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The Psychology of Money
Timeless lessons on wealth, greed, and happiness
The Great Depression of the 1930s is a well-known event that caused widespread economic decline and suffering. However, not all Americans experienced it in the same way. For example, John F. Kennedy’s wealthy family actually grew richer during the Depression. The way we experience the economy and money is unique to our individual circumstances, and it shapes our financial worldview and decision-making. Even wealthy individuals can have vastly different experiences and lessons learned depending on their personal background and historical context. It’s important to recognize that our knowledge of the economy is limited, and this understanding is crucial to understanding the psychology of money.
Economists often rely on the assumption that individuals make rational decisions that maximize their returns, but the reality is messier. For example, low-income households in the US spend on average $411 on lottery tickets each year, despite struggling to come up with $400 in emergency funds. While this behavior may not be rational, it is understandable given the desire for a chance at a better life.
A 2006 study by economists Ulrike Malmendier and Stefan Nagel found that personal history, particularly what the economy was doing during an individual’s early adulthood, influences financial decision-making. For example, if inflation was high during this time, individuals were less likely to invest in bonds later in life. Similarly, if the stock market was strong during early adulthood, individuals were more likely to invest in it later on. These decisions are often based on gut instincts formed early in life and may not change even when faced with contrary evidence.
In essence, the economic concepts we use today are relatively new compared to other aspects of human life, such as the domestication of dogs. Money has been around for only a few thousand years, and many of the fundamental financial concepts that we take for granted, such as retirement and the 401(k), are less than two generations old. As a result, we are still learning how to handle money effectively and make sound financial decisions. It’s not surprising that we sometimes struggle with financial planning and decision-making, given that these concepts are still in their infancy.
Understanding the role of luck in financial outcomes is crucial for making informed decisions. While we tend to overestimate our own abilities and downplay the role of luck in our success, we are quick to attribute failure to the flaws of others. This is partly due to our cultural obsession with success and our tendency to celebrate those who have gotten lucky, even if they are not particularly skilled or responsible.
Building randomness into financial models is important because luck can play a significant role in outcomes. However, it can be difficult to quantify the extent to which luck is responsible for a particular success or failure. While we may not be able to fully account for the role of luck, it is important to recognize that it is a factor and to incorporate it into our decision-making processes.
Focusing on broad patterns rather than specific cases can be a useful approach when it comes to making financial decisions. By analyzing common patterns of success and failure, you can gain a better understanding of the factors that tend to lead to good or bad outcomes. This can help you make more informed decisions that are more likely to work out well.
It’s also worth keeping in mind that luck can play a significant role in financial outcomes, and it’s often hard to predict or control. While you can certainly try to make smart decisions and take calculated risks, there’s always a degree of uncertainty involved. By focusing on broader patterns rather than specific cases, you can help reduce the impact of luck on your financial decisions and increase your chances of success.
Envy is a natural human emotion, but it can become problematic when it leads to irrational behavior and poor decision-making. As illustrated in the example of Rajat Gupta, the desire for more wealth and success can lead people to engage in illegal or unethical practices that have serious consequences.
One way to mitigate the negative effects of envy is to focus on gratitude and contentment. Rather than constantly comparing oneself to others and wanting what they have, it can be helpful to reflect on what one already has and appreciate the good things in life. Practicing mindfulness and being present in the moment can also help cultivate a sense of gratitude and reduce the tendency to chase after more and more.
Additionally, setting realistic goals and expectations can help avoid the trap of insatiable greed. It’s important to recognize that there will always be people who have more than we do, but that doesn’t mean we can’t be happy and fulfilled with what we have. By focusing on personal growth and improvement, rather than external markers of success, we can create a more meaningful and fulfilling life for ourselves.
It’s true that getting rich and staying rich are two very different things, and the story of Jesse Livermore is a cautionary tale for anyone looking to build and maintain wealth. While making money often requires risk, optimism, and courage, keeping it requires humility, perseverance, and a healthy dose of fear.
Many successful entrepreneurs and investors have a healthy respect for risk and a deep understanding of the potential downsides of their decisions. They recognize that luck plays a role in the success and that past performance is not a guarantee of future results. Instead of getting overconfident and taking larger and larger risks, they stay focused on their long-term goals and remain disciplined in their approach.
For those looking to build and maintain wealth, it’s important to remember that there are no guarantees in the world of finance. Market crashes, economic downturns, and other unforeseen events can wipe out fortunes in a matter of days. But by staying humble, persevering through tough times, and maintaining a healthy respect for risk, it’s possible to build a lasting legacy of wealth and success.
Heinz Berggruen’s success as an art collector was a result of buying vast quantities of art and holding on to them for a long time, even though the majority of his acquisitions turned out to be duds. His strategy was to evenly spread his risks across a wide range of investments, much like an index fund. This approach allowed him to wait until a few winners emerged, at which point the value of the entire collection converged upon the return of the best elements in the portfolio. This principle, known as the long tail, applies to all investments and suggests that when you get a few things right, you can afford to get more things wrong. Failure is inevitable, but what really matters is the nature of your successes. In short, having a diversified portfolio and holding on to your investments for a long time can be key to success in investing.
Final Summary –
Financial decision-making is a lot messier in the real world than it is in economics textbooks. Lots of decisions – like buying lotto tickets when you’re broke – aren’t rational, but they do make sense in their own way. The same goes for investment choices, which are often driven by people’s formative experiences of the economy in early adulthood rather than cool appraisals of current market conditions. Put simply, financial calls are entangled with psychological factors. So what’s the best way forward? Well, accept that luck plays a role in success, learn to fear losing what you already have, and hedge your bets.
To add to that, it’s important to recognize that emotions and biases can influence financial decision-making, and it’s essential to understand and manage them to make sound choices. Additionally, diversification is key to hedging your bets and reducing the risks associated with investing. Finally, it’s crucial to have a long-term perspective and avoid making impulsive decisions based on short-term market fluctuations.
About the Author –
Morgan Housel is a partner at The Collaborative Fund. He is a two-time winner of the Best in Business Award from the Society of American Business Editors and Writers, winner of the New York Times Sidney Award, and a two-time finalist for the Gerald Loeb Award for Distinguished Business and Financial Journalism. He lives in Seattle with his wife and two kids.