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/