Sharing my Chapter wise notes from the book ‘Psychology of Money’. It’s a quick summary for those who haven’t read it yet 🙂 It’s a must read for anyone who is in their twenties.
Introduction: How wealthy you’ll be doesn’t depend on how much knowledge of finance you have. It is dependent a lot on how you behave – greed, optimism, fear etc.
Ordinary people with no formal knowledge of finance can be wealthy if they have certain behavioral skills and vice versa.
- No One’s Crazy: People from different generations, raised by different parents who earned different incomes and held different values, living in different parts of the world, born into different economies, experiencing different job markets with different incentives and different degrees of luck, learn very different lessons. Everyone has their own unique experiences about how the world works, and what you have experienced is more compelling than what you learn second-hand. Individual investors’ willingness to bear risk depends on personal history. Not intelligence, or education or sophistication. Just dumb luck of when and where you were born. Example: In the 1960s in America, inflation increased prices by threefold whereas in the 1990s it was so low that you wouldn’t even care about it. A person who is in their 20s in the 1960s would have a very different view on inflation than a person in their 20s in the 1990s.
- Luck & Risk: Luck & Risk are siblings, say, two sides of the same coin. Apart from our individual efforts, luck and risk play a very important role in guiding the outcome in life. Bill Gates went to one of the schools in the world that had a computer. According to the UN, in 1968, there were 303 million high school-age people in the world. 18 million of them lived in the United States. About 270k of them lived in Washington State. A little over 100k of them lived in the Seattle area, out of which only 300 attended Lakeside school, the one that Bill Gates attended. This had a significant role in who Bill Gates is today. He was definitely curious, intelligent and passionate, but something as small as going to the Lakeside school had a significant role in guiding the outcome of his life. Be careful who you praise and admire. Be careful who you look down upon and wish to avoid becoming. Not all success is due to hard work and not all poverty is due to laziness. Therefore, focus less on specific individuals and case studies and more on broad patterns. When things are going extremely well, realise it’s not as good as you think. You are not invincible and if you acknowledge that luck brought you success then you have to believe in luck’s cousin, risk, which can turn your story around just as quickly. On the contrary, while judging our failures we should recognize the room for risk and forgive ourselves.
- Never Enough: Knowing when you have ‘Enough’ is a skill. Let’s take an example of Rajat Gupta. To become a billionaire when he was a millionaire already, he got involved in Insider trading, was caught as a result and lost all that he had. To make money he didn’t have and didn’t need, he risked what he had and did need. That’s foolish.
- The hardest financial skill is getting the goalpost to stop moving.
- Social comparison is a problem. There will always be someone who would be doing more than you do and have more than what you have.
- “Enough” is not too little. The idea of having “enough” may look like leaving opportunity and potential on the table. “Enough” is realizing that the opposite-an insatiable appetite for more-will push you to the point of regret.
- There are many things never worth risking, no matter the potential gain. Reputation is invaluable. Freedom and independence are invaluable. Family and friends are invaluable. Being loved by those who you want to love is invaluable. Happiness is invaluable. And your best shot at keeping things is knowing when to stop taking risks that might harm them. Knowing when you have enough.
- Confounding and Compounding: $81.5 billion of Warren Buffet’s $84.5 billion net worth came after his 65th birthday. That’s the power of compounding. The secret is to start investing early in life, even if it’s a small amount, and be disciplined about it.
- Getting Wealthy vs Staying Wealthy: The ability to stick around for a long time, without wiping out or being forced to give up makes the maximum difference. Compounding only works if you can give an asset years to grow. There will be ups and downs, but the ones who stay consistent despite the ups and downs reap the maximum benefit. Eg in the past 170 years we have seen stock market crashes, depressions, major loopholes in the government and systems, pandemic etc but still, the standard of living on an average has increased more than 20 times.
- Tails, You Win: You can be wrong half the time and still make a fortune. Basically, the 80:20 rule applies here as well. 20% of your investments could help you make a fortune. Example: In 2018, Amazon drove 6% of the S&P 500 returns. And Amazon’s growth is almost entirely due to Prime and Amazon Web Services, which itself are tail events in a company that has experimented with hundreds of products from Fire Phone to travel agencies. The same applies to you as an investor.
- Freedom: a) The highest form of wealth is the ability to wake up every morning and say “I can do whatever I want today.” The ability to do what you want, when you want, with who you want, for as long as you want, is priceless. It is the highest dividend money pays. Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing than any of the objective conditions of life we have considered. b) If your job is to build cars, there is little you can do when you’re not on the assembly line. You detach yourself from work and leave the tools in the factory. However, if you have a thought based and decision job- your tool is your head, which never leaves you. You might be thinking about your project during commute, as you’re making dinner, while you put your kids to sleep etc. Compared to generations prior, control over your time has diminished. And since controlling your time is such a key to happiness, we shouldn’t be surprised that people don’t feel much happier even though we are, on average, richer than ever.
- Man in the Car Paradox: By buying fancy things, people generally aspire to be respected and admitted by others. If respect and admiration are your goals, be careful how you seek them. Humility, kindness, and empathy will bring you more respect than horsepower ever will.
- Wealth is What You Don’t See: There is a difference between being rich and being wealthy. Being rich is measured by the material possessions you have for example: house, car, etc. even though you turn bankrupt the next moment. Being wealthy on the contrary is the measure of the income not spent. Its value lies in offering you options, flexibility and growth to one day purchase more stuff than you could right now.
- Save Money: a) Investment returns can make you rich. But whether an investing strategy will work and how long it will work for, and whether markets will cooperate, is always in doubt. Results are shrouded in uncertainty. Personal savings and frugality – finance’s conservation and efficiency are parts of the money equation that are more in your control and have a 100% chance of being as effective in the future as they are today. And you need not save for a particular goal (eg: purchasing a house or a car). You can just save for saving’s sake. And indeed you should. Saving is a hedge against life’s inevitable ability to surprise you by showing you unexpected worst moments. b) Intelligence is not a reliable advantage in a world that’s become as connected as ours has. But flexibility is. In a world where intelligence is hyper-competitive and many previous technical skills have become automated, competitive advantages tilt toward nuanced and soft skills-like communication, empathy and most of all, flexibility.
- Reasonable > Rational: Aiming to be mostly reasonable works better than trying to be coldly rational.
- Surprise: History is the study of change, ironically used as a map for the future. Many investors fall into a trap called “historians as prophets” fallacy. Two dangerous things happen when you rely too heavily on investment history as a guide to what’s going to happen next.
- You’ll likely miss the outlier events (Great Depression, World War II, dotcom bubble, Covid 19 pandemic) that move the needle the most.
- 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. Eg: Take venture capital. It barely existed 25 years ago. There are single venture capital funds today that are larger than the entire industry was a generation ago.
- Room for Error: There is never a moment when you are so right that you can bet every chip in front of you. The world isn’t that kind to anyone. The wisdom in having room for error is acknowledging that uncertainty, randomness and chance – “unknowns” are an ever present part of life. Margin of safety is the only effective way to navigate a world that’s governed by odds, not certainties. Example of how to use this concept in practical life: Assume your future returns of what you’ll earn in a lifetime is one-third lower than the historic average. The one-third buffer is a good way to help you be safe.
- You’ll Change: Long-term planning is harder than it seems because people’s goals and desires change over time. People are poor forecasters of their future selves. At every stage of our lives, we make decisions that will profoundly influence the lives of the people we’re going to become, and then when we become those people, we’re not always thrilled with the decisions we made. Eg: Young people pay good money to get tattoos removed that teenagers paid good money to get. But here’s a contradiction. The first rule of compounding is to never interrupt it unnecessarily. So, how do we plan for life’s changes? Answer is we should avoid extreme ends of financial planning. Aiming, at every point in your working life, to have moderate annual savings, moderate free time, no more than a moderate commute, and at least moderate time with your family, increases the odds of being able to stick with a plan and avoid regret than if one of those things fall to the extreme sides of the spectrum. Secondly, we should also come to accept the reality of our changing minds.
- Nothing’s Free: Everything has a price, but not all appear on labels. Investing too has a price -”volatility”. Market returns make you pay a price in terms of volatility/ uncertainty. However, the right and optimistic mindset we should develop is that volatility is a fee not a fine. When you invest in something and something doesn’t go your way, then you tend to withdraw as an immediate response to it. This is because you feel you did something wrong and you are paying a fine. However, you should view it as a fee for getting returns later.
- You & Me: Everyone is playing a different game and no one is crazy. When investors have different goals and time horizons-and they do in every asset class-prices that look ridiculous to one person can make sense to another, because the factors those investors pay attention to are different. An iron rule of finance is the money chases returns to the greatest extent it can. If an asset has momentum-it’s been moving consistently up for a period of time-it’s not crazy for a group of traders to assume that it’ll keep moving up. Not indefinitely; just for the short period of time, they need it to. Momentum attracts short-term traders in a reasonable way. Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term.
- The Seduction of Pessimism: Real optimists don’t believe that everything will be great. That’s complacency. Optimism is a belief that odds of a good outcome are in your favor over time, even when there will be setbacks along the way.
- When you’ll Benefit Anything: a) 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. b) Everyone has an incomplete view of the world. But we form a complete narrative to fill in gaps.
Kahneman once laid out the path these stories take:
- When planning we focus on what we want to do and can do, neglecting the plans and skills of others whose decisions might affect our outcomes.
- Both in explaining the past and in predicting the future, we focus on the casual role of skill and neglect the role of luck.
- We focus on what we know and neglect what we don’t know, which makes us overly confident in our beliefs.
Thank you for the book, Harshad and Ujjwal. Such a thoughtful gift! 🙂 Both Harshad and Ujjwal are my cousins who are on their way to making it big in life.
