Extracts from 'The Psychology of Money'
by Morgan Housel
Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.
Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time—especially in times of chaos and havoc—will always win.
Compounding works best when you can give a plan years or decades to grow. This is true for not only savings but careers and relationships. Endurance is key. And when you consider our tendency to change who we are over time, balance at every point in your life becomes a strategy to avoid future regret and encourage endurance.
Aiming, at every point in your working life, to have moderate annual savings, moderate free time, no more than a moderate commute, and at least moderate time with your family, increases the odds of being able to stick with a plan and avoid regret than if any one of those things fall to the extreme sides of the spectrum.
Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error— often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline—anything that lets you live happily with a range of outcomes.
But most of the time today is not that important. Over the course of your lifetime as an investor the decisions that you make today or tomorrow or next week will not matter nearly as much as what you do during the small number of days—likely 1% of the time or less—when everyone else around you is going crazy.
At the Berkshire Hathaway shareholder meeting in 2013 Warren Buffett said he’s owned 400 to 500 stocks during his life and made most of his money on 10 of them. Charlie Munger followed up: “If you remove just a few of Berkshire’s top investments, its long-term track record is pretty average.”
“The great investors bought vast quantities of art,” the firm writes. “A subset of the collections turned out to be great investments, and they were held for a sufficiently long period of time to allow the portfolio return to converge upon the return of the best elements in the portfolio. That’s all that happens.”
Academic finance is devoted to finding the mathematically optimal investment strategies. My own theory is that, in the real world, people do not want the mathematically optimal strategy. They want the strategy that maximizes for how well they sleep at night.
Stanford professor Scott Sagan once said something everyone who follows the economy or investment markets should hang on their wall: Realizing the future might not look anything like the past is a special kind of skill that is not generally looked highly upon by the financial forecasting community.
The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking. The odds are in your favor when playing Russian roulette. But the downside is not worth the potential upside. There is no margin of safety that can compensate for the risk.
The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.
There is an iron law in economics: extremely good and extremely bad circumstances rarely stay that way for long because supply and demand adapt in hard-to-predict ways.
Think about market forecasts. We’re very, very bad at them. I once calculated that if you just assume that the market goes up every year by its historic average, your accuracy is better than if you follow the average annual forecasts of the top 20 market strategists from large Wall Street banks.
John Stuart Mill wrote in the 1840s: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”