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wealthfront.com

PERSONAL FINANCE
FOR ENGINEERS

Adam Nash @adamnash
October 9, 2013
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

wealthfront.com | 2
Why Personal Finance?
•

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

wealthfront.com | 3
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

wealthfront.com | 4
Fast Five Finance Basics
1. Behavioral Finance Basics

2. Liquidity is Undervalued

3. Cash Flow Matters

4. The Magic of Compounding

5. Good Investing is Boring

wealthfront.com | 5
How many of you think
you are rational with
your money?
(show of hands)
ANCHORING

MENTAL ACCOUNTING

CONFIRMATION &
HINDSIGHT BIAS

GAMBLER’S FALLACY

You are NOT rational
HERD BEHAVIOR

OVERCONFIDENCE

OVERREACTION &

AVAILABILITY BIAS

LOSS AVERSION
(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

wealthfront.com | 8
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

wealthfront.com | 9
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)

wealthfront.com | 10
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

wealthfront.com | 11
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?

wealthfront.com | 12
Overconfidence
•

In one study, 74% of investment
managers believe they deliver
above average returns.


•

Positively correlated with High IQ...


•

Learn humility early

wealthfront.com | 13
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”

wealthfront.com | 14
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.
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.
Choice B:

You have a 100% chance of losing $500.
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

wealthfront.com | 17
It’s OK to not be rational.
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...)

wealthfront.com | 19
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.

wealthfront.com | 20
Liquidity & Returns
•

In almost all cases, liquidity is inversely
correlated with returns


•

Examples: 

-

•

Cash = very liquid

Private equity = very illiquid


Common mistake: Safety != Liquidity

wealthfront.com | 21
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.

wealthfront.com | 22
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”

wealthfront.com | 23
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.

wealthfront.com | 24
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.

wealthfront.com | 25
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!

wealthfront.com | 26
The Benefits of 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

In most retirement planning
models, money saved between
ages 25 - 35 produces more
money than all savings between
35 - 65!

46.9x

wealthfront.com | 27
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.

wealthfront.com | 28
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

wealthfront.com | 29
Basic Asset Allocation
•

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

wealthfront.com | 30
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 the cheapest index fund with
the lowest drift and best liquidity.


•

Rebalance every year.

wealthfront.com | 31
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-financeeducation-series-2-recommended-books/

wealthfront.com | 32
Disclosure

Nothing in this 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
Text
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.   

wealthfront.com | 33
Personal Finance for Engineers (Twitter, 2013)

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Personal Finance for Engineers (Twitter, 2013)

  • 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 solely on the content of this presentation or discussion • The opinions in this deck are intended purely to provoke discussion & further education wealthfront.com | 2
  • 3. Why Personal Finance? • 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 wealthfront.com | 3
  • 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 wealthfront.com | 4
  • 5. Fast Five Finance Basics 1. Behavioral Finance Basics 2. Liquidity is Undervalued 3. Cash Flow Matters 4. The Magic of Compounding 5. Good Investing is Boring wealthfront.com | 5
  • 6. How many of you think you are rational with your money? (show of hands)
  • 7. ANCHORING MENTAL ACCOUNTING CONFIRMATION & HINDSIGHT BIAS GAMBLER’S FALLACY You are NOT rational HERD BEHAVIOR OVERCONFIDENCE OVERREACTION &
 AVAILABILITY BIAS LOSS AVERSION (PROSPECT THEORY)
  • 8. 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 wealthfront.com | 8
  • 9. 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 wealthfront.com | 9
  • 10. 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) wealthfront.com | 10
  • 11. 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 wealthfront.com | 11
  • 12. 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? wealthfront.com | 12
  • 13. Overconfidence • In one study, 74% of investment managers believe they deliver above average returns. • Positively correlated with High IQ... • Learn humility early wealthfront.com | 13
  • 14. 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” wealthfront.com | 14
  • 15. 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.
  • 16. 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. Choice B:
 You have a 100% chance of losing $500.
  • 17. 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 wealthfront.com | 17
  • 18. It’s OK to not be rational.
  • 19. 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...) wealthfront.com | 19
  • 20. 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. wealthfront.com | 20
  • 21. Liquidity & Returns • In almost all cases, liquidity is inversely correlated with returns • Examples: - • Cash = very liquid Private equity = very illiquid Common mistake: Safety != Liquidity wealthfront.com | 21
  • 22. 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. wealthfront.com | 22
  • 23. 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” wealthfront.com | 23
  • 24. 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. wealthfront.com | 24
  • 25. 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. wealthfront.com | 25
  • 26. 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! wealthfront.com | 26
  • 27. The Benefits of 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 In most retirement planning models, money saved between ages 25 - 35 produces more money than all savings between 35 - 65! 46.9x wealthfront.com | 27
  • 28. 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. wealthfront.com | 28
  • 29. 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 wealthfront.com | 29
  • 30. Basic Asset Allocation • 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 wealthfront.com | 30
  • 31. 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 the cheapest index fund with the lowest drift and best liquidity. • Rebalance every year. wealthfront.com | 31
  • 32. 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-financeeducation-series-2-recommended-books/ wealthfront.com | 32
  • 33. Disclosure Nothing in this 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 Text 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.    wealthfront.com | 33