Understanding the psychology of money

Investing is not the study of finance. It is the study of how people behave with money.

So said Morgan Housel, a behavioural finance expert based in the USA, at the recently held Allan Gray Investment Summit. This virtual event brought together local and international investment managers and other finance experts to share their perspectives on how to make sense of the current environment and invest for the future.

“As counterintuitive as it may seem, investors can learn the most about the risks in today’s world by looking at stories that, mostly, have nothing to do with investing,” said Housel.

Below are his top money rules from everyday stories.

1. Timing is meaningless, but time is everything

“The central trap investors fall into is underestimating the amount of time needed to put the odds of long-term success in their favour,” said Housel.

He illustrated this by looking at the returns of the US stock market over 10- and 20-year periods from 1871 to 2012, which ended in a positive real return every time.

“And yet, most investors who tell you that they are long term are talking about one or five years,” said Housel. “The golden rule is that when progress is measured generationally, results shouldn’t be measured quarterly.”

He explained that many things about investing, including compounding – which can only happen if you invest and forget – may not seem intuitive.

“Warren Buffet accumulated 99% of his wealth – about US$120 million – after he turned 65, which means that his net worth is tied to the length of time he has been investing. His secret to success is that he has been investing for 80 years. If he retired at 60, you would have never heard of him.”

2. How to be happy: Get the goalpost to stop moving

“If your expectations grow faster than your income, you will never be happy with your money. This is because it is not your circumstance, but rather your expectations relative to your circumstance that matters most,” said Housel.

He told the story of Stephen Hawking who at the age of 21 was diagnosed with motor neuron disease, which left him paralysed and without control over his body. Hawking was once asked how happy he is with his life, to which he replied: “My expectations were reduced to zero at age 21 and everything else was a bonus.”

Another example of disproportionate expectations relative to experience, can be understood when looking at the 1950s.

“Many baby boomers will tell you that this was the best economic time ever recorded in the USA. The future appeared to be astonishingly bright but, in reality, the average home was 37% smaller than that of today, and workplace deaths were three times higher. The average household in the USA today – adjusted for inflation – is twice as wealthy.”

So why the belief that the 1950s was great?

“There was very little inequality. It was easy for people to keep their expectations in check, because there were not tons of wealthy people inflating the expectations of what a good life is meant to be; there were no CEOs earning much more than the workforce; and there were no billion-dollar hedge fund managers,” explained Housel. “Today our income has doubled, but so too have our expectations.”

3. Risk is what you don’t see

“The biggest risk is often the one no one sees coming,” said Housel. “How risky something is depends on whether you are prepared for it.”

He told the story of the famous escape artist, Houdini, who would invite the strongest man in the audience to join him on stage and punch him in the stomach. It did not matter how strong the man was, but he was never able to get Houdini down. But, when Houdini invited students to visit him backstage, one of them punched him so hard in the gut, that he later died after his appendix ruptured.

“He survived the world’s biggest risks because he was planned and practiced. But he couldn’t survive the one that he didn’t see coming.”

Housel said history shows that the real risks in the global economy come from surprise events, like Pearl Harbour, September 11, the 2008 financial crisis, with no better example than the COVID-19 pandemic.

“The biggest economic risk is the one that no one is talking about, because if no one is talking about it, then no one is prepared.”

How should you think about risk in today’s upside-down world?

“Think about risk like California thinks about earthquakes: Instead of trying to forecast when the next earthquake is going to happen, they understand that it can happen at anytime, so they are always prepared for it. In other words, don’t try to predict or forecast a recession, for example, expect that it is going to happen given history, and prepare for it.”

4. Understand the difference between getting rich versus staying rich

“Getting rich means being optimistic, taking chances and risks. Staying rich requires a degree of pessimism and paranoia, and the understanding that history is a continuous chain of disappointments; bear markets, pandemics and recessions; and that you need to survive long enough for your long-term optimism to pay off,” concluded Housel.

 

Source: MoneyMarketing