Are you panicked about the economy? Anecdotally, people don’t seem quite as worried as in past downturns. Maybe we haven’t hit the bottom? Perhaps people are better educated about economic cycles? Who knows. The psychology of money can be confounding, but trying to understand how it works can be critical for your financial wellness – how you feel about your money and the actions you take.
Understand the Psychology of Money for Financial Wellness in 2022 (and Always)
In 2020, Morgan Housel — an award winning writer, former columnist at The Motley Fool and the Wall Street Journal, and a partner at the Collaborative Fund – published The Psychology of Money: Timeless lessons on wealth, greed, and happiness. The book was heralded as an “essential read” for anyone interested in making smart financial decisions.
Given the economy today, we thought it was worth revisiting a handful of key lessons from the book.
As Housel told Steve Chen on the NewRetirement podcast, “To me everything I’ve learned about money, whether it’s personal finance, or investing or running a business, is that it’s not a math based field. It’s a soft social sciences based field. It’s closer to psychology and sociology and history. What’s going to separate the good from the bad, from people who do really well and people who do really bad, is not your intelligence. It’s not your education. It’s not your IQ. It’s whether you keep control over your emotions.”
Housel is known for being an engaging, graceful, informed, and accessible writer and the book, The Psychology of Money, is well worth the read. He offers insights on financial decision making and illustrates his wisdom with interesting anecdotes.
However, here are just a few of some of his important lessons to help you navigate a looming recession, inflation, the prospect of additional stock market downturns, or whatever economic surprises may be in store.
Your motivations for spending, saving, and earning are unlike anyone else’s. And, that is okay.
Housel told Steve, “We’ve seen different things. We have different circumstances, we have different goals, and therefore there is not one right answer that is right for me and right for you and right for anyone else. I think that it’s discouraging for people. It’s hard for people to accept that.”
He continued, “When people want to think that there was one right answer they want to think we’re debating this is algebra. There should be a right answer and if we’re coming to different answers is because one of us is wrong. I just don’t think it’s like that whatsoever.”
For example, while Housel generally recommends index funds for investments, he acknowledges that some people like additional risk and enjoy speculative investing. That’s okay, have fun (just maybe not with the money you need. Play with a slush fund, not the majority of your assets.)
This may sound shocking, but Housel believes that there is not much you need to know to manage your personal finances efficiently. In fact, in some ways, the less expert you are, the better.
He explained, “There’s no other field in which someone with the best education, someone who went to Harvard Business School and works at Goldman Sachs, and then goes to work for Bridgewater, one of the best hedge funds, that person can under perform someone who didn’t go to college and knows nothing about investing but just dollar cost averages and does a bunch of index funds. There’s no other field where someone with no training and experience can outperform someone with the best training and experience.”
You see, index fund investing (investing in the whole market as opposed to individual or a basket of individual stocks) has historically outperformed actively managed accounts (accounts where someone is trying to buy and sell individual stocks to beat the overall market). The fees are generally significantly higher on actively managed accounts as well.
Effective money management when you are working and accumulating assets is astoundingly simple: Earn. Spend less than you earn. Invest.
Housel told Steve, “Live below your means, diversify, be patient and that’s it. I don’t have anything else to tell you.”
He continued, “Just basically live below your means so you save money and ideally save as much as you can 10 or ideally 50% of your money. Invested it in an abroad index fund. Keep fees low, rebalance on some regular basis or automate it. Do that for 10 or 15 years and you’re going to be financially comfortable maybe financially independent.”
It is easy to think that the psychology of money is complex or nuanced. It isn’t. The answers are fairly simple.
Housel admits to making the “wrong” financial decisions himself, simply because they are the “right” choices for him.
He describes one example, “On a spreadsheet this [an investment] is wrong and my response is, I know it’s wrong I know it’s not efficient but it works for me and it helps me sleep at night which is my only goal.”
He continued, “I think the more that people can embrace that this [personal finance] is a messy field with no right answers and your only goal should be to find something that works for you and helps you sleep at night, not what maximizes your returns but just helps you sleep at night, I think once people embrace that then a lot of the problems that they face in money and investing become a lot clearer.”
Reflecting on the reasons behind your financial decisions is critical to your financial success. However, as with emotions where some people need a psychiatrist or counselor to help analyze their own feelings, sometimes it may be useful to have a financial advisor to help you acknowledge your motivations for financial decisions.
You can’t predict the future. Trying to do so is futile.
Housel quotes the great author, Nobel Prize winner, and psychologist, Daniel Kahneman, who said, “The correct lesson to learn from a surprise is that the world is surprising.”
He explained, “When you are surprised [by an economic event], the lesson is not, what did we learn about market dynamics? No, what we learned is that the world is surprising. The future is going to be as surprising as the last four months have been. That’s the lesson. That’s the takeaway. The next four months can be as unpredictable as the past four months have been. Of course, that’s the case. It’s disheartening to think about it like that. But well, of course, that’s true we could have a bigger surprise during the rest of the year than we’ve had so far this year.”
One of the most persistent problems with the psychology of money is that financial knowledge is almost no match for emotion.
Housel makes the point that having read about or knowing about something is quite different from experiencing something. The actions you think you might take when considering a stock market crash are actually quite different from what you will actually do in the midst of a stock market crash.
He makes the point that it is hard to imagine the full context of an economic downturn, it typically isn’t just a downturn in stocks, it is also the overall state of the world and your personal circumstances. Myriad factors can have an emotional impact on you to make an emotional decision, even when you logically know the right things to do.
So, what are you supposed to do with economic surprises? Plan to be flexible. Plan conservatively. Plan for your own priorities.
Housel explained, “If the market falls 30% it is not good.” But, he elaborated that it is not like when an airplane has catastrophic engine failure and the plane is going down. If that happens, you probably want to jump out of the plane with your parachute on.
Housel cautioned, “When a market falls, you need to remember that a 30% decline is normal historically. It happens about once per decade on average. Then when it happens, it’s not fun, but you’re like, ‘Okay, I knew this is going to happen, I expected this to happen.’ It’s not fun but it’s okay. This is the process.”
The future is unknown. However, many people think that building a financial plan means betting on a certain combination of outcomes. But, that is simply not realistic.
Housel pointed out, “Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right.”
His advice? Leave room for error in your plans. He cautions, “Room for error—often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline—anything that lets you live happily with a range of outcomes.”
Maintaining a written financial plan is proven to:
- Improve financial decision making
- Make you feel better about your financial situation
- Boost financial outcomes
Housel advises flexibility. He also recommends that you have a plan b. And, maybe also a plan c, d, e, and f.
He said, “Planning is important, but the most important part of every plan is to plan on the plan not going according to plan … “
The NewRetirement Planner is the best tool for anyone interested in a flexible plan A (and Plan B). You can create multiple scenarios and figure out how to fund the life you want in almost any economic scenario.