Money: A Dance Between Numbers and Human Nature
The psychology of money
Money. Some have it. Some don’t. Some have mastered it. Most are still chasing it. You may think of money as just numbers, spreadsheets, and math. Or an equation that needs to be solved. But the real financial decisions are made far from calculators, around dinner tables—with ego, pride, fear, and personal history. The true nature of money is the dance between the cold arithmetic of a spreadsheet and human nature. When it comes to money, we are complicated creatures and financial success is not so much about how much you know but how you behave. This article was inspired by Morgan Housel’s amazing book, “The Psychology of Money.” Let’s delve into the strange and human side of money.
Financial DNA
We all come from different generations, with parents earning different incomes and holding different values, living in various parts of the world, and being born into different economic environments with varying incentives and varying opportunities. We all have very different experiences with money. Take, for example, the stock market and inflation. People born in 1970 saw an almost tenfold increase in the S&P 500 during their teens and 20s, leading most to have a positive view of the stock market and a higher inclination to invest.
People born in 1950 saw the stock market go nowhere in their teens and 20s, leading to a more negative view of the stock market and less inclination to invest. People born in the 1960s experienced significant inflation during their teens and 20s, leading to a higher awareness and a more negative view of inflation and its effects. People born in 1990 experienced relatively low inflation during their lifetime, leading to less concern and awareness of its effects. A person’s experience with the stock market and inflation during their formative years greatly shapes their attitudes and behaviors towards investing and financial decision-making.
People justify every financial decision they make based on the information they have at that moment and their mental model of the world, which has been passed onto them by their parents and is shaped by their unique life experiences. Although they can be misinformed, lack information, or make bad decisions, their actions make sense to them at that moment and align with their own personal story. According to Housel, “people do some crazy things with money. But no one is crazy.” We all have unique worldviews, and since there is no universally correct way to manage money successfully, none of us are crazy. We make financial decisions based on our personal life experiences and our worldview.
Compound kings (Buffett’s dirty little secret)
Compound Kings, There is no doubt that Warren Buffett is considered one of the greatest investors of all time. What is staggering is that $81.5 billion of Warren Buffet’s $84.5 billion net worth was earned after he reached his mid-sixties. Housel explains that “few pay enough attention to the simplest fact: Buffett’s fortune isn’t due to just being a good investor but being a good investor since he was literally a child.” As a result of investing at an early age, Buffet was able to harness the power of compounding. Let’s say you invest $1,000 at an interest rate of 8%. Your initial investment would earn you $80 after one year.
If you compounded your total of $1080 at 8% interest the next year, you would now earn $86.4. You’ve earned money on your initial investment as well as the interest you earned on the principal. An investment compounded over time gains interest not only from the original investment but also from the interest generated on top of the original investment. The counterintuitive nature of compounding makes many of us not realize how extreme the results can be. Compounding, however, can help you earn more money over time.
Warren Buffett began serious investing at age 10 and had a net worth of $1 million by age 30. Let’s imagine an alternate reality where Warren Buffet behaved more like most young men in their 20s and used a lot of his early income on traveling and a few nice cars. If he started with a net worth of $25,000 at age 30 and retired at age 60 but continued to generate amazing average returns of 22% annually, his net worth today would be around $11.9 million (99.9% less than his actual net worth today of $84.5 billion). Warren Buffett’s financial success can be attributed to the financial base he built in his early years and his longevity in investing. His skill is investing, but his secret to success is time and the power of compounding. Consider this from another perspective.
The richest investor of all time is Warren Buffett. However, in terms of average returns, he is not the greatest. Jim Simons, for instance, is a hedge fund manager who has compounded money at a staggering 66% annually since 1988. A much higher rate than Buffet. The net worth of Simons, however, is 21 billion, which is 75% less than Buffett’s. How is this possible? According to Housel, the reason for this is that Simons wasn’t able to find his stride in investing until he was 50 years old. Effectively giving him less than half as many years to compound as Buffett.
Housel estimates that if he had invested over a time frame as long as Buffett, his net worth today would be “sixty-three quintillion nine hundred quadrillion seven hundred and eighty-one trillion seven hundred eighty billion seven hundred and forty-eight million one hundred sixty thousand dollars.” ($63,900,781,780,748,160,000) It’s important not to underestimate the power of compounding. No matter how counterintuitive the results of compounding may seem, they should never be ignored.
Pessimism and money
Pessimism and Money Optimism is the belief that the odds of a good outcome are in your favor over time, even if there are setbacks along the way. But when it comes to money, we all have a bias toward pessimism that we hold dear in our hearts. Looking back, however, things have generally improved over the years. So what is it about pessimism that we are inclined to embrace rather than optimism? The answer is that good things take time and don’t happen overnight.
Money is a subject that attracts pessimism for a variety of reasons. Let’s start with the fact that money matters to all of us. When we hear about something bad happening in the economy, we’re more likely to pay attention. For example, a 40% decline in the stock market over six months is likely to attract attention immediately and may even attract government intervention. However, the incremental nature of a 140% gain over six years can go largely unnoticed. Every year, half a million American lives are saved by the progress of medicine over the last 50 years. Slow progress, however, attracts less attention than quick, sudden losses such as terrorism, plane crashes, and natural disasters. There are many overnight tragedies, but few overnight miracles.
To be practical, we don’t have to be pessimistic. Despite setbacks, we can hold onto the belief that, over time, the odds of a positive outcome are in our favor. When reading the news highlighting a stock market crash, economic woes, or other money problems, try to remember that things tend to improve over time.
Two forgotten elements (A story)
Two Forgotten Elements In 1968, there were roughly 300 million high-school-age people in the world, and of those 300 million, 300 students attended a small school in Seattle called Lakeside. Lakeside happened to be the only high school in the world at the time that had a professor with the foresight to lease a computer, the Teletype Model 30. This was no ordinary computer; it was advanced for the time and the type of computer that even graduate students didn’t have access to. And for one lucky student at Lakeside, this would change everything. That student was Bill Gates. From 300 million to 300. In 1968, there was roughly a one-in-a-million chance of being a high school student with access to a computer. Bill Gates and his schoolmate Paul Allen would go on to create Microsoft together.
Even as a teenager, Gates showed exceptional intelligence, hard work, and a vision for computers unlike anyone else. But going to Lakeside also gave him a one-in-a-million competitive advantage and a head start. And Gates is not shy about this; in 2005, he said, “If there had been no Lakeside, there would have been no Microsoft.” What is not often mentioned in the early Microsoft story was a third member of this gang of high-school computer prodigies. Kent Evans. Just as intelligent, just as visionary. Kent could very well have been one of the founders of Microsoft, alongside Gates and Allen. However, that would never happen.
A mountaineering accident took Kent’s life before he graduated high school. The odds of a high school student being killed in a mountaineering accident are around one in a million. Just as an extremely rare stroke of luck would propel Bill Gates and Paul Allen to great success, Kent Evans would experience an extremely rare event and an encounter with what Housel calls the close sibling of luck, risk. Luck and risk are like the wind and the waves that determine the course of a sailboat.
The sailor can control the rudder and the sails, but ultimately, the direction and speed of the boat are influenced by external factors that cannot be fully predicted or controlled. The pursuit of success is full of twists and turns, and the role luck and risk play in shaping our lives is an important perspective to keep in mind. Understanding that success is a complex combination of factors, including both talent and luck, can help us approach our own financial decisions with greater humility and perspective.
The key to happiness
Key to Happiness People want to become wealthier to make themselves happier, but according to Housel, “the key to happiness is the ability to do what you want when you want, with whom you want, for as long as you want.” The pursuit of material wealth has led to many people working harder and giving up more control over their time, despite being richer than ever before. However, studies show that having control over your life is the most dependable predictor of positive feelings of well-being, more than your salary, house size, or career prestige. Ultimately, controlling your time is the highest dividend money pays. Pursuing money without valuing time is like filling a bucket with a hole in it. No matter how much water you pour in, it will continue to leak out. Similarly, no matter how much money you accumulate, it won’t bring lasting happiness if you don’t have control over your time and can’t enjoy the fruits of your labor.
Tail events
Tail Events Heinz Berggruen, a man who fled Nazi Germany and settled in America, became one of the most successful art dealers of all time. He collected a massive amount of art, including works by famous artists like Picasso, Klee, and Matisse. In 2000, he sold part of his collection for over 100 million euros. What was his secret to acquiring so many masterpieces? Was it a skill? Was it luck? According to Horizon, a research firm, great investors buy vast quantities of art and hold onto them for a long period of time. They waited for a few of those paintings to become well-known and worth a lot of money, even though most of the paintings they bought were not worth very much.
In other words, it’s not about being right all the time, but having a diversified portfolio and waiting for a few winners to emerge. Perhaps 99% of the works someone like Berggruen acquired in his life turned out to be of little value. He could be wrong most of the time, but that doesn’t particularly matter if the other 1% turns out to be the work of someone like Picasso. These events are known as long tails. When a small number of events can account for the majority of outcomes. The long tails of Berggruen’s art collection are what led to his ultimate fortune. The story of Berggruen teaches us a valuable lesson about investing and this long-tail concept also applies to many aspects of business and investing.
The obvious example is venture capital. Most of the startups in a VC fund will fail and lose money for the fund, but all they need are a few outlier startups that make 20x + returns to make up for losses. Take Amazon, for instance. In 2018, it drove 6% of the return on the S&P 500, even though it was just one company. if we look inside Amazon. Its growth was largely driven by two tail events: Amazon Prime and Amazon Web Services. These two products alone more than made up for all of Amazon’s less successful experiments, such as the fire phone or travel agencies. After the disastrous release of the Amazon Fire Phone, rather than apologize to shareholders, Jeff Bezos said, “If you think that’s a big failure, we’re working on much bigger failures right now. I am not kidding.
Some of them are going to make the fire phone look like a tiny little blip.” Bezos understands that it is ok to make mistakes and fail with most products if the process creates the 1% of tail event products that drive everything. Tail events are mostly unintuitive and hidden from us because we only see the finished products and not all the failures along the way that led to that finished product. Housel, in the book, uses a real-life example of a stand-up comedian. When you are reading the Netflix special, you are saying to yourself, “Wow, this comedian is amazing.” What you aren’t seeing are all the trial-and-error failed jokes that the comedian tried out in small clubs all around the country before doing the special.
The Netflix special is a 1% compendium of all the tail event jokes that actually made people laugh. 99% of the jokes along the way were probably just okay. When it comes to investing, even though long tails are prevalent, most of us ignore them. When things go wrong, we tend to focus on the immediate consequences and losses rather than recognizing that occasional failures are part of the process. Understanding and embracing the concept of long tails can provide a different perspective on risk and failure.
In investing, long tails also manifest in the form of outlier events that have a significant impact on the overall market. For instance, a black swan event, such as the global financial crisis of 2008 or the COVID-19 pandemic in 2020, can have profound consequences for financial markets and individual investments. While these events are rare and unpredictable, they play a crucial role in shaping the trajectory of investments over the long term. Investors who are aware of the potential for long tails, both positive and negative, can better navigate the uncertainties of the financial world.
Saving money: A means, not an end
Saving Money: A Means, Not an End Many people approach saving money with the goal of accumulating as much as possible, often viewing it as an end in itself. However, the purpose of saving is not merely to amass wealth but to provide options and reduce dependency on specific outcomes. Saving money is a means to an end, offering freedom and flexibility. The ability to withstand financial shocks and have the liberty to make choices without being constrained by immediate financial concerns is the true power of saving.
Housel provides an analogy to emphasize this point. Imagine you have a 95% chance of winning a million dollars or a 5% chance of getting nothing. Most people would be averse to taking that risk. Now, consider the same scenario, but instead of a million dollars, you get a million dollars worth of Starbucks gift cards. Suddenly, the risk seems less daunting. The Starbucks gift cards represent the ability to endure financial uncertainty because, even in the worst-case scenario, you still have something valuable that can be used. This is analogous to having savings in real life—it provides a safety net and options even when facing unexpected challenges.
The seduction of pessimism
The Seduction of Pessimism Pessimism can be seductive when it comes to financial decision-making. It often feels safer to prepare for the worst-case scenario, to anticipate setbacks, and to be cautious. However, the seduction of pessimism can lead to missed opportunities and a failure to fully embrace the potential for positive outcomes. While it is essential to be prepared for challenges, it’s equally important not to let pessimism dominate decision-making.
Investors who allow pessimism to guide their actions might miss out on the long-term benefits of staying invested through market fluctuations. The history of financial markets shows that, despite periodic downturns, markets have consistently recovered and grown over the long term. The seduction of pessimism may cause some to exit the market during downturns, missing out on the subsequent recoveries and potential gains.
The unseen cost of risk mitigation
The Unseen Cost of Risk Mitigation Mitigating risk often comes with a cost, and this cost is not always immediately apparent. While risk mitigation strategies, such as insurance or diversification, provide a sense of security, they also come with trade-offs. Insurance premiums, for example, are a direct cost of protecting against specific risks. Diversification may result in lower potential returns compared to concentrated investments in high-performing assets.
Understanding the unseen costs of risk mitigation is crucial for making informed financial decisions. It requires a careful consideration of the balance between security and potential growth. Sometimes, accepting a certain level of risk is necessary to achieve financial goals and optimize returns over the long term.
Conclusion
Understanding the psychology of money is essential for making sound financial decisions. Money is not just about numbers; it’s deeply intertwined with human behavior, experiences, and perceptions. By recognizing the impact of personal history, biases, and emotions on financial decisions, individuals can develop a more nuanced and effective approach to managing money.
Key principles discussed in Morgan Housel’s “The Psychology of Money” include the role of compound interest in wealth creation, the influence of personal experiences on financial decisions, the importance of time and control in achieving happiness, the concept of long tails in investing, and the true purpose of saving as a means to gain freedom and options. Additionally, the seduction of pessimism and the unseen costs of risk mitigation highlight the need for a balanced and informed perspective on financial decision-making.
Ultimately, the psychology of money is a complex interplay between rationality and emotion, and gaining insights into this dynamic can empower individuals to navigate the financial landscape with greater wisdom and resilience.
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