Do you want to put together a long-term financial plan? Why should you be sensible, rather than logical, when planning for the future?
To be logical is to make a decision based on known facts, while to be sensible is to show sound judgment. They are similar, but they are not the same. In his book The Psychology of Money, Morgan Housel suggests making sensible decisions when making a long-term financial plan because it will put your mind at peace.
Here’s how to create a feasible financial strategy, according to behavioral finance expert Morgan Housel.
Be Sensible, Not Logical
In his book The Psychology of Money, Morgan Housel says that the key to creating a long-term financial plan you can stick to through decades is to make sure it’s sensible, not logical. Housel implies that most people mistakenly think they want a logical financial strategy (one driven by mathematically sound strategies) because that will make them the most money. However, he argues, what people really want is a sensible strategy, which prioritizes your peace of mind, and that following a sensible strategy will maximize your earnings in the long run.
(Shortform note: The more complicated something is, the smarter it seems. So a sensible strategy, which prioritizes your peace of mind over complicated math, may seem too simple to work. But in a 2015 article, Housel argues that you don’t need to understand the math behind why your strategy works—only its real-world consequences.)
The Problems With a Logical Strategy
Housel argues that there are two major problems with purely logical strategies.
First, purely logical strategies don’t try to prevent regret, since they’re focused on making as much money as possible. However, most people also want to feel as little regret as possible. Regret might come from missing an opportunity, or it might come from how negatively you feel if people around you think you’ve invested poorly. Purely mathematically driven strategies might require you to pass on some investment opportunities, making you feel like other people are judging you for poor insights. In this way, strictly logical strategies sometimes don’t coordinate with our sometimes-illogical desires.
(Shortform note: The fact that purely logical strategies don’t try to prevent regret may have some benefits: One psychologist argues that if you try too hard to prevent regret, you’ll grow too scared to take the risks you need to achieve your goals.)
Second, purely logical strategies often aren’t realistic. As an example, Housel cites a study that recommended a retirement savings strategy in which you invest two dollars in the stock market for every one dollar you own (putting yourself into debt to do so), starting from a young age. The study showed that even if you lose your money in a market downturn, you’ll eventually regain your wealth in the long run if you simply continue to invest two dollars for every dollar you own. Housel agrees that this strategy is mathematically optimal but notes that it would never work in real life: If following a strategy lost someone all their money, no one would continue to follow it.
(Shortform note: If a strategy is obviously not realistic—like the one Housel cites—why would people follow it? In the blog post his book is based on, Housel argues that we’re often overly impressed with the academic credentials of these studies’ authors, so that we follow their advice blindly. Fancy degrees make people think you know what you’re doing. However, in finance, Housel argues, academic knowledge doesn’t guarantee financial success.)
Why a Sensible Strategy Makes You More Money
Housel argues you’re better off following a sensible strategy, even if it doesn’t perfectly maximize your earnings, because it can account for the non-financial elements you care about—like your desire to prevent regret or the ease of following a strategy—and therefore, will ultimately make you more money.
Why, exactly, does this happen? As Housel repeatedly states, the longer you have money in the market, the more likely you are to increase it. Therefore, the best long-term financial strategy is to pick a strategy and commit to it long-term. Because you’re more likely to stray from a strictly logical strategy if it drives you to feel regret or if it’s unreasonably difficult to follow, a sensible strategy—one that’s easier to stick to—will ultimately make you more money.
(Shortform note: One easy way to remain committed to a long-term plan—that is also sensible because it’s easy to follow—is to follow Sethi’s advice in I Will Teach You To Be Rich and automate your investments. Behavioral scientists argue that automating your finances is the best approach because we tend to keep doing whatever we were doing—so if you automate your investments, you’re less likely to change your strategy simply because it’s too much work and you can keep investing even if you do nothing.)
As an example, Housel notes that many people have a “home bias:” They only invest in their home country. Given how many countries there are, this is illogical. But if you feel more kinship with companies from your country, it’s sensible: Investing requires you to trust your money to strangers, so you should find the strangers you’re most comfortable with.
(Shortform note: Housel never points out that there are legitimate, logical reasons to invest in your home country over a foreign one—like the fact that most people will be more familiar with the laws, the market and the language of their own country than of others’.)
How, exactly, do you create a sensible financial strategy?
One method Housel suggests is to invest in companies you love. This is illogical: Your personal feelings about a company have no bearing on their earning potential. However, when a company you love does poorly, you’ll be far less likely to abandon your investment because you genuinely care about the company, want to support it, and believe that it will ultimately be successful because you’re confident in its mission. By investing in companies you love, you’ll stay in the market longer, which will ultimately lead to more financial success.
(Shortform note: If you love the company you work for, you may want to invest in it. After all, you’re far less likely to abandon an investment if you not only love that company but you’re employed by that company, too. However, other financial experts warn against this strategy because it doubles your financial risk: If the company fails, you’ll lose money both because your investments will become worthless and because you’ll be out of a job.)