This document provides an overview of personal finance topics for engineers. It begins by explaining why personal finance is important but poorly covered, and why it is relevant for engineers specifically. It then outlines some fast finance basics like behavioral finance, liquidity, cash flow, compounding returns, and the benefits of index fund investing. The document also discusses more advanced topics such as calculating returns in Excel, retirement planning challenges, collectible coins, and derivatives. The overall message is that personal finance is not as rational as people think, and the keys are to save early, avoid debt, and keep investing simple through low-cost index funds.

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/