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
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.
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/