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Money
Vivek Kaul 11 min read 10 Dec 2023, 08:38 PM IST
Summary
- If you aren’t already following these principles, 2024 might be a good starting point
MUMBAI : Over the last few years, Morgan Housel has become a very popular writer and blogger on personal finance. His two books, The Psychology of Money and Same as Ever, have extensively covered the idea of how to go about managing one’s money. In this piece, we will look at the basic ideas that Housel espouses and how you can go about implementing them in your own personal journey of earning money and saving it.
The Warren Buffett principle
As cliched as it might sound, the power of compounding remains the most powerful way of building wealth. As Housel writes in The Psychology of Money: “If something compounds—if a little growth serves as the fuel for future growth—a small starting base can lead to results so extraordinary they seem to defy logic." Housel offers the example of Warren Buffett. At the time of writing the book (it was published in 2020), Buffett’s net worth was $84.5 billion. Of this, $84.2 billion was accumulated after he turned 50.
Housel carries a thought experiment to make a very interesting point. At the age of 30, Buffett’s net worth was $1 million. But let’s say he was more like a normal person and had a networth of around $25,000 when he turned 30. Now, what if he managed to generate an extraordinary return of 22% per year on this amount, how much would the $25,000 be worth at the age of 60? Take a guess. It would be worth $11.9 million. Yes, you read that right. Which is almost like zero in comparison to $84.5 billion that Buffett was worth. The real compounding happened only after he turned 50.
Of course, this is not to say that what Buffett achieved is easy. It isn’t. But the fact of the matter remains that you and I can easily benefit from this compounding, even without taking much risk. Let’s take the case of the Public Provident Fund (PPF), which has an initial lifespan of around 15 years. Let’s say you invest ₹1.5 lakh every year into it and an interest of 7.1% per year, as is the case currently, continues to be paid.
After the period of around 15 years, the PPF account can be extended for five years at a time, with or without contribution. Let’s say you decide to continue contributing and extend the account every five years. By the time the twentieth year ends, the investment would be worth ₹67 lakh. By the 25th year, the value would have risen to ₹1.03 crore. By the 30th year, it would be worth ₹1.55 crore. This is the power of compounding. As time goes by, the value of the investment in absolute terms increases at a faster pace.
The do nothing principle
In this day and age, money can be easily managed out of a smartphone. Hence, the tendency to fiddle around with one’s investments has gone up. The trouble is that more activity doesn’t necessarily mean better money management. Of course, there are people around us who want us to fiddle with our money. The stock brokers want us to buy that new stock listing on the exchanges. The mutual fund managers want us to buy that new scheme they are launching. The insurance agent wants us to buy that policy which our parents had also bought. Nonetheless, it is important to remember what Housel writes in Same as Ever: “This may be most common in investing, law, and medicine, when “do nothing" is the best answer, but “do something" is the career incentive." So, your hard-earned money shouldn’t become someone else’s incentive that easily.
How not to take cues from others
Most investors invest where others around them are investing. This is exactly how crypto investing took off, or the more recent trend of investing in small cap stocks and/or buying options. In recent years, financial influencers have also had a role to play. Of course, the TV gurus were always at work. The trouble is that when influencers and TV gurus recommend something, they don’t know who you are. You might be someone who is already stretched given your family responsibilities. Or may be paying off a home loan or an education loan. Or you may not be making much money to start with and shouldn’t be punting on derivatives.
We all have our games and it is important to figure out what that game is, and then stick to playing it. And if you can’t do that, then there are enough and more mutual funds out there to indirectly invest in stocks. Bank fixed deposits can easily be done online these days. Investment in gold can also be made digitally. It’s simple. It’s boring. And it’s what works best in the long-term. Of course, following this is psychologically difficult.
Most investors invest where others around them are investing. This is exactly how crypto investing took off, or the more recent trend of investing in small cap stocks and/or buying options. In recent years, financial influencers have also had a role to play. Of course, the TV gurus were always at work. The trouble is that when influencers and TV gurus recommend something, they don’t know who you are. You might be someone who is already stretched given your family responsibilities. Or may be paying off a home loan or an education loan. Or you may not be making much money to start with and shouldn’t be punting on derivatives.
We all have our games and it is important to figure out what that game is, and then stick to playing it. And if you can’t do that, then there are enough and more mutual funds out there to indirectly invest in stocks. Bank fixed deposits can easily be done online these days. Investment in gold can also be made digitally. It’s simple. It’s boring. And it’s what works best in the long-term. Of course, following this is psychologically difficult.
Risk is what you don’t see coming
Risk is what you don’t see coming: This is perhaps the personal finance principle which most people tend to ignore, working with the assumption that tomorrow will be like today is. Now, most tomorrows are like todays, until they are not. As Housel writes in Same as Ever: “The biggest risk is what no one sees coming, because if no one sees it coming, no one’s prepared for it; and if no one’s prepared for it, its damage will be amplified when it arrives."
Indeed, this applies at the aggregate macro level as well as the individual micro level. At the macro level, investors go chasing whatever is the flavour of the reason—from real estate to crypto to hot IPOs to options—at different points of time. Of course, such herd mentality normally doesn’t end well—when prices stop going up like they were—and start falling, as they often tend to do.
At an individual level, people don’t buy term insurance, on the pretext that it doesn’t deliver any returns and the assumption that a sudden death is not something that could possibly happen to them. In some other cases, people end up borrowing too much assuming that interest rates will continue to remain low, until interest rates rise. So, as Housel puts it, in reality, the right amount of debt you can take on is probably a little less than what you think you can possibly handle.
The importance of cash
It’s important to have money in savings bank accounts and fixed deposits. Of course, you might feel stupid at a point when other forms of investing are delivering huge returns, like small-cap stocks currently are. Or like real estate was in the 2000s. But things eventually turn. In that scenario, money in the bank will prevent you from having to sell your bluechip stocks and other investments, and ensure that the compounding continues because only if you survive will you succeed. Or to put it in another way, the return of capital is more important than the return on capital.
The stand-up comedy principle
There are two kinds of stand-up comedy routines: one you see on Netflix where every joke that the comic makes lands perfectly with the audience, and another where the comic is performing in a small club and the jokes are just not landing. The point is that it is not possible for comics to know in advance which jokes will land and which won’t, which is why they test their material in front of small audiences, before recording that big one-hour special. The idea is to see what works and leave out what doesn’t, given that there will always be duds.
A similar principle works in case of investing. One will always end up investing in dud stocks while chasing whatever is the flavour of the season or even investment-oriented insurance schemes, which tend to make your insurance agent richer. So, the trick is to not bet your life on anything, and also to move on quickly once a mistake has been realised.
Saving for the sake of saving
As Housel writes in Same as Ever: “Spending less than you make, saving the difference, and being patient is perhaps 90% of what you need to know to do well."
The trouble is that this is such an obvious point that it doesn’t get taken seriously. Also, it doesn’t help the financial services industry make much money. They like activity.
Further, people need a goal to save. What are we saving for? For our children? Their education? Their weddings? Holidays? The next house? The next car? Or to keep up with the Sharmas? Housel feels that saving for a specific goal makes sense only in a predictable world. As he writes in The Psychology of Money: “Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment." So, saving for the sake of saving should be a goal in itself.
Keeping up with the Sharmas
Once a certain level of stability has been achieved on the money front, the need to show it off becomes a very important factor of the lived life. And this can only be done by spending money, simply because money invested is not visible to the world at large. An expensive car is. A house one doesn’t live in is.
As Housel writes in The Psychology of Money: “When you see someone driving a nice car, you rarely think, “Wow, the guy driving that car is cool." Instead, you think, “Wow, if I had that car, people would think I’m cool." And that’s the paradox. So, people are not admiring you for the new expensive car that you own but they are instead using that car as a benchmark “for their own desire to be liked and admired". Envy is a very strong emotion and it leads you to spending money in order to keep up with the Sharmas.
In fact, as Luke Burgis writes in Wanting: “The imitation of superficial things is a part of everyday life," and in this day and age, social media makes it very easy to do just that. As he further writes: “Before Facebook [or Instagram or Twitter for that matter], a person’s models came from a small set of people: friends, family work, magazines and maybe TV. After Facebook [and all other social media], everyone in the world is a potential model." We want to do what everyone else around us is doing and that leads to money being spent and not saved.
Being rich vs being wealthy
This principle follows from the previous one. In order to keep up with the Sharmas, we need to keep spending money. And that automatically means lower savings. And this is where understanding the difference between being rich and being wealthy comes to the fore. If you have bought an expensive car, even on a loan, you are certainly rich, simply because unless you make enough money to be able to service a loan, the bank wouldn’t have given you one. Your current income makes you rich, but wealth is something which is not visible. Or as Housel puts it: “[Wealth] is income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now."
Of course, this doesn’t mean that you don’t spend any money at all. But at the same time, there is a journey that needs to be made from starting to make money to becoming rich to becoming wealthy. And you can’t get there without saving and without thinking about these things.
Highest form of wealth
All the other principles add up to this principle in Housel’s scheme of things. As he writes: “The highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want today." And this “ability to do what you want, when you want, with who you want, for as long as you want," only comes into the picture once enough money and more has been made. Of course, the definition of enough is different for different people.
And it is important to draw a line of how much is enough. Or as Housel writes in Same as Ever: “Money buys happiness in the same way drugs bring pleasure: incredible if done right, dangerous if used to mask a weakness, and disastrous when no amount is enough."
To conclude, if you are already following these principles, well and good, but, if you aren’t, 2024 might be a good point to start as any.
Vivek Kaul is the author of Bad Money.
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