Morgan Housel on Greed and Fear, Frugality and Paranoia
Morgan Housel’s highly anticipated new book, The Psychology of Money, opens with a quote from Arthur Conan Doyle’s Sherlock Holmes:
It is a fitting introduction to a work from the Sherlock Holmes of financial writing.
Like the famous fictional detective, Housel observes seemingly obvious things about human behavior. Just in his case, he applies these observations to solving mysteries about investing, not crimes.
“Investing is not the study of finance,” he explained in “The Psychology of Money,” a recent CFA Institute webinar moderated by Blair duQuesnay, CFA. “Investing is the study of how people behave with money.”
Beware Greed and Fear
Housel’s fascination with understanding and applying human behavior to investing— what we now think of as behavioral finance — began when he first started writing about finance full time in 2007. It was auspicious timing: The global financial markets and banking system were under extreme stress. The following year, in September 2008, Lehman Brothers collapsed and almost brought the global financial system down with it.
The effects of the global financial crisis (GFC) would be felt for years to come and spurred many questions.
“Almost everything I wrote centered around this idea of: ‘Why did the financial crisis of 2008 happen? What were its causes? Why did people behave the way that they did? Have they learned their lesson? Why do they keep making the same mistakes over and over again? Will they keep making those mistakes in the future?’” Housel said.
Housel, now a partner at the Collaborative Fund, soon learned the answers weren’t contained in any finance or economics textbook. He had to look further afield, to other disciplines.
He discovered he could find subtle clues about the origins of events like the financial crisis by studying psychology, sociology, and other subjects. “You could explain why policy makers did the things that they did through the lens of politics, and theories about politics,” he said. “You could explain how people thought about greed and fear through a lot of other fields, like medicine and military history.”
Disciplines that on the surface have little connection to economics or investing could actually yield valuable insights because they ask similar questions. “What is people’s relationship with greed and fear? Are people able to take a true long-term mindset? How gullible are you? Who do you trust? Who do you seek information from?” he said. “Those are the most important questions in investing and they also apply to a lot of fields.”
Housel believes the psychological side of investing is the most critical.
“You can be the best stock picker in the world, you can be the best economist in the world, you can have the best analytical abilities, the academic credentials of anyone else in the world,” he said. “But if you lose your cool, if you lose your temper, in March of 2020, or in 2008, or in 1999, none of that matters.”
Not for nothing, the other quote Housel includes in the epigraph is attributed to Napoleon: “A genius is the man who can do the average thing when everyone else around him is losing his mind.”
The reason why the behavioral side of investing is so important is that it can effectively short-circuit whatever analytical skills you may have. If you haven’t mastered the behavioral side of investing, all those analytical skills that take so long to develop are irrelevant.
The key takeaway: “Investing is not just about money,” he said. “Investing is about our relationship with greed and fear.”
Timing is meaningless. Time is everything.
Housel offered a simple story about the ice ages to explain why compounding is so important and yet so often overlooked.
There have been five distinct ice ages over the very long history of the planet, he noted. Each turned the earth into a giant snowball. For as long as humans studied these phenomenon, the tilt of the earth’s axis away from the sun was thought to be the cause. Winters were so brutal and extreme, the theory went, that the planet would freeze over the millennia. But that wasn’t the case at all: Moderately cool summers were the problem.
Cool summers meant the winter snow didn’t melt. When the snow didn’t melt it reflected more heat away from the earth, cooling the planet further, and leading to more snow the next winter. And when there was more winter snow accumulation, there was less summer snowmelt. And around and around it went.
“It’s not intuitive to think that you start with something as benign and tiny as a moderately cool summer that leads eventually to the entire planet being covered in snow, but that was exactly what was happening,” Housel said. “You start with a normal planet, you have a cool summer, and before long — tens of thousands of years — the whole planet is covered in snow.”
Which is how compounding works.
“You start with something that is so meaningless and benign, and a change in circumstances that doesn’t seem to make any difference, that is easy to overlook because it’s not intuitive,” he said. “But over a period of time, it adds up to something truly extraordinary. And that, of course, is so true in investing as well.”
To drive home the point, he noted that Warren Buffett started investing at age 11 and continues today at age 90. So how much of his net worth came after his 50th birthday? About 96%. “If he had started at 25 like a normal person and retired at 65,” Housel said, “his net worth would be $11.7 million not $90 billion.”
Housel said most investing mistakes come from the question: “What will happen next?” While most investing fortunes come from asking: “How long can I stay invested for?”
He quipped that there are 2,000 books on Amazon devoted to answering how Buffett became so successful but there has never been one simply called: “The reason he is so successful is because he has been investing for three-quarters of a century.”
That is 99.9% of the explanation for how Buffett has gotten to where he is now, Housel said. “That answer is not intuitive and it’s too simple for smart people to take seriously, and so it tends to go overlooked.”
Risk is what you don’t see.
“The biggest economic risk is what no one is talking about, because if no one’s talking about it, no one’s prepared for it, and if no one’s prepared for it, its damage will be amplified when it arrives,” Housel said.
In recent years, for example, the risks people talked about included trade wars, next quarter’s earnings, budget deficit forecasts, and the elections. “It’s not that those things are not risky,” he said. “It’s that we see them coming, we talk about them, and we can prepare for them.” The risk no one was talking about or paying attention to was the global coronavirus pandemic.
So how do you deal with this as an investor?
“Think about risk the way California thinks about earthquakes,” Housel said. “If you live in California, you know there are going to be big earthquakes in your future but you don’t know when or where . . . but you have an expectation . . . you are always prepared for it.”
It’s also important to give yourself a wide berth, with room for error, and to realize there’s a distinct difference between getting rich and staying rich, Housel said.
“Getting rich requires swinging for the fences, taking a risk, being optimistic,” he said. “Staying rich requires a form of pessimism, being pessimistic about the short run, and the ability to survive whatever might happen, whatever may come your way.”
What are the risks we are not talking about today? A banner 2021.
“Something I think people are discounting and are not thinking about enough, and this is not my baseline forecast, are the odds of the economy doing extremely well next year,” Housel said.
What if a vaccine arrives early in 2021 and everyone is soon vaccinated? Life can return to normal. That will release lots of pent-up demand.
“Then you combine that with three things,” he said: “the amount of Federal Reserve stimulus flooding throughout the economy, the amount of stimulus from Congress just in terms of stimulus payments that have been made this year, and the amount of savings Americans have generated this year.”
Put it all together: pent-up demand, savings, and unprecedented fiscal and monetary stimulus.
“If those two things collide at once,” Housel said, “2021 could be one of the best years from the economy that we have seen in our lives.”
The counterargument, of course, is that if we don’t get good vaccine news and stimulus measures are fumbled, 2021 could be one of the worst years for the economy in decades.
“I think both of those extremes seem almost equally likely right now,” he said. “But I think we are discounting particularly the optimistic side, when things are as bad as they have been in 2020, when you have 40 million people lose their jobs, it seems ridiculous to say we could be facing one of the best economies that we have ever seen in a matter of months.”
Frugality and Paranoia
To preserve wealth requires a “combination of frugality and paranoia,” according to Housel.
Creating wealth and preserving wealth are two different skills, he added.
“When you think about building wealth just through one lens, you are missing that it’s really a two-sided equation,” Housel said. “You need this barbell personality of optimism about the long run of the market’s ability to solve problems and create productivity and produce profits that accrue to shareholders.”
But that’s just one side of the equation.
“You also need pessimism about the short run about being able to survive long enough to benefit from the long run,” he said. “I’ve often said, ‘Save like a pessimistic and invest like an optimist.’ You need both and they seem contradictory: Long-term optimism and short-term pessimism, if not paranoia.”
So how does Housel define optimism?
“A real optimist is someone who knows that the short run and the medium run are going to constantly be filled with setbacks and delays and crises and tragedies but that those things do not prevent long-term growth and long-term optimism,” he said.
“If someone says that they think everything is always going to be okay, that’s not an optimist. That’s a complacent, whereas a real optimist is someone who understands that the short run is always going to be a mess, always going to be a disaster, both for you and other people, constantly running into problems, running into setbacks, but those things do not preclude long-term growth. And that, to me, is the real optimist.”
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