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The Psychology of Money

Part 1: Why People Fail to Achieve Financial Success

Money is everywhere and touches almost every part of everyone’s life. So why do so few people succeed in mastering it? In this section, we’ll learn why so many people struggle to manage their money well. We’ll discuss why people follow so many different rules when it comes to money and how that can hamper your financial success. We’ll then explore three additional reasons people struggle to achieve financial success: We underestimate the role of chance in financial success, we look to the past to predict the future, and we confuse being wealthy with being rich.

Lesson #1: Everybody Acts in Ways That Feel Rational to Them

In a world that largely assumes that money acts on mathematical principles, why do so many people act in so many different ways when it comes to money? In Chapter 1, Housel argues that it’s because everybody acts in ways that feel rational to them—but what seems rational to you isn’t rational to me.

Housel argues that people develop drastically different ideas about what’s rational because our personal experiences with money define how we approach it in life, but we all have vastly different economic experiences, so we all approach money differently.

Housel argues that it’s not what you learn but what you live through that most affects your relationship to money. We create mental models of the financial world based on what we experience, and we act accordingly. Housel attributes this to the fact that real-life experiences leave an emotional impact that is impossible to replicate. In particular, Housel notes that while you can learn a lot of financial information from external sources, like textbooks, you cannot truly experience the anxiety of a particular financial situation unless you have lived through it.

(Shortform note: If what you live through most affects your relationship to money because of the emotional impact personal experience has, can fictional sources—like a novel—recreate the emotional impact of a particular financial situation? It’s possible: Reading about something a character does stimulates the regions in your brain that control that action, so you might feel what the character feels, too.)

Early Adulthood Matters Most

Housel contends that people base their decisions mostly on the financial climate in their early adulthood, instead of **on their goals or the specific features of investments available to them. He specifies three financial areas in which your personal experience—and thus your views—might consequently drastically differ from others:

Stocks. Housel notes that depending on your birth year, stocks behaved drastically differently in your early adulthood. For example, if you were born in the early 1970s, the stock market increased greatly, but if you were born in the early 90s, the stock market crashed. (Shortform note: One expert points out that financial advisers aren’t immune to developing stock outlooks based on what stocks did when they were young, so you should keep that in mind when taking their advice.)
Inflation. Similarly, Housel argues, your birth year greatly affects your experiences of inflation: If you were born in 1990, you’ve hardly experienced it; if you were born in 1960, inflation tripled prices in your early adulthood. (Shortform note: Experts note that many of the factors driving the inflation Housel references, of the mid-1980s and early 1980s, no longer exist. For example, unionized workers now rarely have a contractual provision that automatically raises their wages when the cost of living rises, so businesses don’t have to raise their prices as high to cover these costs. Therefore, many economists believe that while inflation might sometimes increase in the future, it's unlikely to reach the levels of that era.)
Unemployment. Housel notes that different groups can experience the job market very differently: In November 2009, the United States’ unemployment rate was 4% for college-educated white women and 40% for young African-American high school dropouts. (Shortform note: In Biased, Jennifer Eberhardt argues that **Black people in the United States face disproportionately high unemployment rates due to both bias in the job application process and housing discrimination.)

(Shortform note: Housel’s argument that people base their decisions mostly on the financial climate in their early adulthood comes from a study that argued the same. However, the study shares an important caveat that Housel fails to include: While the financial climate in your early adult life remains influential decades later, you place the most weight on your most recent returns when making an investment decision. In other words, your early adulthood experiences affect your financial decisions today—so your experiences of stocks, inflation, and unemployment may affect your financial decisions today—but they don’t determine them.)

Since your personal experience with money differs drastically from others’, Housel contends, you operate on different financial information and have different values than everybody else. Therefore, behavior that seems irrational to you seems rational to other people.

For example, 1970-born Rick might view stocks as a surefire money maker because they increased greatly in his early adulthood. As such, he might invest heavily in them. But 1950-born Pam might view stocks as an unstable investment given how little they moved in her early adulthood—and instead hold mostly cash. Rick and Pam both view the other’s strategy as irrational—but each strategy is rational within the mental model each person holds.