They are the devil in a world where people change overtime. They make our future selves prisoners to our past, different, selves.

Embracing the idea that financial goals made when you were a different person should be abandoned without mercy versus put on life-support and dragged on can be a good strategy to minimize future regret.

Question 36

When do bubbles occur like the dot com bubble of the late 1990s?

Answer 36

Bubbles form when the momentum of short-term returns attracts enough money that the make up of investors shifts from mostly long-term (stable) to mostly short-term.

Think: finicky day traders looking to make a quick buck.

Question 37

What three things make financial pessimism, easy, common, and more persuasive than optimism?

Answer 37

1. Money is ubiquitous so something bad happening tends to affect everyone and captures everyone’s attention.
2. Pessimist often extrapolate present trends without accounting for how markets change and adapt.
3. Progress happens too slowly to notice, but setbacks happens too quickly to ignore.

This underscore the point that in investing, you must identify the price of success—volatility and loss amid the long backdrop of growth—and be willing to pay it.

Question 38

At the personal level, there are two things to keep in mind about a story-driven world when managing your money. What are they?

Answer 38

1. 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.

Truth: the bigger the gap between what you want to be true and what you need to be true to have an acceptable outcome, the more you are protecting yourself from falling victim to an appealing financial fiction.

2. Everyone has an incomplete view of the world, but we form a complete narrative to fill the gaps.