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Personal Finance
    for Engineers

     Adam Nash
    April 15, 2011
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
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)
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
Fast Five Finance Basics
• Behavioral Finance Basics
• Liquidity is Undervalued
• Cash Flow Matters
• The Magic of Compounding
• Good Investing is Boring
“Advanced Settings”

• Calculating Returns in Excel
• Why Retirement Planning is Hard
• Why Do You Collect Coins?
• Understanding Derivatives
• Recommended Books
How Many of You Think You
 Are Rational with Money?
      (raise your hands)
You Are Not Rational
• Anchoring
• Mental Accounting
• Confirmation & Hindsight Bias
• Gambler’s Fallacy
• Herd Behavior
• Overconfidence
• Overreaction & Availability Bias
• Loss Aversion (aka 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
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
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)
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
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?
Overconfidence

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

• Positively correlated with High IQ...
• Learn humility early
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”
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
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...)
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.
Liquidity & Returns
• In almost all cases, liquidity is
  inversely correlated with returns

• Examples:
  • cash = very liquid
  • private equity = very illiquid
• Common mistake:
  Safety != Liquidity
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.
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”
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.
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.
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!
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!
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.
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
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
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/
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
XIRR FTW!
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
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
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.
Visualization
              20



              15
Stock Value




              10



              5



              0
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                                   Stock Price
Visualization
              20



              15
Stock Value




              10



              5



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                   0   2   4   6   8   10 12 14 16 18 20
                                   Stock Price
Visualization: Call
                         Stock         Call @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
Visualization: Call
                         Stock         Call @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
Visualization: Call
                         Stock         Call @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
Visualization: Put
                         Stock         Put @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
Visualization: Put
                         Stock         Put @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
Visualization: Put
                         Stock         Put @ 10
        20



        15
Value




        10



        5



        0
             0   2   4     6     8   10 12 14 16 18 20
                                 Stock Price
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
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
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
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
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
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
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
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
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
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/

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Personal Finance for Engineers

  • 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
  • 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/

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