We have understood assets, liabilities, and asset classes until now. If you have not read those posts, you can check them out here. In this post, I am going to summarize my understanding of the well-known book The Psychology of Money.
If you haven’t heard about this book you can check it out below in your preferred language.
English ; Tamil ; Telugu ; Marathi
If you have read all my posts, you know that I have only discussed money in quantitative terms, with some benchmarks, whether it be concerning corpus or returns on that corpus. In this book, the author discusses money from an abstract perspective and describes what separates the successful from the unsuccessful in terms of money by giving examples of people from various walks of life.
At the start of the book, the author mentions that the two most important things that affect an individual are health and money. But I would like to add one more thing to this: relationships.
Money can be understood as a tool or a facilitator that helps people solve the majority of their life problems. If you have money you can use it for yourself, your family, or friends, or you can put it to use for people who are less fortunate than you, that is you can do charity. Although money is an important thing it is not everything. Health and relationships are other important things.
If you have to sacrifice your health for money then it is not worth it. After all, what is the use of money if you don’t live to use it? Investing in your Health can have a compounding effect on you as with other investments.
Relationships are another important part of an individual. After all, what is the use of all the material things if you lose all the relationships in their chase? We are taught in schools that humans are social beings, and forming relationships is a byproduct of being social.
So, to summarise, people should balance all three, namely money, health, and relationships, in their lives to have a fulfilled life.
No One’s Crazy
This is the first chapter of the book.
Ever wonder why different people have different opinions on topics? In economics, we are taught that human beings are rational, and if this is true people should have the same view right? But we forget in addition to this, human beings are emotional too.
People have different opinions on topics because their opinions are shaped by their experiences. For example, at the time of writing this article, I am sitting in India in an urban city having a good internet connection and all the other necessities of life at my disposal, but at this very time, there might be people who might be facing a crisis of necessities or might not have a good internet connection at their disposal. Thus all the people don’t experience the world alike at the same time.
Have you ever wondered why people have different problems? For example, a person with enormous wealth would have a hard time managing all his wealth by himself, so he hires a wealth manager to manage it. But a person with little or no wealth wouldn’t understand this and would think that the guy is crazy to spend extra money on a wealth manager.
Therefore it would be right to say that people’s opinions are based on their experiences and this is why sometimes opinions of one generation might not make sense for the other.
Luck and Risk
In this chapter, the author argues that Luck and Risk are siblings, like success and failure. The exact role of luck is successful outcomes.
Be careful who you praise and admire. This means that we should have a good background study of people before admiring them for their success. This is because everyone has some unfair advantage and these unfair advantages are not in the same field. Therefore a person with an unfair advantage in a particular field might outshine another equally skilled person with no advantage. Therefore we should be careful who we look down upon and wish to avoid becoming. As much as we recognize the role of luck in success, the role of risk means we should forgive ourselves and leave room for understanding when judging failures.
The above doesn’t mean we shouldn’t focus on success, but means we should focus on broad patterns which lead to success instead of focusing on successful people who can be extreme examples.
The author states that the trick when dealing with failure is arranging your financial life in a way that some financial uncertainties won’t derail you, so you can keep playing until the odds fall in your favor.
Never Enough
The author says there is no reason to risk what you have and need for what you don’t have and don’t need. Deciding what is enough money is important for one’s well-being. He tells the story of Gupta from rags to riches and again to rags. To have a better life the author lists down the following points.
- The hardest financial skill is getting the goalpost to stop moving.
- Avoid Social comparison
- Enough is not too little
- There are many things never worth risking, no matter the potential gain
For me, the point is the hardest point to conquer. As for point 2, I think people are swayed away by peer pressure, if people focus more on what makes them happy they can easily avoid this trap as each person is different and has different interests.
I would like you to read the book and list down your thoughts on points 3 and 4. If you don’t have the book you can get it through the below links in your preferred language.
English ; Tamil ; Telugu ; Marathi
Confounding Compounding
Confounding simply means causing surprise or confusion, especially when results are not produced according to expectations.
The author says that you don’t need tremendous force to create tremendous results. If something compounds 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.
For example, Warren Buffet’s fortune isn’t due to just being a good investor, but being a good investor since he was a child. Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. His skill is investing, but the secret to his wealth is time. That’s how compounding works.
The counterintuitive nature of compounding leads even the smartest of people to overlook its power. Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and that can be repeated. It’s about earning pretty good returns that you can stick with and that can be repeated for the longest period. That’s when compounding runs wild.
Now this compounding doesn’t only apply to money, but also to skills, health, and knowledge.
Getting Wealthy vs Staying Wealthy
The author argues that getting money is one thing and keeping money is another.
Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking a risk. It requires humility, and fear that what you have made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you have made is attributable to luck, so past success definitely can’t be relied upon to repeat.
A survival mindset is the key to making wealth. Few losses can wipe out your full fortune.
The author says applying a survival mindset to the real world comes down to appreciating 3 things, one of those things is planning is important, but the most important part of every plan is to plan on the plan not going according to plan, which I completely agree with.
Order the book in your preferred language through the below links and read to know more about the chapter.
English ; Tamil ; Telugu ; Marathi
Tails, You Win
In this chapter, the author says you can be wrong half of the time and still make a fortune, as is evident from history that only a handful of companies have helped investors generate a fortune out of their large portfolios, only a handful of companies contribute to the majority of the returns of an index, and only a handful of startups succeed. A good definition of an investing genius is a man or woman who can do the average thing when all those around them are crazy.
Tails drive everything. This is very similar to the Pareto principle. Where the majority of the results come from a minority of the efforts. When you accept that tails drive everything in business, investing, and finance you realize that it’s normal for lots of things to go wrong, break, fail, and fall.
But it is also important to note that there are fields where you must be perfect every time. Flying a plane, for example. Then there are fields where you want to be at least pretty good nearly all the time. A restaurant chef, let’s say.
When we pay attention to a role model’s successes we overlook that their gains came from a small percentage of their actions. That makes our failures, losses, and setbacks feel like we are doing something wrong. So next time whenever there is a failure remember that it is part of the process and no big shot has a track record of 100% success.
Freedom
Controlling your time is the highest degree of freedom experienced in life. Freedom of time gives you time to think about new ideas and new strategies and paths.
Compared to generations prior, control over our time has diminished. And since controlling our time is such a key happiness influencer in our lives, we shouldn’t be surprised that people don’t feel much happier even though we are, on average, richer than ever.
People have come to realize that things like quality friendship, being part of something bigger than themselves, and spending quality, unstructured time with their children are of a higher priority. Your kids don’t want your money anywhere near as much as they want you.
Man in the Car Paradox
In this chapter, the author says no one is as impressed with your possessions as you are. People tend to want wealth to signal to others that they should be liked and admired, also known as status signaling. But in reality, those other people often bypass admiring you, not because they don’t think wealth is admirable, but because they use your wealth as a benchmark for their desire to be liked and admired.
This in turn leads to social pressure to own those things, which they would never have actually wanted. Thus we should always evaluate if we are buying things just out of social pressure or do we genuinely want it.
Wealth is what you don’t see
In this chapter, the author says spending money to show people how much money you have is the fastest way to have less money. Modern capitalism helps people fake it until they make it a cherished industry. But the truth is that wealth is what you don’t see.
Wealth is hidden. It’s income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now.
The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. Keep this in mind when quickly judging others’ success and setting your own goals.
Save Money
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.
Efficiency is very important. 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.
Let’s take an analogy. Imagine a bucket and you are filling it with water. If the bucket has a small hole, then the time needed to fill it will be more compared to the bucket with no hole. If the hole in the bucket is large, then filling the bucket becomes almost impossible. The filling of water is your savings rate and the hole in the bucket is your expenses, if your expenses are low then you can fill your bucket of wealth faster. So people’s ability to save is more in their control than they might think.
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.
Reasonable > Rational
In this chapter, the author highlights an important human trait emotion. He says aiming to be mostly reasonable works better than trying to be coldly rational. You are not a spreadsheet, you are a person. A screwed-up emotional person. Don’t aim to be coldly rational when making financial decisions. Aim to be just pretty rational.
Academic Finance is devoted to finding the mathematically optimal investment strategies. In the real world, people do not want the mathematically optimal strategy. They want a strategy that maximizes how well they sleep at night.
Surprise
The highlight of this chapter is the line: ‘History is the study of change, ironically used as a map of the future’. An overreliance on past data as a signal to future conditions in a field where innovation and change are the lifeblood of progress can be detrimental.
Things that have never happened before happen all the time. For example, the covid, new wars, etc. are unprecedented and unaccounted-for events that occur all of the time and catch us by surprise.
Imagine how different the world economy be without the outlier events (Hitler, Stalin, the great depression, World War, etc.)
History can be a misleading guide to the future of the economy and stock market because it doesn’t account for structural changes that are relevant to today’s world.
I have only highlighted the learnings from some of the chapters of the book. I would encourage everyone to go through the book themselves. You can purchase the book through the links below in your preferred language.
English ; Tamil ; Telugu ; Marathi
This is all for this post, hope you all got to learn something new. Don’t forget to follow my Facebook and Instagram pages for regular updates. See you all in the next post till then keep learning.