Monthly Archives: January 2012

What I Read

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This came in via email and I thought I’d crosspost here.

I like Barry Ritholz daily summary of news – he embeds John Mauldin’s weekly eletter, which I also like. http://www.ritholtz.com/blog/ is where I subscribed to his daily email. With that email, I don’t need to read much else for current events.

I don’t subscribe to the Times or the Wall Street Journal but when their articles rise on Google News, I tend to read those.
I read all the stuff on our site – endurancecorner.com – as the writers are people that I know and trust. I don’t read forums, other than Endurance Corner, as I avoid sources of noise.
I check google news too often – I’d be fine checking every 48 hours but check a few times per day.
That’s about it. When I have time, I read non-fiction. A key focus for me in 2012/2013 is creating more space in my life for kids, writing and reading.
The book list that follows has been helpful – I particularly like all of Gordon Livingston’s writings. For business, Charlie Munger’s essays and books are excellent. I read the Drucker essay, below, once a year.
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Great Reads

Buffett: The Essays of Warren Buffett

Cialdini: Influence

Drucker: Managing Oneself

Karp: Happiest Baby On The Block

Kahneman: Thinking, Fast and Slow

Le Guin: Tao Te Ching

Livingston: Too Soon Old, Too Late Smart & Always Keep Dancing & How To Love

Munger: The Psychology of Human Misjudgment

Munger: Poor Charlie’s Almanack & Seeking Wisdom

Shiller: Irrational Exuberance

Taleb: The Black Swan, Fooled by Randomness and Antifragile

Risk and Pain

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Reading my last two columns, you may have felt an emotional response. If you aspire to a big house, or send your kids to private school, then you likely stopped reading. Why?

Ideas that conflict with the default decision create pain. Our brains don’t like pain so switch off.

For high value topics, both financially and emotionally, it is worth training the ability to stay engaged and work through the answers. Adding together the last two columns, most of us are looking at $3 to $8 MILLION worth of expenditure. That’s simply two topics – smart decision making is worth serious cash for you, and your employer.

The last sentence is an example of how I stay engaged — make the question “bigger” that the local issue that’s causing you pain. I have to stay engaged with housing and education because my larger issue is an ethical life with meaning (that’s free from unnecessary financial stress).

Making the issue bigger is called “broad framing” and it’s an effective tool for pain management. In addition to framing, I ask:

  • Where is the pain?
  • Is it a gain, or a loss?
  • Is it small, or large?

Kahneman’s book contains a risk matrix that lays out situations where we will seek/avoid risk. What most interested me is that we can frame choices so our “irrationality” works in our self-interest. Kahneman has excellent examples (litigation, negotiation, organ donation) that you may have heard over the years.

Two weeks ago: I asked if the big house is worth $7,400 every single month?

  • I made the financial costs visible
  • I made the financial payments frequent
  • I wrote the article while living alone in a small two-bedroom condo

I made owning my “big house” more painful. Then I asked myself, am I feeling a million dollars worth of pain? Hell no, I replied!

One week ago: I asked if private education is the best way to invest in my children?

  • I framed the question as broadly as possible
  • I made the goal to maximize the overall benefit to my family
  • I used a reference group of other people’s children

This removed feelings of pain. The default option had me thinking that spending on education equals love. That’s an emotional error. The true choice is directing family investment to maximize benefits for everyone. Broad framing is an effective counterbalance when people seek to link spending with love. 

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Let’s consider two more areas where framing might be useful: nutritional supplements and helping family members.

Nutritional supplements remind me of lottery tickets. We accept that they are largely a waste of money but there is a remote payoff of everlasting life.

As a public service announcement, a friend of mine pointed out that we might be increasing our risk of death through unnecessary supplementation. My buddy is a nephrologist, Vice-Chair at the Mayo Clinic and an assistant professor of medicine.

Does that reframing change how I feel when I watch my daughter eat multi-vitamins? You betcha!

Investments of time are often more costly than investments of money. Munger’s Psychology of Human Misjudgment (and many other sources, including Kahneman) point out a few things about how we see our role in the world:

  • We overestimate our ability to influence events
  • We overvalue the recent, the present and the status quo
  • When we think about risk, we overestimate the risk of highly-salient negative events (terrorism, plane crashes, homicide).

Combine all of the above and we are prone to large errors when it comes to people that are close to us (peers, friends, family, kids). That’s hardly news, until you consider the top two emotional drains in your life.

Do it now – what are the top two emotional drains in your life? Do you have key relationships that are more about negotiation, than love?

Unless a supplement-eating friend dies of cancer, the vitamin discussion is unlikely to have a visible impact in your life. There’s a financial cost from buying unnecessary goods but most of us would spend our vitamin money elsewhere, rather than save it.

However, the emotional drain from continuing to pour love and money into the worst performers in our life is worth considering. To help myself here, I set my goals looking to the future:

  • Break the chain – pain that comes to me, stops with me
  • Forgive – by acknowledging that people who bring the pain, received it from someone else
  • Acknowledge – that my ability to impact the world is limited, and mainly achieved via how I improve myself

If that seems a bit soft then consider a risk-policy to never fund a losing situation. In the acquisitions business there is a simple mantra, never fund operating losses. In the markets the mantra is only losers average down.

In human terms, it could mean that I help pay for education, addiction treatment, health care… but we each need to take care of our basic living costs. If someone can’t help themselves then I’ll take the pain (of watching them fail) to create the motivation for a change that will result in future benefits.

The re-framing is a change from “prevent pain” to “create the conditions for positive change.”

These are difficult decisions to make with close friends and family. However, the expected payoff (time, money, emotion, love) is far greater.

Bottom Line: Break the chain and frame wisely.

A Million Dollars of Education

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What first got my attention on education was realizing that a month of my daughter’s pre-school was costing more than a semester of my finance degree at McGill University. Digging a little deeper, the long-term cost of education blew me away when I ran the numbers.

Like most parents, we believe our daughter is a gifted genius and we want the best for her. Since I’m the CFO of my family, I’ve been approached to share my thoughts on private education.

What’s the default option with private education?

  • We want the best for our kids
  • Private education costs more so it must be better
  • I can afford it, today
  • Therefore, let’s start down the path

Duscussing education with parents I see the full range of human misjudgement. We all want our kids to succeed so our most-human tendencies manifest. I won’t give specifics as my sources are good friends. Just ask around and you’ll see what I mean.

Similar to our discussion on housing, let’s run some numbers using actual education costs in 2012 dollars. The first figure is Colorado and the second is California. These are figures for the private track:

  • Pre-school: $6,000/$12,000
  • Elementary/Middle: $15,000/$25,000
  • High School: $25,000/$50,000
  • University: $50,000/$62,500

I did a little research on education inflation and it’s been running at 6% per annum. I created a spreadsheet to look at the cost per kid at a 5% inflation rate, which also matches my forecast portfolio return if I don’t spend that money on education. If you want to play with my assumptions then make a copy of the spreadsheet (file/make a copy).

Depending on where you live, the private track has a future value of $875,000 to $1,375,000 per kid.

Knowing that we won’t be rational when we look at our own kids, think about the brothers and sisters of your peers, spouse’s family and your cousins (that’s your reference group). Would it have been a good investment drop a million bucks (each) on all of their educations?

The questions are worth asking but most of us don’t ask, we default:

  • I love my kids
  • Private is better
  • I can afford today
  • I’ll do it

Stack the education default on top of the housing default and many of my peers are looking at $3-8 million worth of expenditure. That kind of money can make a lasting difference in your city when directed wisely.

Likewise, if you think carefully about your goals (and frame broadly) then you might discover alternative uses for those funds.

…you might enjoy working less and teaching your kids what you know

…you might have superior ethics because you haven’t placed pressure on yourself to earn millions over the next two decades

…you may be a better spouse without all that pressure

…your kids might do better if you back them financially as adults

…if you’re in a weak public school district then your relocation budget might be bigger than you think

A very successful friend of mine always wondered why his father refused to pay for any of his education. My friend got himself through MIT and, as it turned out, didn’t need help from anyone.

Perhaps his Dad ran the numbers.

A Million Dollars of Housing

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This article is twice a long as normal but it might save you some big money.

Get a pen and paper – I’ve made it easy for you to follow along.

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When it comes to housing, I’m tempted to follow the crowd because it’s easier. However, there is a cost to going-with-the-flow and this article will make that visible.

Using the decision framework from my last post we start by considering the default decision. Watch any housing-based TV program and you’ll see the default decision in action.  There are three components:

  • We want to live in X neighborhood
  • We think buying is better than renting
  • We optimize for size relative to maximum budget

I’ve never heard a person brag that they decided to rent a small, convenient place because it was a better financial deal and they were going to live free of financial concern. We certainly don’t bother watching television shows about these people but we might read a blog, or two!

Let’s calculate the financial cost of the default option to “buy the largest place in the best neighborhood we can afford.” We’re going to use my hometown of Boulder, Colorado – one of America’s most livable cities!

I’m 43 and moved out on my own when I was 17. Over 25 years, what might the default option cost me? I’m going to explain in a way that you can calculate your own position. Start with asking yourself three questions:

  • What’s the absolute cheapest that you could live?
  • What’s the cheapest that you would like to live?
  • What’s the implication of the default decision?

At the start of 2012, the three monthly costs are $1,000, $2,650 and $7,400, respectively, and include:

  • Rent or mortgage-equivalent rent (MER) [1]
  • Insurance
  • Maintenance
  • Utilities
  • Taxes and homeowners association (HOA) fees

If you rent then you avoid many of costs of ownership (building insurance, maintenance, taxes, HOA). You also have much greater freedom in your life – freedom allows us to pursue opportunity. We never see the true cost of the status quo within our lives.

To make it real, let’s work through two choices that would apply to a family moving to Boulder.

Option A – $400,000 house in secondary neighborhood. The total cost is $31,750 per annum ($2,650 per month) which includes:

  • MER = $20,000 per annum (5% of $400,000)
  • Insurance = $750 per annum
  • Maintenance = $1,000 per annum
  • Utilities = $6,000 per annum
  • Taxes/HOA = $4,000 per annum

Option B – $1,400,000 house in a prime neighborhood. The total cost is $89,000 per annum ($7,400 per month) and include:

  • MER = $70,000 per annum
  • Insurance = $1,500 per annum
  • Maintenance = $1,500 per annum
  • Utilities = $6,000 per annum
  • Taxes = $10,000 per annum

Keep in mind that the opportunity cost of being “all in” on a house is understated because it doesn’t reflect:

  • The time to manage the house
  • The investments that you miss because you’re locked into a property asset
  • The option value implicit in the ability to change cities rapidly when you’re a renter

Our minds are extremely poor at putting a value on time, lost opportunity and geographic freedom. How can we value the path not taken?

I am able to see these benefits when I consider my key investment decisions and career moves. The ability to move, or invest, quickly has been useful to me in 1990, 1993, 1998, 2000, 2002, 2005 and 2010. [2]

Each “jump” was worth more than $100,000. Sitting here, I struggle to place a value on being able to take future jumps, and assess their likelihood. However, being trained in finance, I can calculate the future value of incremental cash flows.

What happens if I invest the incremental cost of Option B, rather than buy the default option?

  • Upgrading from $1,000 to $2,650 monthly => forsake $966,462 of future value
  • Upgrading from $2,650 to $7,400 monthly => forsake $2,782,239 of future value

The part that catches my eye is the default option (biggest place, best location) costs nearly $3 million for a place that’s exactly the same size in a secondary location. 

To make it easier for your calculations – each $100 per month is worth $58,575 over 25 years at 5%. However, you only get the future value if you save in the present and earn the target investment return. [3]

Our minds are constructed to find faults with stories that go against the default option.  Perhaps you’re thinking:

  • But what about the house – it will increase in value
  • I don’t have to pay the money myself – a bank will lend to me and that “costs” less than my own money
  • The bigger house will make me happier
  • The assumptions aren’t accurate [4]

Perhaps, but these are default options in their own right, which I’ll address over time.

If you frame the happiness/satisfaction decision as broadly as possible then you might find that you can purchase one heck of a lifestyle by purchasing frequent, novel experiences rather than being locked into an enviable, but excessive, housing situation.

Personally, I feel happy when I can exercise, read, write, share experiences with my wife and hug my kids. I have also noticed that my family responds best to time with me when I’m relaxed. [5]

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NOTES

[1] What do I mean by mortgage-equivalent rent? 30-year mortgage rates are ~5% right now in the US so derive your mortgage-equivalent rent by charging yourself 5% of the net capital value of your target house. Depending on your geography, this could be more, or less, than what it would cost to rent your target house. This is an interest only calculation.

[2] I am likely to underestimate the role of luck and I’ll address that later in this series.

[3] Many corporate pensions are using long-term return figures of up to 10% per annum. At 10% annual forecast return, each $100 per month is worth $123,332 at the end of 25 years. Depending on your investment return, $100 per month is worth $50,000 to $125,000 when done consistantly and invested conservatively over the long run. 

[4] 5% is the key assumption and likely understated because, in my lifetime, mortgage rates have varied between 4% and 18%. The exact assumptions aren’t essential to make the larger point that long-term costs lie hidden from consideration.

[5] When seeking to reduce expenditure, I bribe myself by spending a portion of the savings during my adjustment period. In 2011, I funded a trip to Bora Bora by downgrading my travel choices for the year. Balance the pain from adverse shifts by using strategic purchases. 

Million Dollar Decisions

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I’m going to kick off 2012 with a series of essays based on the book Thinking, Fast and Slow by Kahneman. The book has all the entertainment value of Blink, by Gladwell, with superior information for action. To keep it real, and make it interesting, I’m going to use case studies from my own life.

If you get yourself a copy of the book, and read in parallel to my essays, then you will improve how you make decisions in your life. I learned a lot by spacing my reading with personal reflection.

In many ways Kahneman’s book is similar to The Black Swan, by Taleb, a book that saved me from personal bankruptcy. However, in one important way, the book is different. Throughout the text, Kahneman inserts simple exercises that illustrate our tendencies towards risk seeking and risk aversion.

I think of myself as rational but I “failed” most tests of rationality! The fact that the author failed the same “tests”, yet won a Nobel Prize, soothed my ego but didn’t release me from a sense that I was costing myself big bucks.

A review of my life highlighted that I was making most decisions on autopilot. I’ll share my case studies on:

  • Housing
  • Education
  • Work
  • Portfolio Allocation
  • The Status Quo – the hidden costs of being attached to it
  • The Role of Luck – how it skews us
  • Managing Personal Experience – duration neglect, peak experience sensitivity, relativity
I’m 43 years old. By the time I am 63, I will have made million dollar decisions on each of the topics above – for myself and for my family. Further, there are non-financial decisions (spouse and peers) that will have a massive impact on my life experience over the next twenty years (as well as this week!). 

Being highly rational… I’ll explain my key decisions using a framework to counteract the common errors outlined in the book:
  • Frame the problem as broadly as possible
  • Identify the stars and dogs within the framework
  • Identify the goal of the decision as well as the sunk costs that might skew judgments
  • Gain accurate information about a reference group of similar people making similar decisions
  • Understand the social norms and default decision options
  • Consider the implications of inverting the norms, defaults and preferred course of action
  • Research risk polices that might govern the decision
The above takes a lot of effort and I find myself constantly tempted to default to social norms. Going further, when I default to the norms I feel pleasure (because the pressure is off to think).

Knowing that mental laziness costs me satisfaction and money, gives me motivation to think things through. Stating that I’m going to share my thinking in a series of essays, creates social pressure for me to follow through.

Next Thursday: Housing – you’ll get to learn from my mistakes on this one.