The irrational human factor behind finance: A Reflection on Morgan Housel’s “The Psychology on Money”

“The Psychology of Money” draws a distinct comparison between the ideas of “money” and “personal finances.” Though they might seem similar, they are often disordered in our minds, especially by the frenzy of information that pervades modern society through incessant news coverage and contrasting social media opinions. The first, money, is a social indicator and earmark that everyone can recognize, since the inception of modern currency in the Persian and Ancient Greek Empires by King Alyattes (Alram, 2012). The latter, the concept of personal finances, is a topic that stems from the first and is one that is constantly on our minds but rarely discussed between us and surrounded by a veil of personal privacy. This is because we all have a very specific relationship with our personal finances, highly rooted in our past experiences, resulting in incredibly diverse execution of the assignment of value, habits and behaviors we exhibit.

Morgan Housel gives his unfiltered perspective on personal finances, investing and business decision-making. He draws interesting comparisons between his personal understanding of finance and the historical way the industry is taught in traditional (or “textbook”) education. Finance has long been regarded as a quantitative field, where fluency in Excel and a strong understanding of mathematical concepts are the paramount skills needed to identify and select promising investments. Housel, however, regards the key skills to be a successful financier as the more interpersonal “soft” qualities — the ability to strike a deal over dinner or discerning a good investment from a bad one by analyzing the people-driven values. Although mathematical acumen is necessary to fully comprehend the intricacies of financial markets, Housel repeats his thesis all along the book: people are more important than numbers. He does make many convincing arguments to back up his overarching claim, and the way the book is structured (with 20 separate chapters each explaining an important lesson) compliments his tendency to return and reinforce his thesis. There is a strong sense of interconnectedness across each lesson the book gives, and this is particularly welcoming for readers who might not know too much about the world of finance. After reading the book and evaluating its lessons, my thesis stands slightly different from Housel’s. Although his argument is undoubtedly valid, I believe that he oversimplifies the redundancy of mathematical acumen in finance — in my opinion this type of fluency is just as necessary in the world of investments as the case Housel makes for interpersonal skills.

One of the topics he covers is the unique understanding of finance everyone has, given their prior experiences. This, in my opinion, is the key driver behind people’s confusion between concepts of “money” and “personal finances.” He uses the example of the Great Recession — most people alive did not live through this period, and those who did might have different perceptions towards investing (perhaps more risk-averse than someone who lived through a long period of economic growth). Hence, Housel argues that we must not judge people’s investing activities due to us not fully comprehending the experiences that made them take certain actions. A more up-to-date example posterior to the publishing of the book could be the current global economic climate defined by rising inflation and hands-on approach from the FED towards interest rate hikes. Our experiences are a result of our anchoring bias, and there are no “wrong” or “right” experiences — but instead so many different cases. Hence, attempting to fully comprehend others’ experiences is futile: “Your personal experiences with money, or anyone else’s, make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you, or they, think the world works” (Housel, 2020). The world’s financial panorama is an ever-changing combination of trends and relying heavily on our experience means that we are basing our decisions on our beliefs about an “outdated” world.

The anchoring bias that Housel describes in this chapter is something that I personally absolutely agree with. Given how much importance humans place on proportions and numbers, it is quite unbelievable how much value we place on our own experiences as if they were the only ones that ever mattered. As Housel says, they represent a miniscule grain of sand in a beach of different scenarios across history. Placing the amount of weight on them that we inherently do is simply irrational. This is the strength of Housel’s argument at many points in the book: using the obsession we have with interlinking numbers and finance, while “flipping” the statistics around to make us see the irrationality our reasoning is based upon.

Another claim Housel makes is that we must avoid not factoring in luck into our decisions. Although luck is by nature impossible to predict and difficult to accurately implement into our decision-making process, we must prepare for the swings of it and try to estimate where and when it might occur. To support this point, he uses the example of Bill Gates. He is undoubtedly one of the most renowned businesspeople in recent history, as well as one of the most important pioneers in the technology space. This, of course, was largely part due to his individual talent and effort. However, he also happened to attend one of the only high schools in the U.S. which owned a computer with enough processing power to handle basic software programming systems at that time. This fact enabled him to continue honing his programming skills, gaining a competitive advantage over other young programmers at the time who did not have access to a computer on school grounds. Housel again uses numbers to feed our need for numeracy when evaluating finance: “In 1968, there were roughly 303 million high school-age students in the world according to the UN — 8 million of them lived in the US — 270,000 of them lived in Washington State and only 300 of them attended Lakeside School. This means that one in a million high-school-age students had the chance to attend the high school. Bill was just one of them” (Housel, 2020), (United Nations, 2015). This is not to discredit Bill Gates’ career, but it is important to assess the accidental impact of actions outside of our control, which often have a greater influence than our conscious decisions. Considering the role this kind of luck plays in business by focusing less on specific case studies and individuals and instead identifying broad trends and patterns will help us identify how we can, to an extent, manipulate luck to our will.

Risk, as Housel puts it, is the “sister” of luck. He argues they are closely linked — for each one-in-a-million stroke of luck, there is always an action taken that is seemed to be almost certainly safe, yet the unthinkable one-in-a-million probability of risk becomes reality. To explain this, Housel builds on the Bill Gates example, and talks about the unfortunate death of Kent Evans, one of Gates’ high school friends: “Evans was as skilled with computers as Gates and [Paul] Allen. “We would have kept working together. I’m sure we would have gone to college together.” Kent would have been a founding partner of Microsoft with Gates and Allen. But it would never happen. Kent died in a mountaineering accident before he graduated high school. Every year there are around three dozen mountaineering deaths in the US. The odds of being killed on a mountain in high school are roughly one in a million” (Housel, 2020). Housel’s argument here is that Gates and Kent were set on exactly the same path, but the same force in the same magnitude happened to work in the opposite direction, causing this unexpected yet interlinked set of outcomes.

In my opinion, this is where Housel’s argument loses some potency by basing itself on a coincidence as opposed to a quantifiable outcome. One thing would be saying that luck and risk are related, something that I would wholeheartedly agree with — many times a risky decision leads to a great payoff based on the idea of a chain of unlikely occurrences taking places — or in other words: luck. This, in my opinion, is not to say that an event of “unluckiness” of the exact same proportion will happen to another stakeholder. The nature of luck and risk, as Housel even mentions, is that it is so unquantifiable and unpredictable, it is simply just impossible to integrate into our decision-making even if we’ve planed and accounted for everything: “Risk is what’s left over when you think you’ve thought of everything” (Housel, 2020). Attributing percentages and putting them on a spectrum, as Housel later does with the Gates and Kent example, invalidates his own prior reasoning. If these two things are so inexplicable, surely there would be no use in attempting to draw comparisons and explain the interlinked cause of these events. Although the Gates example is a great instance of being at the right place at the right time and what it means in terms of “luck”, I think it is unfair and even irrational to compare it to the unfortunate fate of Kent.

Housel also talks about the difference between obtaining new financial gains and growing our already existing wealth. Gaining new money requires a combination of risk-taking and optimism. Keeping and growing wealth already under our possession requires the opposite: humility. The most successful investors that have been around for a long time have focused on becoming financially unbreakable rather than chasing after fast, big returns. Having the expectation that your plan will probably not quite go according to plan allows us to have a strong grasp of a very underappreciated force in financial investing: our margin of safety. A frugal budget, flexible thinking, and a loose mindset that places importance on consistently not making wrong decisions are the three pillars to investing with humility. Investing well also revolves around remembering the laws of probability distribution. People often focus discussion about the very best financiers — the ones who took an outlandish bet and enjoyed an enormous payoff. These kinds of people and events are the result of a tail event, according to Housel. Long tails are the farthest ends of a distribution of outcomes, and these have a tremendously big impact in finance. Outlying one-in-a-million events often take up all our attention, when in reality, the rules of probability state that you can be wrong just under half of the time, and still make a fortune.

He likens this theory to an index fund, or a venture capital fund. Venture capitalists know that their investments are inherently risky. Most startups will fail 24 months from inception, and yet they still take risks on these young companies, showering them with capital and expertise. Their investments are governed by one of the most important rules of investing: a winning investment strategy will always have failures regardless of risk, but it is the big wins that will equate to a positive return on a portfolio. Out of 20 investments in startups, a venture capital firm can expect 12 of these to fail altogether. 6 or 7 of these might break even with their initial investment, perhaps even give them a little extra profit. But 1 or 2 of them will grow 20x and above, exponentially defying all expectations and wiping out all the other losses they took. Housel claims people should stop assigning all their attention to these tail events, and instead appreciate their rarity and magnitude, while remembering that most investors will never be part of one of these tail moments yet still have a very successful track record. However, he also acknowledges the underlying importance of these tail events: all financial markets and decisions are in one way or another based on these outlandish tails.

To criticize the way he approaches this explanation, it could be seen as slightly counterintuitive. He carries truth when he makes both claims: tails drive financial decisions; yet don’t obsess over tails, but the way in which he presents it is quite convoluted to someone who might not be an investment guru. It is human urge to obsess over anomalies, such as betting on the underdog in a crazy sports game where they end up taking the win with the odds stacked against them. Maybe a way of describing his argument using a comparison such as betting on the underdog would have been more suitable. You should bet on the safe choice 9 times out of 10 (the team with the favoring odds of winning) but be comfortable with chasing a tail outcome 1 times out of 10 (betting on the heavy underdog). Your returns will be much like those of an index fund, with a compound positive outcome, but welcome to take on a certain degree of risk in chase of an outlandish “tail” outcome.

Housel also tries his hand at the everlasting debate revolving around whether money brings happiness. His argument is very reminiscent of a famous 1984 book called “The Sense of Wellbeing in America” that describes the evolution of the American consumer and how he or she is rewarded by their work and spending, by Angus Campbell: “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” (Campbell, 1984). Housel uses Campbell’s claims to support his own — people often get greedy and forget about money’s greatest intrinsic value and highest paying dividend of all: “The highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want today.”” (Housel, 2020). If your money gives you complete control over your time, then you have reached the ultimate goal of investing. In other words: avoid being caught up in how much more you can invest and make, as once you have this control over your time you will be reaping the highest rewards financial gain and investing can give. Housel eventually concludes that you must draw a line around your wealth when you are content with how much you have. He uses the analogy of moving goalposts; as we get older and our careers progress, it is normal we make progressively more money year on year. And it is also perfectly reasonable for our “contentedness boundary” to also inch further — after all, if we are making more money, it is okay for us to want a business upgrade on our plane ticket; when our desire to have more children grows, we must pay for an extra child’s education and other expenses. He says that we reach our goal of being content when this goalpost stops moving.

In my opinion, this is an excellent take on an often-discussed topic. The analogy of goalposts serves to illustrate the internal battle most of us partake in when attempting to fight the urges of greed embedded in human nature. For someone who has not yet earned a full-time income, it is difficult for me to weigh into this debate and give my own perspective. I am lucky enough to have been supported by my family so far — but I have often thought about the balance between money and work and how to satisfy my needs and wants. Housel’s analogy serves as a great reference point when I begin my profession career.

In conclusion, investing is a game, and everyone is playing it differently. Investors’ downfalls often come from paying excessive attention to financial cues from other investors who have a different gameplan, as well as the deep pitfall of greed. The key example lies in living through financial bubbles and the resulting experiences; and how damaging they can be when long-term investors who have their own gameplan begin taking cues from short-term investors attempting to beat one another. Understanding your own horizon and sticking to your gameplan (which is tailored to your own needs) goes a much longer way than paying too much attention to what others are doing. This is my own takeaway from the book and ties into Housel’s neat interpretation of numbers in the “0.0000001% experience” example. Removing these irrational biases from our financial planning is extremely difficult due to our deep-rooted beliefs, but it might be our saving grace. To contrast Housel’s arguments, I do also believe you must have an additional “textbook” approach to finance. Know what quantifiable factors affect rates of return and be able to discern a good investment given mathematical metrics. However, in harmony with Housel, don’t let this “traditional” approach be the sole driver to your gameplan — use it in tandem with the interpersonal approach. And most importantly pay attention to luck, but don’t attempt to quantify it or let it govern your decision-making. Accept its volatility — and you might very well become the next Bill Gates.

References

· Alram, Michael. “The Coinage of the Persian Empire.” Oxford Handbooks Online, 2012, https://doi.org/10.1093/oxfordhb/9780195305746.013.0005.

· Campbell, Angus. The Sense of Well-Being in America: Recent Patterns and Trends. McGraw-Hill, 1981.

· Morgan, Housel. The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness. Ingram Pub Services, 2020.

· United Nations. “#YouthStats: Education — Office of the Secretary-General’s Envoy on Youth.” United Nations, United Nations, 2020, https://www.un.org/youthenvoy/youth-statistics-education/.