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