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
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 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!
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/