The Psychology of Money

18th Sep 2021

In March 2020, there was a huge drawdown due to the pandemic. My portfolio in StashAway was also affected. Although the amount was small, I felt compelled to sell off my investment. I knew I wasn't being rational, but it was difficult to resist that urge.

I realised then that I cannot manage my money without taking into account my own biases. It is impossible to separate my emotions from how I handle my finances. However. finance is often portrayed as a science. You can build mathematical models, backtest your investment thesis, etc. There is a ton of research in this field.

"The Psychology of Money" doesn't approach personal finance from a completely rational perspective. Instead, it explores how we think about money, and how that affects the way we manage our finances. I have learned a lot from reading this book, here are some of my takeaways.

No One's Crazy

People should make investment decisions based on their financial goals and what's available to them at the time. Theoretically, this makes sense.

However, economists Ulrike Malmendier and Stefan Nagel discovered that people's lifetime investment decisions are actually heavily influenced by the world around them at that time. For example, if you grew up during a time when inflation was high, it is likely that you would invest less in bonds (as inflation adversely affects bonds).

What this tells us is that every decision we make with our money is justified. We make them based on what we know right now, with our unique mental model of how the world works. This allows us to be more understanding of the different financial decisions that people make.

Never Enough

We invest because we want to be rich, simple as that. But how much is enough? The author cited numerous examples of wealthy, and successful people who flout the laws to pursue more. They had no sense of what was enough.

There will always be someone we can compare ourselves to, it is important that we identify our metaphorical goalpost, to know what is enough for us, so that the goalpost doesn't keep moving forward.

Wealth is What You Don't See

When Morgan Housel worked as a valet, he admired many fancy cars, but not the person driving them. The paradox of the man in the car is that while he believes people admire and respect him, it is more likely that these people are impressed by the fancy car, not the man himself.

However, wealth is NOT the fancy car purchased. What it instead tells us is that the person is now worth (Price of COE) + (Depreciation) + (Car Insurance) + (Misc.) less.

Wealth is the financial assets that weren't liquidated. This is difficult to grasp. We tend to judge whether a person is wealthy, by what we see, because that's the information available to us.

Aim to be Reasonable, not Rational

A heuristic that we can use when we make financial decisions is to ask ourselves this question: "Will I be able to sleep soundly at night?". Our mental models are different. What is reasonable to us may not be reasonable to someone else.

It is rational to use leverage to invest in a broad index ETF or index fund, considering how the market trends upwards over time. This strategy could be reasonable to some people, but to others, they may not be able to watch their investments dip drastically (due to leverage) and have the stomach to continue with the strategy.

The important thing is to do what works for you, as long as you stay invested.

I highly recommend this book to anyone who just started investing. Personal finance is a very nuanced field. There isn't a single optimal solution that is applicable to everyone. This book has helped me to make better financial decisions by taking into account my own mental model and circumstances. among other things. Most importantly, I learned how to be more understanding toward other people's financial decisions.