9 lessons from The Psychology of Money
A partner at venture capital firm The Collaborative Fund, Morgan Housel fills a tall order: a financial expert who is also well-versed in human psychology. Not to mention a great writer.
In his best-selling Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness, he brings up something that’s rarely emphasized in the personal finance world: evergreen principles of human psychology that deeply impact our financial decisions everyday and how we should navigate them to lead financially healthy lives.
Here are the 9 important lessons I took from this book.
1) Doing well with money has little to do with how smart you are and a lot to do with how you behave.
We tend to lump finance in the same category with mathematical sciences because, well, it involves numbers, but Housel reminds us that this is a severe misconception.
“Physics isn’t controversial,” he argues, “it’s guided by laws. Finance is different. It’s guided by people’s behaviors.” Anyone who’s been through a recession and felt deeply visceral panic would probably agree that a financial crisis is best understood through the lens of psychology rather than math.
In fact, our experiences with money are to a large extent dictated by our beliefs and mental models rather than naked facts. This is because humans perceive the world around them, not in data but in stories. Stories are more powerful than statistics. Housel argues that stories are especially seductive when a smart person who wants to find solutions faces a combination of limited control and high stakes—a scenario that, coincidentally, happens often when money is concerned.
2) It’s imperative to know what “enough” means to you.
It’s difficult to grasp the concept of “enough” when struggling to meet basic needs, but it’s crucial to come up with your own unique definition of enough as you begin to build wealth.
Housel argues that there are two major challenges when determining what “enough” means to us financially. The first is to get the goalpost to stop moving—at first, $100K net worth seems to be a lot, but once you get there, it becomes laughable and you find yourself wanting ten times more than that, and when that happens ten times more and so on and so forth.
“Modern capitalism is a pro at two things,” Housel writes, “generating wealth and generating envy.” Which brings us to the second problem: social comparison. Our social environment tends to shape our financial expectations, so it is helpful to proactively question whether those expectations align with your actual values and priorities.
Having enough doesn’t mean depriving yourself, in fact, it’s quite the opposite. “Enough” exists in this sweet spot between meeting your true needs and being tied down by your possessions. In Housel’s words, it is “realizing that an insatiable appetite for more will push you to the point of regret.”
3) The math of investing can be counterintuitive and difficult to comprehend.
The power of compounding interest is a mind-boggling miracle of mathematics.
Get this: “81.5 billion of Warren Buffett’s $84.5 billion net worth came after his 65th birthday.” This is because time is the most powerful force when investing—as the name of the concept suggests, your money compounds with time, i.e. it grows faster and faster the more time you give it.
This is a mathematical truth you can double check for yourself by googling “compound interest calculator,” and yet, it is so deeply counterintuitive for the human mind that it will still be hard to believe. Housel writes, “the danger here is that when compounding isn’t intuitive we often ignore its potential and focus on solving problems through other means.”
You might calculate the approximate amount of money you’ll make in the next ten, twenty, thirty years, and think you’ll never become wealthy—because you didn’t take into consideration the compounding interest you can earn by investing, which is the thing that’ll help you build wealth at a speed you can’t even fathom if you give it enough time. Start now and let the compounding mesmerize you in a decade or two.
4) Wealth is built in the intersection of courage and fear.
When it comes to money, luck and risk are the most important factors outside of individual effort. If focus and hard work are one part of the equation, treading the line between luck and risk is another. Knowing when to be cautious and when to be bold is no easy feat, but it’s an absolutely crucial balance to maintain when it comes to managing your money. In the words of the author, “the line between ‘inspiringly bold’ and ‘foolishly reckless’ can be a millimeter thick and only visible with hindsight. Risk and luck are doppelgängers.”
On one side of the equation, not screwing up and staying alive is crucial to staying in the game long term, a prerequisite to grow your money. Fear is a great tool to help with this. Housel writes, “there’s only one way to stay wealthy: some combination of frugality and paranoia.” He adds, “if I had to summarize money success in a single word it would be ‘survival.’”
On the other side of the equation, you absolutely need to take risks and believe that the odds are in your favor in the long run, even when things may look messy now. You know people who are so scared of the market fluctuations that they never get in it? Well, they’ll never be able to build wealth unless they know how to manage risk instead of avoiding it.
In short, getting money requires risk and optimism, while keeping it necessitates a combination of humility, frugality, and fear. To walk this line, Housel suggest adopting what he calls “a barbelled personality”—“optimistic about the future, but paranoid about what will prevent you from getting to the future.”
5) No one’s really impressed with your possessions.
Having a certain set of possessions, like a nice car, big house, designer clothes, etc. might make you feel a certain way you like to feel, and there’s nothing wrong with that. However, it helps to keep in mind that they don’t do anything for other people. In other words, no one is impressed with your possessions as much as you are.
This is a truth we seldom realize but it becomes so obvious when you think of your own impression of others. When you see someone with something you want to have, your thought is more likely to be “it would be so cool if I had this, too,” rather than “wow, this person is so cool.” In other words, you spend more time putting yourself in their shoes to live vicariously through their possessions than putting them on a pedestal.
And yet, we often make the mistake of thinking we garner admiration and respect by what we possess. The truth is this comes not because of what we have but rather how we make people feel about themselves— it is by showing respect, interest, and curiosity that we make a lasting impression on others.
6) You don’t know what you’ll want in 2, 5, or 10 years.
Humans are good at recognizing how much things have changed in the past but terrible at predicting future change. Psychologists call this the End of History Illusion—the present time is mistaken to be ever-lasting when we know too well that things have changed considerably in the past.
But what does this mean in terms of managing our money? Housel proposes that we should (1) avoid the extreme ends of financial planning and be ready for multiple different future priorities, and (2) simply accept the reality of our changing minds.
One dangerous phenomenon to watch out for in relation to this cognitive dissonance is the concept of sunk costs. Housel writes, “sunk costs—anchoring decisions to past efforts that can’t be refunded—are a devil in a world where people change over time. They make our future selves prisoners to our past, different, selves.”
Not only do we change, but so does our environment, often in ways that we can’t possibly predict. (If nothing else, Covid-19 drove this last point home for everyone, I think.) And looking back at history is no help either—the only lessons we can take from the past are those that have to do with the evergreen parts of human nature (like greed, fear, envy, power struggles, etc.). Still, the most important lesson remains that life is always full of surprises and there is no way to predict how it’s all going to unfold.
7) The secret to wealth is the discipline to save money.
This is the first prerequisite to building wealth. Saving money is the only variable we can control completely—investing involves some risk, our income options may be relatively limited. “Since you can build wealth without a high income, but have no chance of building wealth without a high savings rate,” Housel writes, “it’s clear which one matters more.
After all basic needs are met, savings rate is dependent on a deep understanding of what purchases bring us true joy and which ones are unconsciously inherited from the spending culture around us. This allows us to create a gap between what we have and what we want, and puts us in control of our money. More money saved, in turn, means more flexibility and helps us be prepared for various life scenarios to unfold.
As Housel brilliantly puts it, “wealth is the nice cars not purchased. The diamonds not bought. The watches not worn, the clothes forgone and the first-class upgrade declined. Wealth is financial assets that haven’t yet been converted into the stuff you see.” This doesn’t imply that you should deprive yourself. Once again, it only means that you need to know what will give you the best return on your investment based on the values and priorities that are unique to you rather than something you saw someone else do.
8) Controlling your time is the highest dividend money pays.
All discussion about money is ultimately about time, because money is a stand-in for time. And the ability to control how to spend one’s time is one of the greatest indicators of happiness. In fact, doing something on a schedule that’s outside of your control can feel awfully similar to doing something you hate.
Having a six-month emergency fund of basic expenses means being less frustrated with your job because you know you won’t be destitute if you took some time off to recuperate and look for something else. In that sense, controlling your money means controlling your time, means controlling your life. You will spend less time doing things someone you don’t agree with tells you to do. Money is freedom you can store and grow.
This is a central premise of the Financial Independence (Retire Early) movement. Wealth gives you independence, which doesn’t necessarily mean you’ll stop working. It means you’ll only do the type of work you love with people you like in places and during times that are convenient for you.
9) It’s crucial to know what game you’re playing.
This is very important, mainly because it dictates what financial cues you will take and which you won’t.
What is your time horizon? Are you looking to retire early? Or make sure you have enough in retirement because you started investing later in life? Do you have kids? Do you want to have kids? Do you want to travel? Move to a different country? Is owning your home important to you? Why or why not?
How would you define your personality? Are you risk-averse or do you not mind a bit of calculated risk? What are your values? How do you want to spend your time? Where do you want to live? Where do you ideally see yourself in a decade or two?
Your answers to these questions will determine whether you will buy a house or rent, what retirement account to invest in, which purchases to prioritize, where to park specific percentages of your money, and so on. For example, Housel describes himself in these general terms (you can, and should, get more in detail than this but this is a good start): “a passive investor optimistic in the world’s ability to generate real economic growth and confident that over the next 30 years that growth will accrue in [his] investments.”
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Psychology of Money is full of timeless wisdom about how people behave when it comes to their money, and insight about how to navigate our own emotions to reach wherever we want to go financially. Housel’s storytelling is a captivating amalgam of actionable and philosophical—I highly recommend it both as a pleasant read and a useful reference book.
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