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Personal Finance for Engineers
 

Personal Finance for Engineers

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  • Full Name Full Name Comment goes here.
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  • Many people are making 500$+ a day!!just go to http://bit.ly/1dKNyHF
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  • Engineers tend to make higher incomes earlier in life than most people, and thus face some of these questions earlier. They also tend to have stock options, a fairly advanced financial instrument, as part of their standard compensation. Probably most troubling, engineers also consider themselves exceptionally rational, which makes them more prone to human weaknesses when it comes to money.
    Website: http://www.absolutewealth.com/category/articles/
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  • I am impressed by the presentation as a primer. It acknowledges some of the primary inadequacies of traditional thought processes of investing. I would say that each of the major points here is often involved in conversations with clients over time.

    As a Certified Financial Planner for the past 9 years and former practicing tax attorney, I would add that there are many implications to the points made herein that do not necessarily lead to the conclusion that most people assume . . . that is that passive index investing is the best way to go. It is, of course, in certain environments. A primer on secular bull and bear markets would also be additive in helping to address these questions.

    Here are a couple of examples that deconstruct some common observations. . .

    The study that the average mutual fund fails to beat its relevant index. Most good asset allocators are not looking for the average fund. In addition, most funds suffer from closet benchmarking, making them de facto losers on a relative basis unless (as one Yale paper finds) the manager can meaningfully vary from his/her benchmark or meaningfully concentrate on their best picks. But, if you take a bunch of closet benchmarking funds (as a representation of the average fund) and charge them 1% over time and then compare them to their benchmark, then the result of their underperformance to a benchmark is predetermined. So, absent any deprogramming of this, the index is better, but with a more sophisticated approach, better risk adjusted returns can be found. One doesn't need to look much further than Mr. Buffet to see that it is possible, but it does require greater sophistication and effort. And, even then, there will be years of under and out performance.

    Another example, as is relevant to the behavioral and anchoring elements of the presentation, is that most 5 star managers are 2 to 3 star managers at one point during the relevant measuring period. And, most investors hire 5 star managers when they have recently outperformed the most. Well, the riskiest managers outperform after risk is rewarded and the most conservative outperform after the market has been hardest. So, the average investor tends to hire a manager at exactly the wrong time . . . when the environment just experienced made the manager outperform. Reversion to the mean over time would suggest hiring recently underperforming former 5 star managers who would likely recover relatively as the market normalizes. Hence one needs to look at the managers performance through different types of markets and adjust accordingly.

    None of this is meant as advice, but only to further highlight the myriad different considerations one could consider in investing alone (before even delving into tax elements). Engineers overall tend to be more rational investors and better able to follow the data vs. emotions. But it is important to understand, as the presenter duly notes, that the data alone can also lead one down the exactly wrong path. Volatility as a destructive force in long term returns would also be a worthwhile element to focus on, as most solely focus on average returns without considering the volatility inherent to them.

    Sorry for the long comments . . . glad to be a resource for questions . . .

    Tony Canini
    Sr. Vice President
    Merrill Lynch
    4159553907
    anthony_canini@ml.com
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Personal Finance for Engineers Personal Finance for Engineers Presentation Transcript

  • Personal Finance for Engineers Adam Nash April 15, 2011
  • Caveats & Preface• I am not a financial planner• This presentation is not financial advice• You would be extremely foolish to make investment decisions based on the content of this presentation or discussion• The opinions in this deck are intended to provoke discussion & further education
  • Why Personal Finance?• Poorly covered in traditional education, even top tier universities• Not technically different, but signal:noise ratio is terrible• Massive impact on your life (Money is one of the top 3 reasons for marital problems)
  • Why “For Engineers”• Understand / Prefer Math• Tend to make higher incomes early in life, thus face questions sooner.• Tend to have complicated instruments, like stock options, as part of their compensation.• Believe they are rational, which is actually a problem when it comes to money
  • Fast Five Finance Basics• Behavioral Finance Basics• Liquidity is Undervalued• Cash Flow Matters• The Magic of Compounding• Good Investing is Boring
  • “Advanced Settings”• Calculating Returns in Excel• Why Retirement Planning is Hard• Why Do You Collect Coins?• Understanding Derivatives• Recommended Books
  • How Many of You Think You Are Rational with Money? (raise your hands)
  • You Are Not Rational• Anchoring• Mental Accounting• Confirmation & Hindsight Bias• Gambler’s Fallacy• Herd Behavior• Overconfidence• Overreaction & Availability Bias• Loss Aversion (aka Prospect Theory)
  • Anchoring• People estimate answers to new / novel problems with a bias towards reference points• Example: 1974 Study• Most common examples: • Price you bought a stock at • High point for a stock
  • Mental Accounting• Money is fungible, but people put it in separate “mental accounts”• Lost movie tickets example• “Found Money” problem• Vacation fund & credit card debt
  • Confirmation & Hindsight Bias• We selectively seek information that support pre-existing theories, and ignore / dispute information that disproves them.• We overestimate our ability to predict the future based on the “obviousness” of the past. (example: real estate)
  • Gambler’s Fallacy• We see patterns in independent, random chains of events• We believe that based on series of previous events, an outcome is more likely than odds actually suggest• Coin flip example• It’s because with human behavior, there are no “independent” events
  • Herd Behavior• We have a tendency to mimic the actions of the larger group• Crowd psychology is a major contributor to bubbles (believed)• Easier to be “wrong with everyone” than “right and alone”• No one gets fired for buying IBM?
  • Overconfidence• In one study, 74% of investment managers believe they deliver above average returns.• Positively correlated with High IQ...• Learn humility early
  • Overreaction & Availability Bias• Overreact to recent events• Overweight recent trends• Studies demonstrate that checking stock prices daily leads to more trading and worse results on average• Worse in high tech, because we are immersed in “game changers”
  • Loss Aversion (aka Prospect Theory)• You have $1,000 and you must pick one of the following choices: • Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0. Choice B: You have a 100% chance of gaining $500.• You have $2,000 and you must pick one of the following choices: • Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. • Choice B: You have a 100% chance of losing $500.• We hate losses more than we love winning• Average loss aversion is 3:1 (!)• Affects views on wide range of situations, including taxes, holding on to losing stocks, “sunk cost” mistakes
  • It’s OK to Not Be Rational• The key is that humans are predictably irrational• Know your own flaws, and you can set up systems to account for them• Self-awareness is key (yes, my Mom is a psychologist...)
  • Liquidity• Almost universally undervalued• Strictly defined - it’s the quantification of how much money you can get, and how fast.• Liquidity is the power to take advantage of great investment opportunities• Liquidity is also, in the end, the only thing that matters when you need to pay for something.
  • Liquidity & Returns• In almost all cases, liquidity is inversely correlated with returns• Examples: • cash = very liquid • private equity = very illiquid• Common mistake: Safety != Liquidity
  • Practical Outcome: Emergency Funds• Standard recommendation is that you have 3-6 months of living expenses in cash / cash-equivalents.• That number increases if you are in highly volatile industry / career.• Worth considering length of time for potential job search.
  • Cash Flow• The ultimate secret to personal finance is quite simple.• Spend less than you make (on an ongoing basis)• Very easy to measure, but few people do. Annual budget is a great idea.• Don’t forget to model in annual expenses & “personal spending”
  • Savings Targets• What’s the right number? 3%? 6%?10%? 20%?• There is no question - the more you save, the more secure you are. Income comes & goes, but expenses / lifestyle are sticky!• A lot of models assume working 40 years, and producing savings to generate 80% of working income.• These models don’t actually match anyone’s real world experience.• There are a lot of models out there, and rules of thumb, but it’s important to run the numbers yourself.
  • The Magic of Compounding• Not convinced that Albert Einstein said it was the greatest force in the universe.• It’s the key to almost all long term financial planning.• Exponentials are bad in algorithmic cost, good in savings returns.
  • Simple Model• Rule of 72• In Excel, for each year, just use =POWER(1+rate, year)• 4% over 20 years is 2.19x• 8% over 20 years is 4.66x• Careful: it works on debt just as well as savings... in reverse!
  • The Benefits of An Early Start• Compounding really takes off over long time periodsYears Return at 8% In most retirement 10 2.16x planning models, money saved 20 4.66x between ages 25 - 35 30 10.06x produces more money than all 40 21.72x savings between 50 46.9x 35 - 65!
  • The Dangers of Debt• Bankruptcy is literally when you can’t pay your debts. You can’t go bankrupt if you don’t have debt.• You will never find an investment that pays 8% guaranteed, let alone 20%+• You will find *tons* of credit offers out there that will charge you that.• “Bad” debt is toxic, your best return is to pay it off. But emergency fund takes precedence.
  • Good Investing is Boring• No one wants to be average, but with investing, average is actually well above average.• You will beat most mutual funds, and a large majority of your peers with simple, low-cost index funds.• Asset allocation explains ~90% of the variance between fund performance
  • Basic Asset Allocation• Different types of assets (cash, bonds, stocks, etc) have different volatility & return characteristics• Combinations can lower volatility significantly, with moderate impact to returns• Complication: historical performance does not predict future performance
  • Simple Operating Model• 2 hours of work per year.• Pick an asset allocation that is appropriate for your emotional character & time frame & goals.• For each asset class, pick cheap index fund to represent.• Rebalance every 1-2 years.• http://blog.adamnash.com/2010/12/31/ personal-finance-how-to-rebalance-your- portfolio/
  • Calculating Returns in Excel• You can model as a cash flow in Excel• Two columns: Dates & Amounts• Additions are negative, Withdrawals are positive. (yes, that’s right)• XIRR function is magic, but solving non-linear equations requires a hint
  • XIRR FTW!
  • Why Retirement Planning is Hard• Saving is hard enough• Reliably modeling future returns is extremely difficult (simple, monte carlo, etc)• Converting lump sum into annual income is borderline impossible• No do overs
  • Why Do You Collect Coins?• Obvious answer: I am a nerd• Less obvious answer: • Collectible gold/silver coins are a unique asset class • Precious metals provide a backstop in value, but over long term, coins trade like collectibles, indexed to the incomes of higher income brackets • Rewards long-term contrarian thinking (buy when unpopular) • Game mechanics are reliable / predictable, if you understand collection games (collect them all, rarity / desirability, subscriptions)• Most likely correct answer: I am a nerd
  • Understanding Derivatives• Derivative is a financial instrument that is based on another financial instrument.• Date back to medieval Japan & rice futures. Critical to managing risk.• Most common types are calls & puts• Call = right to buy a stock at a certain price over a given time period.• Put = right to sell a stock at a certain price over a given time period.
  • Visualization 20 15Stock Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization 20 15Stock Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Call Stock Call @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Call Stock Call @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Call Stock Call @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Put Stock Put @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Put Stock Put @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Visualization: Put Stock Put @ 10 20 15Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Stock + Put = Insurance Stock Put @ 10 Stock + Put 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Stock + Put = Insurance Stock Put @ 10 Stock + Put 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Stock + Put = Insurance Stock Put @ 10 Stock + Put 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Stock + Put = Insurance Stock Put @ 10 Stock + Put 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  • Recommended Books• WSJ Guide to Understanding Money & Investing• The Millionaire Next Door• A Random Walk Down Wall Street• The Essays of Warren Buffett• Common Stocks & Uncommon Profits• The Intelligent Investor• Devil Take the Hindmost• When Genius Failed• Against the Gods: The Remarkable Story of Risk• http://blog.adamnash.com/2007/02/14/personal-finance-education- series-2-recommended-books/