This article is an excerpt from the Shortform book guide to "The Psychology of Money" by Morgan Housel. Shortform has the world's best summaries and analyses of books you should be reading.
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What are the top financial lessons from Morgan Housel’s The Psychology of Money? How can this book help you change the way you view money and wealth?
In his book The Psychology of Money, finance expert Morgan Housel argues against the conventional wisdom about financial success. He says that the key to financial success lies not in hard work and intelligence, but in understanding human behavior. Housel posits that when you understand how emotions and beliefs influence your financial decisions, you’ll make better financial decisions.
Here’s a brief overview of the key themes.
Why People Fail to Achieve Financial Success
Money is ubiquitous—so why do so few people master it? Housel posits two major reasons: We underestimate the role of chance in financial success, and we confuse being wealthy with being rich.
Lesson #1: Chance Plays a Bigger Role in Our Financial Lives Than We Give It Credit For
In his book The Psychology of Money, Housel suggests one reason we fail to become financially successful: We underestimate the role chance plays in our financial lives. For example, we forget Bill Gates was successful not just because he was intelligent but also because he got lucky: He was (literally) one in a million teenagers who had access to a school computer in 1968. (Shortform note: In Fooled by Randomness, former trader Nassim Nicholas Taleb adds that when you succeed matters: Early success helps determine subsequent success because winning an early random advantage positions you to win subsequent random advantages. Microsoft may have succeeded partly because Gates got an early advantage through chance contracts and positive feedback.)
Housel contends our ignorance of chance is dangerous because many people try to gain wealth by imitating the most exceptionally successful people—but thanks to chance, copying what they did often doesn’t lead to success. As Housel notes, the more exceptional the story, the more likely luck played a bigger role in its outcome. So the more exceptional the story, the more unique it is and so the less likely you are to be able to learn lessons from it.
Instead, Housel recommends that you pay attention to patterns, not people. If many wealthy people did Thing A to get wealthy and only one wealthy person did Thing B, it’s more probable doing Thing A will make you wealthy. (Shortform note: Taleb warns that while you can gain moderate success by following the patterns of the wealthy, you’re unlikely to get wild success—millions of dollars and lasting fame—without luck: a positive rare event plus few negative rare events. Just because something (like a certain pattern of behavior) is necessary for wild success doesn’t mean it caused wild success.)
Lesson #2: We Confuse Being Wealthy With Being Rich
Housel pinpoints another reason we fail to achieve financial success: We confuse being wealthy with being rich. He explains that if you’re wealthy, you have a lot of money in the bank. In other words, wealth is money you’re not using but could use if you wanted to. But if you’re rich, your current income is high: You have money you’re able to spend on expensive items.
Crucially, Housel contends, you can tell whether someone is rich, but you can’t tell if they’re wealthy. This is because you can see how much someone spends on items, but you can’t see inside of their bank account to see the money they’re not using—in other words, their wealth. Of course, someone can be both rich and wealthy, but you can only see how rich they are.
(Shortform note: The Millionaire Next Door authors Thomas J. Stanley and William D. Danko first popularized the difference between being wealthy and being rich. They also noted that rich people can lack wealth, and that it’s hard to identify the wealthy since they save their money. But they define wealth as your net worth, which is your current assets minus your liabilities.)
Knowing the difference between being wealthy and being rich is essential because we learn by imitation, Housel argues. And knowing who to imitate—and who not to imitate—helps us protect our money.
In an ideal world, you could learn how to be wealthy by seeing the self-control wealthy people exercise. But since wealth is obtained by not spending your money, you can’t see the process. Therefore, it’s hard to learn wealth by imitation—you don’t know who to imitate. (Shortform note: Even if you don’t know who to imitate, you can discover what habits lead to wealth with the right resources—like The Millionaire Next Door, which describes the habits of the wealthy.)
But it’s easy to see and imitate people who are rich—and if you don’t understand they might not also be wealthy, you may assume being wealthy means you can spend money as you wish. But behaving this way will impoverish you. When you understand the difference between being rich and being wealthy, you avoid this trap and prevent yourself from draining your money away. (Shortform note: Stanley and Danko suggest that rich people who aren’t wealthy are imitating not other rich people but their lower-income parents, who taught them money is something to spend when you have it—not something you save to grow your wealth.)
Understand Why You Want Money
Now that you’ve learned why people fail to achieve wealth, you can adopt the mindsets Housel believes are essential for a healthy attitude about money: Money is valuable because it buys you control over your time, and it’s possible to have enough money.
Lesson #3: Money Buys Us Control Over Our Time
Housel contends the true value of money is as follows: Money buys you control over time, which psychologists contend is the key driver of happiness. When you have control over your time, you can choose what to do and when to do it. Feeling like we control our lives is so essential, we rebel when we don’t feel it—a phenomenon known as “reactance:” People who feel they don’t have control won’t do things they want to do just to regain that sense of control.
(Shortform note: In Influence, psychologist Robert Cialdini adds that we exhibit reactance partly because we find things with limited availability more appealing—especially if those things were previously abundant. In other words, the less control you have, the more control you want—and the more likely you’ll exhibit reactance.)
But modern-day Americans lack control over our time, so we’re not as happy as we could be. Housel explains that as more and more of us do knowledge work, we think about our jobs even at home. As such, we feel like we’re always working and don’t control our time—so we’re unhappy. (Shortform note: Some psychologists suggest we’re unhappy because we have too much—not too little—control over our lives: Modern Americans have so many options we don’t know what to choose, and this uncertainty causes anxiety.)
So how can you become happier? According to Housel, end-of-life interviews indicate that people value things they have the luxury to do because they control their time—like the ability to develop quality relationships. So having more control over your time will likely make you happier, too. (Shortform note: One way to increase your sense of control over your time—and so your happiness—is to determine how much an hour is worth to you. Use this information to evaluate whether it’s worth paying for time-saving services, like a housekeeper.)
Lesson #4: Be Happy With Enough
You now know money’s valuable because it buys you control—but how much money should you have? Housel never gives an exact number—but, he warns, wanting more than necessary can drive you to lose all your money. That’s why he thinks learning to be happy with enough is critical to financial success.
Housel explains that some people are never satisfied: No matter how much money they make, they still want more. This endless pursuit of more can often drive them to risk their existing wealth for wealth they don’t have and don’t even need. (Shortform note: Other experts add that people risk their wealth due to overconfidence: Overconfidence may drive people to risk more than they should because it makes them think they’re not really risking that much.)
When you learn to be happy with enough money—whatever that is for you—you don’t take unnecessary risks with your money. (Shortform note: Mindfulness in Plain English suggests that meditating can help you destroy greed—which may prevent you from taking unnecessary risks.)
How can you learn to be happy with enough? One technique Housel recommends is to stop increasing your lifestyle standards. If you keep wanting an increasingly lavish lifestyle, you’ll never be satisfied. Not only will you then take dangerous risks to get satisfaction, you’ll grow envious of others who live whatever way they want to, which will diminish your enjoyment of life. So it’s critical that, once you reach the lifestyle you want, you decide to be happy at that lifestyle—not one that’s slightly more prestigious.
(Shortform note: Housel seems to disapprove of lifestyle inflation, which is when your everyday spending increases as your income grows. But other financial experts encourage you to enjoy increases to your income by spending on experiences: Experiences make you happier than items do, so you’ll feel more satisfied even if you spend the same money.)
What to Include In Your Financial Strategy
Now that you understand how to think about money, we’ll discuss the three elements Housel considers essential to a financial strategy: Taking advantage of compounding, saving money, and developing a plan for when things go wrong.
Lesson #5: Take Advantage of Compounding
Housel explains that the longer you invest, the more money you make because returns compound—that is, they build on previous returns to make ever-increasing returns. He suggests you take advantage of compounding by finding investments that return solid, consistent results over time. He argues that ultimately, this strategy will make you the most money.
He argues that due to the power of compounding, how long you invest is the most important factor determining your investment success—even more than other factors that seem intuitively important, like your annual returns. As evidence, Housel notes that Warren Buffett is 75% wealthier than investor James Simons—even though Simons’ annual returns are triple Buffett’s—because Buffett’s returns have been compounding for 40 years longer than Simon’s.
(Shortform note: Range’s David Epstein thinks it’s easier to succeed as a generalist, who’s competent in many fields, than a specialist, who masters one field. Buffett and Simon prove both can succeed: Buffet devoted his life to investing; Simons succeeded in other fields first.)
Housel contends that people often ignore the power of compounding because it’s so counterintuitive: Even if you know compounding works, it’s hard to imagine that just waiting can turn unimpressive returns into impressive numbers. As such, we try to get impressive numbers through methods that seem better—like finding the investments with the highest annual returns—even though they don’t work as well as compounding does.
(Shortform note: Why is compounding so counterintuitive? Psychologist Daniel Kahneman explains that humans are notoriously bad at questioning what evidence might be missing. So even if we logically know that how long you invest matters, we struggle to act on this information because we can’t see the numbers in our bank account 50 years from now.)
Lesson #6: Prioritize Saving Money
The second essential element of a successful financial strategy, according to Housel, is to prioritize saving money.
Housel considers saving essential for three main reasons. First, saving is essential to building wealth due to the nature of wealth: Since wealth is the money you don’t use, it’s the money you save—meaning you can’t build wealth without saving money. Second, saving is the most reliable way to build wealth because it’s totally in your control. Other wealth-building methods, like investing or increasing your income, are full of uncertainty. But saving isn’t: You always control how much you save, and saving will be just as effective tomorrow as it is today. Finally, saving is a comparatively easy way to build wealth: It’s much easier to save money you already have than it is to increase your income or your investment returns.
(Shortform note: Not all thought leaders distinguish between saving and investing: In The Success Principles, Jack Canfield suggests maximizing your savings by investing them. But by Housel’s definition, investing isn’t the same as saving: You can’t rely on your investments because you could lose them at any moment.)
To ensure you save money, Housel recommends, stop caring about others’ opinions. Housel argues we overspend because we care too much about others’ opinions of us. Once you exceed the level of spending needed to purchase luxurious basics, he contends, you’re no longer spending for yourself: You’re now spending to prove to others how much money you have. (Shortform note: Housel recommends only spending enough to purchase luxurious basics, which are “comfortable, entertaining and enlightening.” But this is subjective, so it’s hard to tell if you’re overspending. One way to assess whether you’re spending for your ego is to define what’s “enough”—as we saw in Lesson #4—and see if you spend more than that.)
By learning to be humble and ignore others’ opinions, you’ll naturally want less. When you want less, you’ll spend less, and you’ll save more. (Shortform note: In How to Stop Worrying and Start Living, Dale Carnegie recommends several strategies for ignoring others’ opinions, like becoming your own worst critic.)
Lesson #7: Plan for Things to Go Wrong
The final essential element of any financial strategy, according to Housel, is to plan for things to go wrong. Doing so protects your financial future and keeps you in the game long enough to reap the benefits of compounding.
Housel warns that people are often too optimistic with their finances, which leads them to put too much of their wealth at risk at any one time on a strategy that can be taken down by any one factor of bad luck. But the future is uncertain: You don’t know what bad luck or risks you will experience. So if your financial plan only works in a narrow range of possible futures, you’re placing yourself in a precarious position.
Planning for things to go wrong protects you: In doing so, you plan for a wide range of possible futures—and increase the likelihood you’ll become financially successful even if a lot of things don’t go your way. (Shortform note: Having broad competence in many fields, as Epstein recommends, is one way to protect yourself: You’ll survive even if your industry disappears.)
Additionally, planning for setbacks allows you to endure losses long enough to be positioned to take advantage of opportunities when they arise. When you can weather occasional losses, you’ll still be in the game to reap the occasional windfall—which can earn you significant money if you’re able to grab it. This applies to many types of investments, like the housing market: If a downturn wipes your savings out, you won’t be able to take advantage of low housing prices, which could lead to high future returns.
(Shortform note: Housel’s warning about the housing market implies that he thinks buying a house is an investment. But other financial experts warn that a house is not an investment : A house’s value depends on the economic opportunities of where it is, so if your local economic opportunities decline, your house will decline in value and may become a liability.)
How, exactly, can you plan for things to go wrong? Housel recommends the following methods:
Never put your entire fortune at risk. Instead, risk only a small portion at a time. Keep enough invested in safe investments so you can cover any losses incurred by your riskier investments. (Shortform note: In Antifragile, Taleb also warns against risking your entire fortune. But he emphasizes the extreme options over the average ones—specifically, the barbell model: Keep one end extremely safe (like in the bank), and one end high-risk and high-reward. This way, you can only ever lose the small portion of your money you’ve risked—but could earn a lot more.)
Don’t create strategies that hinge on one single factor because if that factor goes wrong, the entire strategy fails. Instead, have backup systems in place that protect you when a particular factor fails. (Shortform note: A single factor many of us base our financial lives on is our ability to keep working. But you could suffer a medical condition that prevents you from working. That’s why financial experts recommend purchasing disability insurance.)
How to Create a Financial Strategy You Can Stick To
Now that you know what to put in your financial strategy, how do you make sure it’s one you’ll stick to? Housel names two principles to keep in mind: Expect your future goals to change, and prioritize sense over logic.
Lesson #8: Expect Your Future Goals to Change
To develop a long-term strategy you can follow over decades, Housel recommends, expect your future goals to change. As we’ve seen, the longer you leave your money alone, the more compound interest it can accumulate. But, he posits, people struggle to leave their money alone because they change—and since they can’t predict how they’ll change, they don’t invest their money in ways that will work for their future selves.
Housel explains that when making financial plans, most people fall victim to the end-of-history illusion, a psychological phenomenon where you recognize that you’ve changed a lot, but you don’t expect to change a lot in the future. However, you’ll probably change just as much in the future as you did in the past. (Shortform note: Why do people fall for the end-of-history illusion? The psychologists who discovered the end-of-history illusion (or the end-of-history effect) suggest that believing you don’t change is comforting: It’s terrifying to imagine a future self drastically different from your current self.)
To protect yourself from the end-of-history illusion, Housel recommends that you don’t make extreme financial plans. In other words, avoid any plan that involves extremes in your commute, savings, or personal time. (Shortform note: What counts as extreme in each area will likely depend on your age and location. So instead of comparing yourself to others not in your situation, consider avoiding the options that feel extreme to you, even if they statistically aren’t.)
Why? Housel explains, if you make an extreme financial plan, you may regret your choices. For example, your single-minded focus on your career may lead to wealth but no loved ones to share it with. (Shortform note: If you do regret an extreme financial plan, ease the pain by finding the silver lining: Learn something from the regret and apply it to your future.)
Second, Housel states, if you make an extreme financial plan and change it later, you won’t be able to take full advantage of compound returns. For example, if you think you’ll never want to settle in one place, you may take jobs that pay just enough to let you travel the world cheaply. But if you eventually want to settle down, you may not be able to retire where you want. Had you taken slightly better-paying jobs and invested that money, you would have more compound returns—but you can’t get that money now. (Shortform note: Remember that you may change your financial plan not because you want to but because you have to. If this happens, you’ll be more exposed to financial ruin if you’ve followed an extreme financial plan, which can help you achieve one goal but might leave you vulnerable to things going wrong in other areas of your finances.)
Lesson #9: Be Sensible, Not Logical
Another key to creating a long-term financial strategy you can follow for decades is to develop a strategy that’s sensible, not logical. Housel implies that most people mistakenly think they want a logical strategy (which focuses exclusively on maximizing your earnings) because that will make them the most money. But what people really want is a sensible strategy, which prioritizes your peace of mind, and that following a sensible strategy will maximize your earnings in the long run.
(Shortform note: The more complicated something is, the smarter it seems. So a sensible strategy, which prioritizes your peace of mind over complicated math, may seem too simple to work. But in a 2015 article, Housel explains you don’t need to understand the math behind why your strategy works—only its real-world consequences.)
Housel explains that following a sensible strategy will ultimately make you more money, even if it doesn’t perfectly maximize your earnings, because it accounts for the important non-financial elements logical strategies ignore—like your desire to prevent regret or the ease of following a strategy. (Shortform note: Why do we follow logical strategies that ignore such important elements? We may be overly impressed with the academic credentials of the experts who recommend them, and so follow their advice blindly.)
How does this work, exactly? As Housel repeatedly states, the longer you have money in the market, the more likely you are to increase it. So the best long-term financial strategy is to pick a strategy and commit to it long-term. Since you’re more likely to stray from a strictly logical strategy if it drives you to feel regret or if it’s unreasonably difficult to follow, a sensible strategy—which is easier to stick to—will ultimately make you more money. (Shortform note: One way to make a strategy easy to follow long-term and thus sensible is to automate your investments, as financial expert Ramit Sethi suggests in I Will Teach You to Be Rich.)
To create a sensible strategy, Housel recommends, invest in companies you love. This is illogical: How you feel about a company doesn’t affect its earning potential. But, if a company you love does poorly, you won’t abandon your investment as easily because you care about the company. By investing in companies you love, you’ll stay in the market longer, which will ultimately lead to more wealth. (Shortform note: Just don’t invest in the company you work for, experts warn: If the company fails, you’ll lose your investments and your income.)
How to Counter Negative Thinking
You now know the keys to creating a financial strategy you can stick to long-term. But in an ever-fluctuating market, how do you handle the inevitable bad times? Housel shares two lessons to help you evaluate bad news appropriately: Don’t be put off by uncertainty, and remember that even if you fail frequently, you can still succeed.
Lesson #10: Don’t Be Put Off by Uncertainty
Housel shares one key to reacting well to bad news: Don’t be put off by uncertainty. He argues that to achieve long-term investing success, you must accept that you’ll feel uncertainty as the market fluctuates. Otherwise, you won’t be able to endure the uncertainty long enough to let your returns compound.
Housel explains that investing inherently includes some measure of uncertainty—and the higher the potential gain, the more uncertainty you feel. For example, the longer you let your stocks compound, the more money you can gain, but the longer you have to feel the uncertainty of not knowing exactly what will happen to your money. (Shortform note: Some discomfort may be inevitable when investing, but constant discomfort isn’t. Checking your investments only once a quarter may reduce your anxiety about your investments.)
According to Housel, most people try to limit the uncertainty they experience by timing the market—but since timing the market is impossible, they end up losing money. (Shortform note: Ironically, in The Intelligent Investor, Benjamin Graham suggests that some people time the market not due to fear of uncertainty but due to overconfidence: They think that if you’re smart enough, you can predict how the market will move.)
So, Housel recommends, instead of trying to avoid uncertainty, accept it’s inevitable when investing. Remind yourself you’re trading your short-term peace of mind for potential long-term investing success—and use that to endure the market long enough to let your returns compound. (Shortform note: In his book, Housel focuses exclusively on the toll investing can take. But in the blog post he based his book on, Housel argued every financial reward takes a toll on some aspect of your life, and you can only get the reward if you accept those tolls.)
Lesson #11: Even If You Fail Frequently, You Can Still Succeed
Another reason to remain optimistic in the face of bad news is that even if you fail frequently, you can still succeed.
Housel explains that nearly every successful financial venture you hear about owes its success to low-probability outlier events—luck. These events, when positive, are so powerful they compensate for a larger number of smaller setbacks a company might go through. For example, Nintendo owes its dominance in the American market to the massive success of Super Mario Bros., which did so well it made up for the losses from other products that failed in the United States. (Shortform note: Housel only discusses positive outliers, but they could be negative: A negative outlier event could drive the failure of an otherwise successful venture because it was so powerful it offset all the other successes.)
Since we only pay attention to these outlier events—and not to the failures the outlier events offset—we forget how rare outlier events are and conversely just how common failure is. As such, we overreact when failures inevitably happen to our own ventures. But when you realize how common failure is, you realize you can fail most of the time and still be successful—so you can react to your failures appropriately. (Shortform note: One area where we do pay attention to the failures offset by outliers is in careers: We often talk about how often successful people failed before achieving their (outlier) success.)
To do so, Housel recommends, pay attention not to the extent or frequency of individual failures but to the impact of your failures on your overall financial health. The outlier events in your life can offset the impact of many individual failures, Housel explains. So paying too much attention to how often you fail or the outcome of one investment paints an inaccurate picture of your financial health. Instead, pay attention to your overall financial health, since that’s what matters. (Shortform note: Instead of focusing on the negative impact of failure, consider viewing each failure as an opportunity to learn what not to do in the future.)
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Here's what you'll find in our full The Psychology of Money summary :
- Why the key to financial success lies in understanding human behavior
- How to make better financial decisions
- How chance plays a bigger role in our financial lives than we think
