WHEN I THINK BACK to Finance 101, what I recall—more than anything—is 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 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, formulas are helpful—and I don’t discount their value—but equally important is an understanding of psychology. For that, there may be no better guide than Morgan Housel’s recently published book, The Psychology of Money. The book offers many useful ideas, but I’d like to highlight four that may be particularly helpful as we enter the new year:
On the topic of risk, Housel provides both a timely warning and a counterintuitive 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.” 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 suggests putting the math aside.
Instead, he recommends two steps. First, save more than you think you might ever need. Second, keep more of your savings in cash than you think you might need. In short, build room for error into your financial plan. These steps might seem unnecessarily conservative. Still, I agree that this is a good way to protect yourself from a universe of unknown unknowns.
Housel also provides an insight that 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. 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 in 2020.
We’re all influenced by our own personal experiences with money. That’s no surprise. There’s 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 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 to 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 the experiences of 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. If you ask folks to explain their own success, they probably won’t attribute much of it to luck.
Housel’s view, however, is that there’s 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’s 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. Today, he’s 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 him or her get started investing. Get your favorite teenagers set up with a Roth IRA, and I can almost guarantee they’ll be forever grateful.
Adam M. Grossman’s previous articles include What We’ve Learned, Unhelpful Advice and Help Today’s Self. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.
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Thank-you, Adam, for reminding me of some important principles. They especially hit home as I am transitioning from a do-it-yourselfer to reliance and trust in a fiduciary. Your fourth point I will embrace after grandkids arrive; our son has a Roth since high school, is a teacher with a pension, and is contributing 11% now (increases by 1%/yr).
The worst problem with the formula for the risk of financial instruments is that it measures the unexpectedness of results, while it is generally interpreted as the unexpectedness of bad results. This is why people think their savings are safer when they lower risk.
The use of volatility (i.e., standard deviation) as a measure of risk is definitely a controversial one. It’s easy, but you’re right that there’s a big difference between an investment that’s “volatile” because it’s going up and one that’s volatile because it’s going down. And I think most people would rather have a “volatile” investment that’s going up than an investment that exhibits low volatility because the price never moves!
Yes, but the problem doesn’t just arise with these ideal cases where an investment is always profitable or always lossy. Ordinarily, values go both up and down. All you can reasonably expect is that your profits outpace your losses over the time you hold the investment. Volatility shouldn’t matter.
I am skeptical of the volatility calculations themselves. As I understand it, they rely on a normal distribution of results… but market returns are not normally distributed. They have ‘fat tails’…
Good article. I think everybody who agrees with me is a genius.
Mr. Buffett was only worth $300 million when he was 50? Ouch! 🙂
Because Buffet benefited from his choice of investments and the large rise in the market since he was 50, it is impossible to estimate the share of the 84.2 billion increase in his wealth that can be attributed to compounding.
Just for fun: $300 million to $84.5 billion over 40 years implies a pre-tax annual growth rate of 15.15%. Pre-tax annual return over the same period (1980-2020) for Vanguard’s S&P 500 index fund (VFINX) was 11.15%, while Mr. Buffett’s stock (BRK-A) grew from $290 to $347,815 at 18.98%.
Great calculations, thanks!
I’d sign up for any of those growth rates… ;>)