When I think back to Finance 101, what I recall, more than anything, is formulas—a whole lot of formulas. First came the calculation for present value, then formulas for valuing bonds, stocks, options, futures, forwards and all sorts of other financial instruments.
This was interesting. But with each passing year, I’ve come to realize that this introduction to finance was also incomplete. It was incomplete because—to state the obvious—the real world doesn’t always adhere to formulas. Yes, the prices of financial assets are connected in one way or another to these formulas, but the connection is often loose, at best. And sometimes the connection becomes so frayed that it’s nearly impossible to see.
Why is this the case—why don’t the prices of investment assets more closely follow their respective formulas? The reason, in a word: people. Or to be more specific: people and their emotions. If you really want to understand finance, those formulas are helpful—and I don’t discount their value—but equally important is an understanding of psychology. And for that, there may be no better guide than Morgan Housel’s recently-published The Psychology of Money. This book offers many useful ideas. I’d like to highlight four in particular that may be helpful as we enter the new year:
On the topic of risk, Housel provides a timely warning as well as a counter-intuitive insight. I’ll start with the warning: “You can plan for every risk,” he says, “except the things that are too crazy to cross your mind.” And for that reason, “the most important part of every plan is planning on your plan not going according to plan.” In other words, plan as if another 2020 might happen this year—or in any given year.
How is this accomplished? If you turn to the textbook, there’s definitely a formula for structuring an “optimal” portfolio. That will yield the right answer mathematically, but it may not be the answer that makes the most sense. That’s why Housel recommends putting the math aside. Instead, he recommends these two steps: First, save more than you think you might ever need. And second, maintain more of your savings in cash than you think you might need. In other words, build in room for error in your financial plan. These steps might seem unnecessarily conservative. For better or worse, though, I agree that this strategy is a good way to protect yourself from a universe of unknown unknowns.
Housel also provides this insight, which might make you feel better about being conservative: “Room for error,” he says, “is underappreciated and misunderstood. It’s often viewed as a conservative hedge, used by those who don’t want to take much risk…But when used appropriately, it’s quite the opposite.” Why? Housel explains the twin benefits of maintaining a conservative balance sheet: First, and most obviously, it helps you to avoid ruin when the unexpected occurs. In addition it allows you to “remain standing” when there’s a market downturn. By this, he means that you’ll be in a strong position—both financially and emotionally—to be a buyer the next time the market drops like it did last year.
We are all influenced by our own personal experiences with money. That is no surprise. There is also a generational element to this: It’s well known that people who grew up during the Depression are naturally more conservative. But this phenomenon isn’t limited to children of the Depression. Housel points out that the economic environment during our own formative years affects us all.
Consider, for example, inflation. “If you were born in 1960s America, inflation during your teens and 20s…sent prices up more than threefold. But if you were born in 1990, inflation has been so low for your whole adult life that it’s probably never crossed your mind.” The same applies to each generation’s experience with stock market returns, with interest rates and with unemployment. As a result, we all have biases—sometimes conscious but usually not—in how we think about money. Of course, there’s nothing you can do to change your own history. What you can do, though, is try to be aware of these unconscious biases. That, in turn, may help you to be as objective as possible in making financial decisions.
3. Role models
Housel points out an interesting paradox: We like learning from other people—but sometimes there isn’t a whole lot to learn. That’s because it’s so difficult to measure the role of luck in any one person’s success or failure. And if you ask someone to explain their own success, they probably won’t attribute much of it to luck. Housel’s view, however, is that there is always an element of luck in anyone’s success. The lesson: Don’t try too hard to copy from someone else’s financial playbook. For a lot of reasons—including luck—it probably won’t work. Instead, develop an investment strategy that is the best fit for you.
The benefits of compound interest are well understood. But usually this concept is illustrated with uninspiring charts and graphs. Housel takes a different approach, providing living examples, including Warren Buffett, who has been investing longer than most of us have been alive. Buffett bought his first stock when he was just 11. And today he is 90. The result: “…Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday.” Without taking anything away from Buffett’s intelligence or skill, there’s no question that compounding has worked in his favor.
The lesson: If there’s a young person in your life—a child, a grandchild, a niece or nephew—the greatest (financial) gift you can give that person is to help them get started investing. Get a teenager set up with a Roth IRA, and I guarantee they will be forever grateful.
Even though financial markets ended 2020 on a high note, it was not a pleasant year. Hopefully 2021 is smoother. But whatever this year brings, I believe these mindset strategies will serve you well.