What is the psychology of money and how does it relate to finance, which is ultimately nothing more than a science of numbers, formulas, and investments?
What I learned, and would like to share with you, is that good money management has little to do with the correct use of formulas or complex investments, and rather depends on how you relate to it and how you manage your emotions and impulses when making a financial decision.
The universal principles of the psychology of money:
I was a bit skeptical of the term Psychology of Money until I read Morgan Housel‘s book, The Psychology of Money.
As I have just stated, according to this author, money management is more than just a “hard skill”, it is a soft skill that we can develop.
In a nutshell, the management of our money is influenced by factors such as:
- Our childhood and how we were raised
- The economic era (boom or bust) in which we grew up
- Our definition of success
- Emotional intelligence to manage our emotions
- Our aspirations and dreams
- The way we relate to our environment.
When you take all these factors into consideration, you understand that although certain golden rules regarding money must be clear, at the end of the day, what really matters is how we emotionally relate to our finances.
Now, before sharing with you the principles of the psychology of money that Morgan Housel raises in his book, I would like you to have something clear:
Personal finances are an extremely subjective subject, that is, your goals are very different from those of your neighbor, your friends, or acquaintances.
So comparisons are useless, there are no universal rules of how “correct” use of money should be, and what should matter most to you is the peace of mind that the investment decisions you make over time offer you.
For this, here I leave you a series of questions that you can ask yourself before making any decision:
- What is my time horizon with this investment?
- Do I need this money in the short term?
- Does it align with my life goals?
- Do I know the risks associated with my investment?
- Will it allow me to sleep peacefully at night?
With that clear, let’s take a look at the universal principles of the psychology of money below :
1. Find humility in success and compassion in mistakes
Morgan Housel raises in his book a universal truth: Things are never as good or as bad as they seem. The world is big and complex.
So you should strive to find humility when you are succeeding, but also compassion when you make poor decisions.
And more so when there are two variables that you cannot control: Luck and risk, which are difficult to identify. So respect the power that both have, and you will be able to focus on those things that you can control.
This is why there must be a balance and not fall into extremes; On the one hand, taking too many risks, or being excessively cautious prevents you from acting.
2. Less ego, more wealth
Do you know the best way to close the gap between your income and what your ego tells you to do with it? Very simple: Save money.
In his book, Housel explains that wealth is the unseen difference between your income and your ego, so take care of it.
How to build your wealth? Eliminating what you could buy today, allows you to have more options in the future.
Keep in mind that, no matter how much you earn, becoming a millionaire and accumulating wealth will not happen unless you control the impulses you have with your money today.
3. Manage your money in such a way that you sleep peacefully at night
This principle of the psychology of money is one of the most important on a personal level, as it allows me to understand that although an investment can be very profitable on paper, it may not fit my life goals.
What did I mean by this? That for you your peace of mind should prevail instead of the aspiration to have an X return on your money, or the obligation to save a specific percentage of money.
As I mentioned at the beginning of this article, finances are personal, so for some, investing in a risky way will allow them to sleep well at night, there are those who prefer to save 40% of their income. Both cases are totally valid.
So before making any decision ask yourself if this will help you sleep peacefully at night, this question is the basis of good personal finances aligned with your life goals.
4. To be a better investor, increase your time horizon
I mentioned this principle in Warren Buffett’s how to get rich article: time is the most powerful force when it comes to investing your money.
While you can’t control luck or risk, when the time comes into the equation, it makes mistakes fade and small things grow.
In the long term, your investments will grow incredibly thanks to compound interest, in the long term, specific errors are compensated with the natural power of the market.
The less you interrupt your investments, the more chances you have to accumulate really incredible figures with your money.
5. You can be wrong half the time and still build a fortune
You have to accept the fact that many things will not turn out the way you expect. There will be many mistakes along the way.
So how is it possible to build a fortune when you’re wrong half the time? This is because a small percentage of things explain the vast majority of results.
This is known as the Pareto principle, and in money management, it is applied so that 20% of the investment decisions you make will produce 80% of your results.
When you see things from this perspective, you will stop looking at your individual investments and start looking at their performance based on your entire portfolio.
For example, you will be able to understand that it is okay to have a lot of bad investments and a few good ones that drive most of your results.
On the contrary, if you analyze each decision individually, you will fall into the trap of thinking that those who make good decisions are more brilliant, and those who make mistakes, more losers than they really are.
6. Use your money to control your time
Without a doubt, one of the keys to being happy is having more control over your time. Basically, this consists of the ability to do what you want, when you want, with whom you want, and for as long as you want.
This is the best return you can get for your money.
So apply this principle of the psychology of money to increase your wealth gap (income-ego), to build (invisible) wealth whose performance allows you to control your time.
7. Be more frugal and less flashy
Have you ever wondered what you really want when you buy a fancy car, a sizable house, or an expensive watch?
For Morgan Housel, what people truly seek is respect and admiration from others, and the most efficient way to achieve this is through kindness and humility.
No one is as impressed with your possessions as you are, so if you’re looking for respect and recognition, develop frugality and focus on your human side to help others.
8. You don’t need a specific reason to save money.
This is one of the most important principles of the psychology of money when it comes to achieving financial independence.
While we all save for a car, a down payment on a house, or a medical emergency, we must also learn to save for things that are impossible to predict.
In his book The Psychology of Money, Housel puts it masterfully:
Everyone’s life is a continuous chain of surprises. Savings that are not earmarked for anything, in particular, are a hedge against life’s inevitable ability to surprise you at the worst possible time.
So the recommendation is quite simple: Start saving money today. You can apply the savings method that 50% does not apply.
9. Define the cost of your success and be willing to pay it
As Raúl Yepes stated, nothing worthwhile in life is fast, fairly, or easy.
That’s right, nothing worthwhile in life is free. And in many cases, the costs associated with what we want in life have a visible price tag.
This is the case with uncertainty, doubt, and regret, which are common costs in the financial world. They are often worth paying for and for this, you should see them as fees to achieve your dream lifestyle.
10. The importance of the margin of error
The wider the gap between what could happen in the future and what you need to happen, the better.
This is known as the margin of error, and it is a fundamental principle in staying in the money game and allowing time to work its magic.
If your financial future has a very small margin of error, any setback or unexpected event could take you out of the game, could lead you to make hasty decisions, and divert you from your goals.
So look for ways to widen this gap, to need less of the future. As the popular saying goes, whoever plays out of necessity loses out of obligation.
11. Avoid the extreme extremes of financial decisions
It is about having a financial balance and avoiding extremes that lead you to high levels of commitment to projects or goals.
No matter what your goals and desires are, remember that they will change over time. So keep this in mind when you are going to decide something in the present. Have a space (financial and resources) for other projects and goals.
12. The risk pays off over time
This does not include any type of risk, because if you make hasty decisions and do not calculate the different scenarios, it is possible that a bad decision will take you out of the game.
The key is to make decisions and have a mindset that allows you to be in the game for as long as possible. The longer you are in the money game, investing, growing, and learning, the better your results will be.
So take calculated risks, which in the long term will give you a good profit margin, and that in the short term does not imply such a high cost that you take yourself out of the market.
13. Define the money game you are playing
To finish, I would like to remind you of the clarification I made at the beginning of this article, finances are personal. So make sure your actions are not influenced by people who have a different game.
This is why the vast majority of people who are intelligent, informed and who study this world of finance rarely agree. To what do you owe this? That each person has very different goals, desires, and investment horizons.
What is the best investment? What is the best decision? The one that works best for you based on your goals, aspirations, lifestyle, and time horizon.
Finally, if you want to learn more about the psychology of money, I invite you to read the book The Psychology of Money by Morgan Housel, it will undoubtedly change the way you see money and understand why you make certain financial decisions.