Where do you see yourself in the future financially? Do you have a financial goal you’re striving for?
According to Morgan Housel’s book The Psychology of Money, you should know your personal financial goals, otherwise, you may find yourself making decisions that don’t align with your goals. For example, short-selling stocks may work for some people, but it wouldn’t work with a long-term compounding plan.
Here’s why it’s important to follow your own financial goals.
Know Your Personal Financial Goals
One way to ensure you pay attention to the right information is to know what financial goals matter to you personally so that you don’t get caught up chasing the goals of other people. In other words, don’t get caught up in a herd mentality chasing investment opportunities that lots of other people are chasing, just because others are doing it.
Housel explains that when you know your personal financial goals, you can ignore irrelevant information that might lead you to make poor decisions, such as basing your financial moves on others’ actions, and thus you’re able to make better financial decisions and better protect your financial health.
To demonstrate the risks of paying attention to the wrong information, Housel points to the economic devastation caused by bubbles. A bubble is an economic situation where an asset price becomes significantly higher than the asset’s actual worth. It causes harm, Housel argues, because during a bubble, long-term investors base their financial decisions on information they don’t realize is only relevant to short-term traders.
Housel explains that in a bubble, short-term traders set the price of an asset class: They see an increasing asset price and purchase it, assuming it will continue to increase. Their purchase pushes the price up more, which attracts more short-term traders—until most of the people invested in a particular asset class are short-term traders, which is when the bubble forms. When this happens, the price the short-term traders are willing to pay for an asset becomes the only price at which it’s available.
Housel explains that this price is reasonable for a short-term trader but not reasonable for a long-term investor. A short-term trader who cares only that the asset price rises in a few hours or days can reasonably purchase assets at a much higher price than a long-term investor, who wants any asset she buys to continue increasing for decades.
(Shortform note: So how do you determine what is a reasonable price for an asset? Housel doesn’t recommend a formula, but one way is to follow the 50/30/20 budgeting strategy: Spend 50% of your take-home pay on what you need, 30% on what you want, and 20% on savings and debt. With this strategy, you wouldn’t invest in any assets that cost more than your 20% savings budget for the month.)
Unfortunately, long-term investors often don’t realize that the asset price available in a bubble doesn’t make sense for their own goals. They mistakenly assume that since others are buying at that price, they should also buy at that price. When the bubble inevitably bursts, their long-term plans suffer dramatically.
|How the Information Age Impacts Our Investing Decisions
Past bubbles—like the dot-com bubble Housel discusses—mostly occurred before the Internet was widely available: People got limited information from the radio or TV. But we now have constant access to unlimited information: How does this affect our experience of bubbles?
In some ways, the Internet has made bubbles more dangerous for unsuspecting investors. Experts note that bubbles are bigger and faster than they used to be, partly because investing apps make it easy to invest. They add that novice investors are often drawn to the market via social media posts about investing. These posts are often irrelevant to the novice’s goals—so if she doesn’t do extra research, she may risk more than she can afford to lose.
However, the Internet may also have made us less susceptible to bubbles. Experts explain that we’re now better at filtering out irrelevant information—so long-term investors may be better at ignoring what short-term investors are doing. Furthermore, as personalization algorithms dominate news apps and social media, we encounter mostly information we already care about. If you’re not interested in investing to begin with, you may be less likely to encounter information about a developing bubble and thus less likely to fall for one.
To avoid a similar fate, Housel argues, you must be consciously aware of your financial goals so that you can pay attention to the right information. One strategy Housel recommends is to write a mission statement for your finances. Ask yourself: How long are you going to invest your money? What do you think is going to happen over that time? What risks are you willing to take?
(Shortform note: The questions Housel recommends to discover your financial goals focus mostly on your investments. But how can you pay attention to the right information in other areas of your life? Consider writing a financial mission statement that encompasses not just investing but other areas of your life.)
Once you discover your financial goals, Housel contends, you’ll have a far easier time ignoring irrelevant information. Instead, you’ll pay attention only to information that’s relevant to your financial goals—and as such, you’ll make better decisions as you pursue them.
(Shortform note: Paying attention to only relevant information may improve your decisions—but not if you pay attention to too much. In Smarter Faster Better, productivity expert Charles Duhigg posits that we may grow overwhelmed by the amount of data available and stop taking it in. To prevent this, the author recommends acting on the data you encounter—like writing it out by hand.)
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- Why the key to financial success lies in understanding human behavior
- How to make better financial decisions
- How chance plays a bigger role in our financial lives than we think