Published on February 20, 2014
wealthfront.com PERSONAL FINANCE FOR ENGINEERS Adam Nash @adamnash February 20, 2014
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
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