The Psychology of Money: Frugality and savings for Wealth & Freedom

‘The Psychology of money’ review is 9 minutes long, and for people in a hurry please find the quick summary here.

Introduction

The book “Psychology of money” shows us that money management has got nothing to do with being smart or having degrees in finance, but it is mostly about behavior. How you behave matters more than what you know, and that is a tough thing to teach, especially to smart people.

There are two things that the book explores in great detail. One is the fact that financial outcomes are based more on luck than on knowledge, expertise, or efforts.

The other is that financial success is not hard science, it is a soft science.

The more I studied and wrote about the financial crisis, the more I realized that you could understand it better through the lenses of psychology and history, not finance.

Morgan Housel

No one is crazy

All of us view this world through the unique lens of our experiences and beliefs, and only through that lens can our decisions be justified.

No amount of empathy or understanding would recreate the power of fear and uncertainty.

We can read all about extreme poverty but we don’t have the emotional scars of those who actually lived through it.

Every financial decision we take is justified at that time. We tell ourselves a story that kind of checks all the boxes and makes absolute sense to us. These decisions are shaped by our experiences and not by logic or reason.

No one is crazy!

Luck & Risk

You are one person in a game with seven billion other people and infinite moving parts

Morgan Housel

It is almost impossible to have 100 percent of our outcomes to be dictated by 100 percent of our efforts. Sure, some of the efforts we put in, reflect on the final outcome, but it’s always a tiny fraction. A surety is something that is not achievable in any outcome, be it financial in particular or life in general. The world is too random, with a whopping 7 billion players and infinite possibilities.

Accept luck and risk to be a part and parcel of life in all its aspects, make provisions for it, and try and accommodate luck and risk in all your decision-making. Let it become a buffer or a cushion of safety for all contingencies.

It’s possible to statistically measure whether some decisions were wise. But in the real world, day to day, we simply don’t. It’s too hard. We prefer simple stories, which are easy but often devilishly misleading.

Morgan Housel

One crucial piece of information that the author wants us to take home is that not to focus too much on individual persons or incidents such as billionaire celebrities or other grand successes and failures, instead, focus on broader patterns of success and failure.

The more specific your focus the more unlikely it is that it applies to you! The more generic the trends and patterns you focus on the more likely it is that it is applicable to you.

Never Enough

Capitalism has become a toxic and insane drive for material needs. There is virtually no ceiling of social comparison, and once you’re sucked in you’re pretty much done for.

There is no reason to risk what you have and need for what you don’t have and don’t need.

Morgan Housel

The wise thing to do would be to stop moving the goal post around, meaning, to have definitive goals in our minds that are not easily moved around. That would make happiness and stability a more achievable goal.

Reputation, freedom, independence, and love are invaluable, family and friends are invaluable. To keep these you have to when to stop risking it all, you need to know when it’s enough.

Compounding confounding

The nature of compounding is very counterintuitive. We have seen that in atomic habits and countless other books as well, how 1 percent betterment daily could lead to significant improvements of almost 33 percent annually.

The reason we don’t see the beauty of compounding is that humans are not wired to think in exponents. We think more linearly and outcomes and habits tend to be more exponential than linear.

Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s.

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 his secret is time.

Getting Wealthy vs. Staying Wealthy

All the wealth and success that we have accumulated in our lives had a large role of chance and luck. So we can’t be complacent and assume the same old path would get us similar outcomes.

Despite having infinite ways to get rich, we only have a few to stay rich, and they include some combination of frugality and paranoia.

Our plans should be accommodating the fact that our plans might fail, and there should be enough room for error that you can confidently say, my plan involves getting returns of 10 percent per annum, but I’ll be fine even if get 5.

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

Tails, you Win!

It’s not whether you’re right or wrong that’s important,” “but how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune.

George Soros

Our life is driven by tail events or events where we fail. Every successful outcome is surrounded on either side by a bunch of failures. So, it’s important that we suck up and continue putting in the work without overreacting to the failures.

Freedom

Perhaps the only benefit of wealth is freedom, freedom to choose when we wake up, freedom to choose what work to do today, what to eat, and so on.

So, the intrinsic value of money is control over our time.

Doing something you love on a schedule you can’t control can feel the same as doing something you hate.

Wealth is What You Don’t See

Wealth is what you don’t see. It is the luxury cars not bought, fancy watches forgone, first-class upgrades declined.

Wealth is financial assets that haven’t yet been converted into the stuff you see.

Against all societal and peer pressures, wealth is only created when we forgo the urge to show it.

Save Money

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

The most important thing to keep in mind is that wealth is not entirely dependent on your income or your rate of returns, it is rather a direct function of your savings rate.

The two pillars of financial independence are Personal Savings and Frugality. As they are more in your control and hence have a better chance at being effective in the future.

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

As discussed earlier, control over your time and flexibility are unseen advantages of money, and once you have that you have an option to wait for a better opportunity to come up, a better job, or a better deal instead of jumping on to the first opportunity that comes your way, out of desperation.

The case against Rationality

Academic finance has wholeheartedly devoted its efforts to identify the most optimal investing strategies, and that would be a very rational pursuit. But people are rarely Rational or Irrational, we are Human. And, as humans we don’t think rationally we think in terms of what will allow us to sleep peacefully at night and what will keep our mental peace intact.

Consider this for a moment, “A rational investor makes decisions based on numeric facts. A reasonable investor makes them in a conference room surrounded by co-workers you want to think highly of you, with a spouse you don’t want to let down or judged against the silly but realistic competitors that are your brother-in-law, your neighbor, and your own personal doubts. Investing has a social component that’s often ignored when viewed through a strictly financial lens.”

We make a decision that increases endurance, and in turn, allows us to participate in the game long enough to tilt the luck ever-so-slightly in our favor.

Surprise

Investing is not a hard science. It’s a massive group of people making imperfect decisions with limited information about things that will have a massive impact on their wellbeing, which can make even smart people nervous, greedy and paranoid.

We can’t ignore the fact that history is a series of high-impact surprises, and the way we see the current financial market is a consequence of a handful of such surprising events. But, we can’t use history as a guide to the future, as the dynamic world we live in will keep churning out surprises that can’t be predicted.

“That doesn’t mean we should ignore history when thinking about money. But there’s an important nuance: The further back in history you look, the more general your takeaways should be. General things like people’s relationship to greed and fear, how they behave under stress, and how they respond to incentives tend to be stable in time. The history of money is useful for that kind of stuff.”

Room for error

“The purpose of the margin of safety is to render the forecast unnecessary.”

Room for error or buffer is our safety net against the vagaries of luck, immunity against the uncertainty of sorts.

This means we could be risk-taking and still have a safety net that would allow us to be standing in the game long enough for the risk to pay off.

That is what Nassim Taleb meant when he said, “You can be risk-loving and yet completely averse to ruin.”

Nothing is free

Nothing in life is ever free, and Investing is no exception!

Investments come with a fee of volatility, fear, doubt, uncertainty, and regret. And those who try to bypass the fee, end up paying more than double in the long run. Just accept the fee, roll with the punches and move ahead.

The Short game and the long game

Know which game you are playing. Quite often we end up taking cues or suggestions from people who are playing a different game altogether. If our idea is to hold stocks, we can’t be getting tips from someone who trades daily. It would be a disaster in the making.

Sexy Pessimissim

“For reasons I have never understood, people like to hear that the world is going to hell.”

Historian Deirdre McCloskey

Pessimism is way more common than optimism, and also sounds more intellectual and smart. But, in the long run, optimism is the best stance to take. The world is getting a little bit better every second and that the odds will be eventually in your favor over time is a good way to begin our day.

“Every group of people I ask thinks the world is more frightening, more violent, and more hopeless—in short, more dramatic—than it really is,”

Hans Rosling, Factfulness

History..Mystery!

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.

Why Don’t We Learn From History, B. H. Liddell Hart

People believe what they want to believe and will either find evidence to validate their beliefs or to disprove opposing views. It’s almost impossible for a politician or a leader to announce that the country is about to enter recession, even if all the evidence points towards it.

It’s just way easier to believe that the economy is going to be just a little bit sluggish.

Most of the time we’re just realizing how little we know about this world and how much of what happens here is out of our control. That’s a hard fact to come to terms with.

“Risk is what’s left over when you think you’ve thought of everything.”

Carl Richards

Most importantly we really want to believe that we live in a very controlled environment, and we flock towards anybody who has a narrative or worldview supporting that. High-sounding leaders and authoritative figures satisfy that itch and give us the illusion of control.

Both in explaining the past and in predicting the future, we focus on the causal role of skill and neglect the role of luck.

Conclusion

It is never as good or bad as it looks. The world operates in a million hues between the black and white view that we have of it.

Hence it is important that we acknowledge the complexity and sophistication of this world and accept the fact that risk and luck play a pivotal role in day-to-day happenings. Financial freedom and wealth creation are all about frugality and savings and not about optimal strategies and mathematically accurate predictive models. So wealth is created by suppressing what you could buy today in order to have more stuff or more options in the future.

Focus on those actions that help you sleep well at night, don’t stress yourself by risking your money on high returning stock options that come with associated risks that have the potential to wipe you off the game.

Become OK with a ton of things going wrong, in fact, know that they will go wrong eventually, but have enough margins of error to keep you safe and in the game. Believe in the 80/20 rule, that a few sound investments will easily outweigh the bunch of other poor investments.

Time is the most powerful force in investing. It makes little things grow big and big mistakes fade away. It can’t neutralize luck and risk, but it pushes results closer towards what people deserve

Save and then save some more. Life has the knack of throwing nasty surprises in the worst possible times, and when that happens you can fall back on your savings.

“Room for error often looks like a conservative hedge, but if it keeps you in the game it can pay for itself many times over. Avoid the extreme ends of financial decisions.”

Know the game you’re in and don’t get cues and tips from people playing a different game.

There is no single right answer; just the answer that works for you.

Write in the comments below, about your financial strategies

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