5 Life Lessons Learned from The Psychology of Money
I've always counted myself as a rationale and reasonable person (as much as one can be). I enjoy (applied) mathematics because it's generally a factual discipline. You get an answer and it's either right or wrong (generally). After graduating from college I became interested in personal finance and investing. Please note I am not a financial advisor nor am I providing financial advice. I began reading several books on the topic of finance. Most of them are about typical topics like: investing, saving, and budgeting. These books treated finance as a hard science. Science that uses observation, experiments and sometimes mathematics to get knowledge. But I decided to read Morgan Housel's book, The Psychology of Money a few months back. It argues that finance is actually a soft skill, and behavior is more important than knowledge.
The lessons Housel describes can be applied to much more than finance. It's lessons about life. I'll be diving into the 5 life lessons I learned from his book. Check out my book notes on it here.
Power of Luck
People always attribute someone's success to something in their control (e.g. skill, knowledge). Not their luck. The same goes for when someone fails, it's about their lack of skill/knowledge etc. But what we don't attribute to someone's success is the power of luck. We are obsessed with the habits, routines and tools of the successful. There's numerous articles on the "morning routine" of people like Elon Musk or Bill Gates. We need to realize is the part luck plays. Someone could have done the exact same things as Elon Musk but might have failed. We shouldn't think of people who've failed because it's a lack of skill or something in their control. Sometimes things don't work out.
A person who has failed could've done everything the exactly the same as someone who has failed. The main difference is the unfortunate side of risk. As Housel says "both flipped the same coin that happened to land on a different side".
Compound interest in investing terms is the addition to the principal (original) sum of a loan or deposit, or in other words principal plus interest. It's exponential. It starts out small in the beginning but over time you see significant games. See the graph below.
For example if you invest $100 a month, with no savings at all. With an average interest of 7% annually.
After 1 year you'll have... $1200
After 5 years you'll have... $6,900
After 10 years you'll have... $16,597
After 20 years you'll have... $49,194
After 30 years you'll have... $113,352
After 40 years you'll have... $239,562
Source: investor.gov (please note this is an estimate of how much your savings could grow over time).
After 40 years you have put $48,000 into your account but you actually get $239,562 (almost 5 times your initial contribution) with compound interest. That's $191,562 earned through the power of compound interest.
Compound interest doesn't only apply to finance. One of the best ways I've applied this idea is to self improvement. If you focus on getting 1% better everyday after a year you will be 37 times better than what you were previously. As James Clear, the author of Atomic Habits said, "habits are the compound interest of self-improvement". The effect of your habits multiply as you repeat them. They make little difference on any given day but the impact they deliver over the months and years can be tremendous. For me I work on a skill for at least 10 minutes a day (like practicing the guitar or writing). Each day 10 minutes doesn't seem like much. But over the course of a year I will have practice the guitar for over 60 hours. A tremendous amount.
While many of us advocate to be rationale. The most logical decisions seem to be the best. We all want to be more like machines (yes or no, right or wrong) but in reality we are human. It's okay to be reasonable over rationale. You have a much better chance of being consistently reasonable than rationale. In finance and specifically in investing investing it's easy to want to be rationale, to not sell all of your stocks when the market falls. But it's difficult to actually do so, not many people can watch all of their stocks drop. Instead it's okay to be rationale.
You want to focus on being reasonable 80% of the time in your life. If you do that you're more likely to stick with your plan. While it might not be logical. You will have peace of mind and that's something valuable. In life you can aim to be reasonable with your nutrition. Instead of being strict or "rationale" with only eating healthy foods you need to be reasonable and treat yourself.
Room for Error
In the book he explained leaving room for error is to save money. For finance, sometimes saving for the sake of saving is the best. You don't always need a specific reason to save, like a new car or house. As the saying goes "sh*t happens". Randomness as a part of life, it's pretty much guaranteed. Increasing the gap (savings) between what you think will happen (a steady income) and what can happen (a job loss) is how you can handle it. By having a solid savings you can handle randomness and error.
In other words, you want to avoid a single point of failure - if something relies on one thing working, and that thing breaks, you are counting the days to catastrophe. In life you want to avoid this as well. It's why we typically carry a spare tire in our cars, or why you may want extra batteries in your house for the smoke alarm. It's why leaving early to allow time for delays is a good practice. Any way for you to create more room for error is better.
Don't Screw Up
I don't mean be afraid of taking chances and fail. If you do that then you'll never take risks and may avoid big payoffs. It's more about not screwing up constantly. In the book Housel says that good investing isn't necessarily about making good decisions. It's not even about making amazing decisions. It's about consistently not making bad decisions. It's the difference between getting wealthy, which is all about risk and staying wealthy which is more about the survival mindset.
There are several ways to do that: plan, leave little room for error, and be optimistic about the future but paranoid about what will prevent you from getting to the future. In life it's realizing that having a realistic level of optimism is healthy. But also being cautious about what could prevent you from your future is important. You want to focus on having a good average of good decisions.