Notes from “The Psychology of Money” by Morgan Housel (Book Summary) | Compounding

Money management is one of the most important skills in life. However, making financial decisions is difficult. We have complicated spreadsheets, a large number of technical terms and a huge amount of varying advice from people on what's the best thing we can do with our money. The result? We end up in a confused state. 

For a long time, I found myself in a similar situation until  I finally read the book "Psychology of Money" by Morgan Housel.

This book talks about money in a very different way. It portrays finance as a soft skill in contrast to complicated maths as it's generally shown as. It demonstrates that having a good hang of human psychology is enough for you to do well with your money.

I would be sharing a series of blog posts, where I will be putting posting some important ideas from this book. I hope they will be helpful for you to make better financial decisions. 

The Crazy Rich Janitor

This book starts off with this very intriguing story

The Story Ronald Reed

Ronald Reed worked as a janitor all his life. He had an annual income of just $12,000 and had no finance education whatsoever. What's interesting about Ronald is that the day he passed away in 2014, people found he had a total savings of $8 million. This left everyone in amazement, as Ronald had neither inherited any money nor won a lottery.

8 Million dollars is huge. Even a Harvard Business Grad with one of the best financial education fails to attain such numbers in his lifetime. So, what was it that Ronald did?

Turns out he did nothing fancy, all he did was every month as he got his salary, he invested some of it in some blue-chip stocks. These investments compounded over time making him extremely rich.

The reason I chose to post this example was to show that even an average person with no great financial education can save up millions. It's a fact that your behaviour with money is more important than how intelligent or smart you are. As Morgan Housel puts it,

Financial success is not hard science it's a soft skill where how you behave is more important than what you know.

Throughout the book, he illustrates various things which can help you develop that skill. 

For this post, let's talk about compounding since I have already mentioned it in the above example.

Compounding

The concept of compounding is simple here is an example to help you understand how it works. Let's say you decide to start investing. You start off with say 1 Rupee of the 1st of the month.

Say you are the ideal investor and have 100% returns i.e. you double the money each time you invest!

On day 2, you will have doubled your amount and you have 2 rs which you invest again,

On day 3 you will have 4,

On day 4 you will have 8  and so on.

Take a moment to guess what will be the amount of money you will be having on the 30th of the month? 

If this goes on, on the 30th of the month you will have exactly 53,68,70,912 Rs (53.6 Crores). Incredible amount right? Just take a note, you started off with just 1 Rs and ended up with such a huge amount.

Even if you start small you if you invest back your profits you can get incredibly rich. 

Let's take another example, Let's say you start a week late! You start on the 8th of the month instead of the 1st with your 1 Rs investment. So,

On 9th you have 2 Rs.

On 10th you have 4 Rs.

On 11th you have 8 Rs.

Now let's answer the same question what is the amount you will have on the 30th.

You will have 41,94,304 Rupees (Around 42 lakhs rupees) which is also a huge amount considering you start off with just 1 Rupee.

But that's not what I want to illustrate with this example. When you started off on the 1st of the month you ended up with 53 crores and if you started off just a week late you end up with 42 lakhs. That is you have 99.21% less amount when you started off just a week late.

While the example I gave is hypothetical, It does apply to real life as well. The amount you get back may not be 100% it's generally around 4-5% per month. The period may not be days but can be months or years. But the core idea remains the same. You need to start investing early so that your investment compound. The following case study is the perfect example of compounding in real life.

Case study: Warren Buffet

Warren Buffet is one of the wealthiest men in the world. Currently sitting at a net worth of 109 Billion Dollar. Buffet is wealthy, but people fail to see the reason for Buffet's wealth is not because he is super smart or the best investor in the world. (As a matter of fact, there are a lot of investors who have double the returns of what Buffet does.)

The following graph shows the net worth of Buffet over the years.

You can observe something that many people fail to notice. Buffet started at the age of 14 with as little as 5000 $. He has been in the market for over 76 years, and, throughout his time in the market, Buffet has been investing money which has compounded over time.

Have a look at his net worth 18 years ago: 36 Billion dollars, and today his net worth is 109 billion dollars, which is around a 200% increase. The example I gave earlier might have been hypothetical but Buffet is an example of the same thing in real life.

Investing may have been Warren Buffets weapon to become rich, but his secret has always been time.

Key Takeaways:

There are important things that you need to remember from this post.

Early bird gets the money

 

The earlier you start the better it is, Buffet is incredibly rich because he started out at the age of 14 years. You need to start as early as possible to get the compounding clock ticking. So go start off on your investments today. 

You don't need a tremendous force to have a tremendous impact

It's easy to understand that you don't really need a large amount of money for investment to get rich. The only thing you need to keep in mind is that as you keep reinvesting the profits you get from your investments, and they will compound over time. So start small but start early is the key.

Please feel free to share your thoughts on compounding in the comment section.

Stay Tuned

The next important thing I learned from the book was the role of luck and risk. I would be sharing my notes related to that in the next week's blog post so stay tuned.

If the insights I shared sparked an interest in you about the book. You can use the following link to purchase it.

Psychology of Money on Amazon

There is also a webinar I took on the same topic, you can check it out if you are interested.