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Personal Finance for Engineers

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Personal Finance for Engineers

  1. Personal Finance for Engineers Adam Nash April 15, 2011
  2. 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
  3. 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)
  4. 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
  5. Fast Five Finance Basics • Behavioral Finance Basics • Liquidity is Undervalued • Cash Flow Matters • The Magic of Compounding • Good Investing is Boring
  6. “Advanced Settings” • Calculating Returns in Excel • Why Retirement Planning is Hard • Why Do You Collect Coins? • Understanding Derivatives • Recommended Books
  7. How Many of You Think You Are Rational with Money? (raise your hands)
  8. You Are Not Rational • Anchoring • Mental Accounting • Confirmation & Hindsight Bias • Gambler’s Fallacy • Herd Behavior • Overconfidence • Overreaction & Availability Bias • Loss Aversion (aka Prospect Theory)
  9. 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
  10. 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
  11. 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)
  12. 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
  13. 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?
  14. Overconfidence • In one study, 74% of investment managers believe they deliver above average returns. • Positively correlated with High IQ... • Learn humility early
  15. 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”
  16. 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
  17. 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...)
  18. 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.
  19. Liquidity & Returns • In almost all cases, liquidity is inversely correlated with returns • Examples: • cash = very liquid • private equity = very illiquid • Common mistake: Safety != Liquidity
  20. 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.
  21. 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”
  22. 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.
  23. 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.
  24. 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!
  25. The Benefits of An Early Start • Compounding really takes off over long time periods Years 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!
  26. 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.
  27. 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
  28. 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
  29. 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/
  30. 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
  31. XIRR FTW!
  32. 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
  33. 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
  34. 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.
  35. Visualization 20 15 Stock Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  36. Visualization 20 15 Stock Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  37. Visualization: Call Stock Call @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  38. Visualization: Call Stock Call @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  39. Visualization: Call Stock Call @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  40. Visualization: Put Stock Put @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  41. Visualization: Put Stock Put @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  42. Visualization: Put Stock Put @ 10 20 15 Value 10 5 0 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  43. 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
  44. 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
  45. 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
  46. 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
  47. Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10 Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  48. Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10 Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  49. Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10 Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  50. Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10 Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  51. Zero Cost Collar Stock Put @ 15 Sell Call @ 15 Collar 20 15 10 Value 5 0 -5 0 2 4 6 8 10 12 14 16 18 20 Stock Price
  52. 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/

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