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What is The Psychology of Money about?

To be successful in personal finance you have to understand one key thing: you don’t have to study how the financial world works, but how people relate to money.

It is a subtle distinction, but very important. The way we behave with money varies from person to person, is difficult to measure, changes over time, and is often overlooked when we describe ourselves. However, it can be improved by taking into account the biases, reasons, and mistakes we make in this regard. 

Morgan Housel, author of the book The Psychology of Money (which I highly recommend), has managed to make a compendium of the 20 behaviors that we have when dealing with money individually. In this article, I summarize the 5 that seem to me to be the most common to find and the easiest to counter once we have identified them.

  1. The bias of anchoring everything to your own history: Your personal experiences may constitute 0.00000001% of what has happened in the world, but they represent 80% of how you think the world works. Therefore, in moments of uncertainty when investing, it is normal for everyone to navigate life with totally different perspectives on how the economy works and what is or is not valuable. How to shake off this irregularity of thought? The best attempt is to think of this phrase that was concluded by a team of economists who for decades analyzed the investment habits of thousands of people: “Current beliefs about investment depend on the realities experienced in the past.”
  2. Underestimating the power of compounding:  I have already talked before about compounding as a wonder of the world, and if I insist on the subject it is because I really believe so. However, it is still common for its enormous power to be little perceived thanks to the human tendency to think intuitively in linear terms. Compounding profits they do not respond well to logic, because being exponential, they are gigantic. Seeing how a moderate annual return multiplies exponentially is sometimes incomprehensible, but it is what lies behind a healthy investment strategy: a good investment is not necessarily the one that allows the highest returns, since these rarely occur. The key is to achieve good enough returns that you can sustain over a long period. 
  3. The tendency to be influenced by people who are playing a different financial game than you: It is tempting to follow the same investment trend as some high caliber investors, but without understanding that they are playing a very different game than you – as in the In the case of short-term strategies that contrast with a long-term investment, or even with phenomena such as Game Stop-type meme stocks, you can be very disadvantaged. When it comes to money, few things matter as much as understanding your own time horizon and not being swayed by the actions of people who behave differently because their time horizons are too. You have to set a goal and commit to following it.
  4. The fallacy of believing that historians are prophets: It is very ironic to see history as a guide to the future when it is literally the study of surprises and changes. That is why it is detrimental to rely too much on past data as if they were unalterable signals of future conditions, especially in the economic field. The basis of the economy is precisely the fact that things change over time, since the invisible hand prevents everything from being too good or too bad for a long time. Therefore, trying to predict the behavior of a stock in the market based solely on the study of history is useless.
  5. The risk avoidance syndrome: Making a decision always carries a risk. However, it is not necessary to think about the economic risk only. The risk can be emotional and physical due to the effort required to carry out the objective. In this sense, it must be considered that any economic benefit has a price beyond the economic rate, which is more tangible. Accepting this reality is critical in order to measure how much of us is being asked for in exchange for success with money.

 

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