Financial wellbeing is not just about budgeting skills; it also has to do with how people view money positively and negatively. Since the 2008 global financial crisis, Morgan Housel, a former contributor for The Wall Street Journal and author of The Psychology of Money, has been writing about the psychology of money. Housel argues that our approach and knowledge of money are dominated by physics’ rules and laws, with little emphasis on psychology’s nuances and emotions.
Housel explains that financial decisions are not made using spreadsheets, but rather they happen in conference rooms and dinner tables where various personal factors such as individual histories, worldviews, egos, pride, and motivations come into play. Housel has identified two tools and four lessons from his book on the psychology of money that are helpful.
First lesson: No-one is crazy
The first lesson is that nobody is crazy; everyone’s financial journey is distinct. Our views on money and how the world operates depend on age, region of birth, family, economy, and job market, among other things. While we may view money management differently, our experiences shape how we perceive it. Housel concludes that our unique experiences inform our decisions, and what may seem foolish to one person may make sense to another.
Lesson 2: Chance and danger
The second lesson is that luck and risk play a significant role in financial outcomes, making the financial world too complicated to rely solely on effort and choices.
According to Housel, our financial outcomes cannot simply be attributed to our efforts and choices due to the complexity of the world. We often overlook the impact of luck and risk because they are difficult to measure and accept. Housel cautions us to keep this in mind when judging others and ourselves.
It’s common for us to blame other people’s failures on their poor decisions, while attributing our own failures to the risks we took. We often try to emulate successful people and avoid those we perceive as failures. However, Housel warns that focusing on individual cases can be misleading, as extreme results are more likely to be influenced by extreme levels of risk and luck. Housel advises caution when making judgments about people based on their financial failures or successes, and instead of looking for general trends to find lessons to put into practice.
Lesson 3: There is never enough
The third lesson is that social comparison often makes people feel inadequate, and getting the goalposts to stop moving is the toughest financial skill to learn. In modern capitalism, there are two things it excels at: making people rich and inducing envy. Social comparison often makes us feel inadequate. Meaning, we often sacrifice what we have and need for what we lack.
Regardless of the potential reward, we should never put our reputation, independence, freedom, close relationships with family and friends, or our happiness at risk. Our best chance of preserving these things is to know when to stop taking risks that may jeopardise them or recognise when we have enough.
Tool #1: Choosing how much is enough
Begin by identifying what in your life would be too difficult to lose. Write down these things and commit to never putting them at risk to pursue more money.
Take a moment to reflect on any subconscious comparisons you make between yourself and others. Do you feel worse about your financial situation after scrolling through social media? Do you feel pressured to keep up with others?
If you have been working for a while, it’s likely that you have received pay increases or changed jobs for a higher salary. Did your lifestyle change with each pay raise? Did you start saving more money? If you experienced “lifestyle creep,” take a moment to reflect on whether it actually made you happier. If it didn’t, decide that any future pay raises will go towards investment savings.
To help you stick to this decision, set up an automated transfer from your salary account to an investment savings account. This will prevent you from impulsively spending the extra money.
Lesson 4: Compounded errors
The fourth lesson is compounded errors, where our brains are not designed to deal with absurdities such as Warren Buffet’s $84.5 billion net fortune, with $81.5 billion acquired after he turned 65.
Growing on growing refers to the compounding effect, which is the idea that a small amount of money can grow significantly over time through the power of compounding. However, according to Housel, we often undervalue what is possible with compounding because it seems illogical. He points to Warren Buffett, known as the “Oracle of Omaha,” as an example of the power of time and compounding. Despite not having the highest average annual returns, Buffett’s exceptional performance is due to his long-term investing approach, which started when he was just ten years old and has continued until now, at the age of 90.
Housel emphasises that anyone can use the strategy of compound growth through investment, but the key is to start as soon as possible. He cautions against focusing solely on getting the best returns, as this is not the goal of good investing. Instead, the goal should be generating reasonable, consistent returns over an extended period of time. Tool #2 is to understand the power of compounding, and to do this, Housel suggests using a compound interest calculator like the one on MoneySmart.
To illustrate the power of compounding, Housel presents a scenario where a person starts investing at age 25, making regular monthly deposits of $200 after an initial $500 deposit. Assuming a yearly interest rate of 8%, the historical return for the stock market, the person would have over $700,000 by age 65. The key takeaway is to recognise how much of this growth comes from interest and to appreciate the magnitude of this growth over time.
Let’s change the circumstance now
Lets imagine a scenario where you accumulate credit card debt in your twenties and delay starting your investment portfolio until age 35. What will your savings look like when you turn 65? Are you surprised that it’s less than half of what it could have been?
Now, consider another scenario. You start saving at 35 but decide to increase your monthly contributions because you realize you’re behind schedule. Will you catch up to what you could have saved if you started at 25? Doing the math, you’ll see that even if you pay in twice as much for the entire period, you’ll come close but still fall short.
What’s the lesson here? Starting to invest early, even with a small amount every few weeks or months, can make a huge difference in the long run. To be truly amazed, run the numbers starting at age 15. This insight can also influence the financial education you provide to your children. By starting to invest early and minimizing credit card debt, they have a good chance of becoming wealthy in the future.
The Bottom Line
To achieve financial wellbeing, Housel offers two tools. The first is to choose how much is enough and write down what would be too painful to lose in life, decide not to risk these things for more money, and be mindful of social comparisons. The second tool is to avoid “lifestyle creep” when one receives a pay increase by setting limits on spending and investing the extra money automatically.
In conclusion, financial wellbeing requires more than just budgeting knowledge. It involves understanding and managing the psychology of money, making informed decisions, and being mindful of social comparisons, risks, and luck.
Author Teresa Coffey
Reference:
Housel, M. (2020). The Psychology of Money: Timeless lessons on wealth, greed and happiness. Harriman House Ltd.
Posts
0 Comments