The things that matter most in personal finance are boring. Spend less than you earn. Invest in a diversified portfolio. Choose an investment strategy that you can stick with when markets get rough. Avoid risking what you have to reach for something you don’t need. These are truisms – we all know them by heart, yet no matter how many times we repeat them, it seems to have little effect on our behaviour.
Morgan Housel is a partner at the Collaborative Fund and a former writer for the Motley Fool and the Wall Street Journal. He is a favourite writer among Northwood staff because he has a true gift for finding novel stories and novel framings that illustrate these nuggets of personal finance and making them unforgettable. In his recently-released book,The Psychology of Money, Housel condenses a lifetime of thinking about wealth, greed, and happiness into twenty short lessons, each of which strips away all of the complexity and focuses only on the core behaviours that lead to long-term success.
There are more than 2,000 books dedicated to how Warren Buffett built his fortune. By now, it seems virtually impossible that there could be anything new to say about Buffett, or any new lessons to draw from his life’s work. Yet Housel’s book is the first to ignore every factor except the one that explains his fame and fortune – time.
Time is the biggest factor separating Buffett from any other living investor. He began investing at the age of 10, and has continued to operate as CEO of Berkshire Hathaway into his 90s. That’s 80 years of uninterrupted compounding. At the time of release of Housel’s book, Warren Buffett’s net worth was $84.5B. Fully $81.5B of that came after his 65thbirthday. There is no question that Buffett has an outstanding record as an investor, with an annualized return of approximately 22%. But if he had followed a more conventional life path, it is likely that none of us would ever have heard his name.
Here is an interesting thought experiment: Assume Buffett chose that more conventional life path, beginning his investing career at the age of 30 with the modest sum of $25,000 and retiring at age 60 to play golf and spend time with his grandchildren. Assume everything else about his life was the same, including the 22% annualized return. How much would he have retired with? Not $84.5B, but $11.9M. More than 99.9% of his wealth came from sticking around for longer than the average investor.
What lessons can we take from this? The first is the incredible competitive advantage of a long time horizon. Most individual investors struggle to save enough during their final working years to fund their retirement, then they immediately begin drawing down their balance to fund their spending. They interrupt compounding just as it is beginning to take off.
Worse still, because they do most of their saving in their final years of work, they must invest conservatively in the years when their wealth is greatest. Only a select few (mostly institutions such as pension funds and endowments) can continue to make truly long-term investment decisions after the flywheel is already spinning. This is one of the reasons that Yale has managed to grow their endowment to over $30B.
The second lesson is to never risk what you have to reach for something you don’t need. Housel devotes a full chapter of the book to the differences between getting wealthy and staying wealthy. Getting money requires taking risk, being optimistic, and putting yourself out there. First generation family wealth is often built by taking large, concentrated risks on a single business – the kind of risks that don’t always work out in your favour.
But once you have money, you no longer need to take risks that could lead to total ruin. The process of staying wealthy requires a different mentality – a specific blend of conservatism, frugality, and paranoia that cuts directly against the process required to generate that initial wealth.
Housel explores this tension in the story of Jesse Livermore, an investor that became fabulously wealthy by shorting the market during the 1929 crash, betting that stocks would decline. In 1930, he was worth about $3B in today’s dollars. Long before Warren Buffett reached this same level of wealth, he had stopped making the kinds of single concentrated bets that could blow up Berkshire Hathaway. By contrast, Livermore’s confidence remained totally unchecked through the 1930s. He continued to make larger and larger leveraged bets in subsequent years, risking everything he had built just to grow that $3B to an even larger number. He eventually lost everything and died broke. Quoting Housel:
Compounding only works if you can give an asset years and years to grow. It’s like planting oak trees: A year of growth will never show much progress, 10 years can make a meaningful difference, and 50 years can create something absolutely extraordinary. But getting and keeping that growth requires surviving all the unpredictable ups and downs that everyone inevitably experiences over time.
It is not a coincidence that these two ideas drive much of Northwood’s strategy and approach to investing. As far as I know, few of our clients at Northwood began investing at the age of 10. However, many are in the position of having more financial resources than they need to fund their own lifetime spending. With the ability pass wealth across generations, our clients have an enormous advantage over typical investors. Taking the long view means that they can stay invested for longer than the vast majority of private investors, and there are enormous returns to allowing their wealth to compound for longer than the average.
That is why (among many other things) we steer clients away from the use of leverage in their portfolios. Goal number one is to never interrupt compounding. It is easy to overestimate the importance of this year’s investment return, and very easy to underestimate the challenge of simply surviving for 80 years or more.
Housel’s book is filled with similar lessons, each of which takes a boring truism in personal finance and replaces it with a story that will remain stamped indelibly on the reader’s thinking long after the book is placed back on the shelf.