Uploaded byAdam Nash
Personal Finance for Engineers (Stanford 2014)
This document provides an overview of personal finance basics for engineers. It discusses how behavioral finance concepts like anchoring, mental accounting, and loss aversion affect financial decision making. It emphasizes the importance of cash flow, emergency funds, spending less than you earn, and the power of compound returns over long periods. The document recommends keeping investing simple through low-cost index funds and rebalancing annually.
More Related Content
Personal Finance for Engineers (Stanford 2014)
- 1. FOR ENGINEERS PERSONAL FINANCE wealthfront.com AdamNash @adamnash April 3, 2014
- 2. wealthfront.com | Caveats &Preface • I am not a financial planner • This presentation is not financial advice • You would be extremely foolish to make investment decisions based solely on the content of this presentation or discussion • The opinions in this deck are intended purely to provoke discussion & further education 2
- 3. wealthfront.com | Why PersonalFinance? • Poorly covered in traditional education, even top tier universities • Not technically difficult, but signal:noise ratio is terrible • Massive impact on your life - Money is one of the top 3 reasons for marital problems 3
- 4. wealthfront.com | Fast FiveFinance Basics 1. Behavioral Finance Basics 2. Liquidity is Undervalued 3. Cash Flow Matters 4. The Magic of Compounding 5. Good Investing is Boring 4
- 5. How many ofyou think you are rational with your money? (show of hands)
- 6. You are NOTrational ANCHORING MENTAL ACCOUNTING CONFIRMATION & HINDSIGHT BIAS GAMBLER’S FALLACY OVERCONFIDENCEHERD BEHAVIOR OVERREACTION & AVAILABILITY BIAS LOSS AVERSION (PROSPECT THEORY)
- 7. wealthfront.com | Anchoring • Peopleestimate 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 7
- 8. wealthfront.com | 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 8
- 9. wealthfront.com | 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) 9
- 10. wealthfront.com | 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 10
- 11. wealthfront.com | 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? 11
- 12. wealthfront.com | Overconfidence • Inone study, 74% of investment managers believe they deliver above average returns. • Positively correlated with High IQ... • Learn humility early 12
- 13. wealthfront.com | 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” 13
- 14. Choice B: You havea 100% chance of gaining $500. 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.
- 15. Choice B: You havea 100% chance of losing $500. Now, 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 a 50% chance of losing $0.
- 16. wealthfront.com | Loss Aversion(aka Prospect Theory) • 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 16
- 17. It’s OK tonot be rational.
- 18. wealthfront.com | It’s OKto 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
- 19. wealthfront.com | Liquidity • Almostuniversally 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
- 20. wealthfront.com | 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
- 21. wealthfront.com | 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
- 22. wealthfront.com | 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
- 23. wealthfront.com | 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
- 24. wealthfront.com | The Magicof 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
- 25. wealthfront.com | 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
- 26. wealthfront.com | The Benefitsof An Early Start • Compounding really takes off over long time periods Years Return at 8% 10 2.16x 20 4.66x 30 10.06x 40 21.72x 50 46.9x In most retirement planning models, money saved between ages 25 - 35 produces more money than all savings between 35 - 65! 26
- 27. wealthfront.com | The Dangersof 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
- 28. wealthfront.com | Good Investingis 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
- 29. wealthfront.com | Basic AssetAllocation • Different types of assets (stocks, bonds, etc) have different volatility & return characteristics • There is an efficient frontier of combinations that can maximize return for a given volatility • Complication: historical performance does not predict future performance 29
- 30. wealthfront.com | Simple OperatingModel • 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 the cheapest index fund with the lowest drift and best liquidity. • Rebalance every year. 30
- 31. wealthfront.com | 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/ 31
- 32. wealthfront.com | Disclosure 32 Text Nothing inthis presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients pursuant to a written agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances. Past performance is no guarantee of future results, and any hypothetical returns, expected returns, or probability projections may not reflect actual future performance. Investors should review Wealthfront’s website for additional information about advisory services.