Month: February 2013

Posted on

Book Review: Simple Wealth, Inevitable Wealth by Nick Murray

Nick Murray’s Simple Wealth, Inevitable Wealth, [1] deserves to be the exception to my rule of never reviewing “How to Invest” books.

Stylistically, Murray’s prose is the Yin to Nassim Taleb’s Yang.[2]  Murray is gentle, meditative, and modest in affect, part financial advisor and part Zen master, contemplating the beauty of compounding investment returns[3] and inter-generational wealth-building.

Yet for all his gentle style, he’s no less sure of himself or passionate when it comes to what he sees as simple, but overlooked principles for building wealth over time.

Since I’ve come to adopt his views as my own, it’s worth highlighting the best of them here.

  • Murray questions the common journalistic narrative[4] as it mostly misleads rather than informs.  Even worse, the journalistic narrative rarely asks the key questions for wealth building such as “What is Risk?”, “What does wealth mean to me?” and “Who am I?” (I’ve hyper-linked to my earlier consideration of the latter two questions.)
  •  Timing the market is a fool’s game[5], whereas time in the market will be your greatest natural advantage.
  • The highest value of an investment advisor is often to tell you to not do anything.  This sounds a lot like advice from Benjamin Graham.
  • Only equities provide the possibility of growing wealth in perpetuity.  I would add – but Murray does not – some other risky assets in addition to equities for certain people and institutions.  Murray has a particular fondness for stock mutual funds, and, for the vast majority of people, I concur that that’s all you need to grow wealth.  My own definition of ‘equities’ would include ownership in not only stock mutual funds, but also allow for a broader variety of risky vehicles such as real estate, traditional business ownership, commodity investments, or other volatile assets.
  • For the individual investor, bonds are an “anxiety-management tool” but not a wealth-building tool.  Unfortunately – given current interest rates – this is truer now than it was when Murray first published his book in 1999.  At this time, fiduciaries who depend on managing money in perpetuity cannot afford to be in bonds, a big, under-recognized problem – in my opinion.

His strongest points, which he spends the bulk of the book proving to my satisfaction are the following:

First, owning a diversified portfolio of equities over the long-term does not carry significant risk of capital loss.  The diversified portfolio of equities is subject to volatility, but volatility passes away under long-term time horizons[6] and should not be conflated with risk.

Second, building wealth through the steady accumulation of equity mutual funds is simple,[7] and the result of this behavior, over a lifetime, is inevitable wealth.

Third, in contrast, bonds or riskless assets will not build wealth, but rather condemn the investor to a long-run loss of purchasing power.  If your goal is to build wealth – rather than provide current income – you cannot afford to be invested in bonds.

Murray’s main message – as restated above – may be manipulated, distorted, exaggerated or parodied, but cannot be proved wrong.

Professionally I’m a “fixed-income/bond guy” through and through,[8] so I believe in the uses and opportunities of bonds and safe cash-flows.  Despite my experience and biases, I believe Murray on his own terms, is absolutely, capital “R” Right.

Please see related post: All Bankers Anonymous Book Reviews in one place.

 

 

[1] Full title of the book: “Simple Wealth, Inevitable Wealth – How You And Your Financial Advisor Can Grow Your Fortune In Stock Mutual Funds”

[2] I greatly admire and recommend Taleb, but as I’ve written on Fooled by Randomness and Black Swan, his prose style can be abrasive.

[4] Also known as the “Financial Infotainment Industrial Complex”

[5] On timing, Murray writes: “Time in the market, as opposed to timing the market, is not a way of capturing the long-term returns of equities; it is the only practicable way.  You have to stay in it to win it.”  This makes a lot of sense if you understand the magical power of compound interest.

[6] He defines long-term as, at minimum, 5 years.

[7] Murray explains that, while the process is simple, simple is not the same as easy.  It’s incredibly hard, in fact, to have enough left over, after paying your bills, to constantly invest in equities month after month, year after year, for your entire life.  But if you can do that, wealth is inevitable.  Hence, the title of the book.

[8] I’ve been a bond salesman, and fixed-income hedge fund manager.  I have no professional experience with the stock market.  Mostly I find conversations about stocks and the stock market incredibly uninteresting.  But I still believe you have to have your money exposed to them, or other forms of risky equity, to build wealth.

Post read (17825) times.

Posted on

Hey Fiduciaries: Is It All Financially Unsustainable?

money-all-goneI’ve been thinking recently about financial sustainability.  One version of the financial sustainability question is “How much can you responsibly spend from investments or endowments each year, without running out?”

There’s a lot packed into that single question, and the answers are not as esoteric as they may first appear to the average person.

Retirees living off accumulated savings, and people saving with the hope of one day living off accumulated savings, grapple with this question all the time.  Charitable foundations and institutions dependent on endowments also care deeply about this financial sustainability question, if they plan to exist in perpetuity.

But what about the rest of us, just struggling to put aside enough for whatever future expenses we anticipate – like college education for our kids, or a regular nest-egg for retirement?  Why should we care?

We should care because I suspect that the assumptions that fiduciaries[1] have made about financial sustainability in the previous generation no longer apply in the current market environment.  We have not, however, started adjusting to the new reality.  We’re not doing anything differently despite the new normal.

What does that mean?  It means that your favorite hospital or school or charitable foundation probably spends too much of its endowment every year to be sustainable.  It means your teachers and fireman and policemen – who depend on a pool of money set aside for their pensions – won’t have enough in the pool when it comes time to be paid.[2]

So, thinking about financial sustainability, I don’t think these are just the esoteric musings of a recovering banker with too much time on his hands, and too much sympathy for trust-fund folks and foundations.

The nub of the problem comes down to three facts:

1. Traditional charitable foundation/endowment spending policies[3] call for annual spending of 5% of assets,[4] as a ‘financially sustainable’ rate.

2. Traditional personal financial planning calls for annual spending of 4% of assets as a ‘financially sustainable’ rate.

3. But — riskless investments offer between 0.5 % and 2% returns.[5]

If you want complete safety with your assets, you can earn about a 1% return, which typically lags the inflation rate and puts you on a completely unsustainable path, if you have the policy of a 5% spending rate referenced in fact # 1 above.

Conversely, and axiomatically, the only way to have a fighting chance at ‘financial sustainability ’ with a 5% spending rate is to rely heavily on more risky investments, to boost the riskless 1% return to, at the very least, your 5% spending rate plus the rate of inflation.

So, a prudent fiduciary of her own money, or an institution’s money, can make the choice of taking no risk and guarantee diminishing the pool of money over time, or take a risk on more volatile markets and hope that things work out.  Which is pretty much where every fiduciary struggles right now.

I want to be very careful and point out a few ways in which what I am saying differs from the usual way we discuss this problem.

First, at the risk of breaking a cardinal rule of financial punditry, I am saying “it’s different this time.”  And by “this time” I mean “the investing life of almost everyone alive right now.”

With US Treasury Bond rates at the lowest level of most anyone’s investing life, as seen in the picture of 1953 to 2012 rates, we’re in uncharted territory for riskless returns.

Whereas previous generations of fiduciaries could choose a portfolio anchored with a large plurality of risk-free assets and cover most of their 5% spending rate, plus inflation, no fiduciary can afford risk-free assets any more.  That anchor of 1% risk-free return sinks your ship over time with a 5% spending rate.

Second, I am consciously avoiding making an argument about future return expectations.  I have no idea what future returns on risky assets will be, and I don’t intend to speculate.

It’s traditional for pension managers or endowment managers or even retirees to make assumptions about the future returns on their portfolio, to justify whatever asset allocation they do or do not wish to make.  Again, I’m not able to speculate.[6]

All I do know is that if you have to earn 6 or 7 times the annual return of riskless assets in order to cover your spending rate and inflation, then you need to fill your portfolio with almost entirely risky assets, just to break even with financial sustainability.

The only other solution, of course, is to lower your spending rate to something much closer to expected risk-less returns.  But nobody wants to take less than half the income they’re used to taking.  Or even anything less than the income they’re used to taking, for that matter.

Now it’s fair to say a version of this problem has always existed for people who manage a big pile of money for annual income but who seek financial sustainability.

What’s different now is that when 10 year Treasury bonds offered safe returns above 6% – like they did in the good ol’ days of 2000 for example – the financial sustainability choice was not so stark, or so risky.  You could count on earning most of what you needed to earn in largely risk-free assets.

Fiduciaries for educational institutions for example, face this quandary right now, all the time.  The ‘endowment norms’ from the 1960s give us cover for the idea that a 5% spending rate is prudent.  Fiduciaries know from surveys of similar institutions that they’re right in the middle of the pack, with plenty of comfortable company.  And they absolutely need that income to run the institution.

But if the norms made sense in an earlier generation of lower risk with higher return rates – – they make much less sense in the past decade – particularly in the last year with less than 2% returns for US Treasury 10-year bonds.

I don’t know what everyone should do about it.  I have no solutions.

My soon-to-retire parents hope that the previously-endorsed 4% spending rate for individuals works out.  I hope so too.  Fiduciaries for public and private pension funds hope their spending rates, return rates, and actuarial assumptions turn out to be right.  I hope so too.

My fear, however, is that from the 20/20 hindsight of our future selves, a 5% spending rate and a 1% riskless return rate look like an impossible mathematical equation that we all should have seen as unsolvable.


[1] My wife made me define this.  “fiduciary” = “person with financial responsibility for something”

[2] Which, in turn, means either: 1. Taxpayers make up the difference,   2. Retired public pensioners receive less than they were promised, or  3. Heavy inflation ‘solves’ the problem by lowering the real value of pension payouts.

[3] Based on 1960s theory about financial sustainability for charitable endowments.

[4] Charitable foundations are required to spend 5% of their corpus every year to retain their tax-exempt status.  This requirement to spend 5% of assets is probably related to where the foundation prudent practice of spending 5% came about.  But I’m guessing here.

[5] With 10yr US Treasury notes below the 2% range for the past year, the lowest in anyone’s lifetime.  Incidentally, of course some smart readers will point out that there’s a longer conversation to be had about whether US Treasury 10 year notes are truly ‘riskless,’ because if interest rates rise the bonds may decline in value before they mature, if you need to sell them rather than wait for the return of principal.  Yes, you’re right.  Other smart readers will point out that a downgraded United States no longer represents a ‘riskless’ investment.  Yes, you’re right too, up to a point.  But to the extent the US owes money on its bonds denominated in US currency, bond principal repayment is not at risk, only its purchasing power upon maturity.  All the returns I’m referring to are nominal.

[6] Fine, I’ll speculate a little bit, the following way.  If mega-bank X, which currently has the ability to borrow $ billions of dollars at 2%, had any comfort at all with a safe way to earn, say, 7% in risky assets, then mega-bank X would be doing that trade for a 5% positive carry (the difference between borrowing costs and earned return) all day long.  The fact that 7% in risky assets seems, well, risky, tells you a little something about return expectations from the smartest minds in the business.

Post read (50129) times.

Posted on

Book Review, Review: Michael Lewis on John Lanchester’s “Capital”

I learned from Michael Lewis’ article in this month’s New York Review of Books that the English have a particularly literary strength compared to us Yanks.

After quoting a passage from John Lanchester’s Capital featuring the inner quotidian dialogue of a Londoner named Ahmed, Lewis observes:

You can find this sort of thing on every other page—a fresh and interesting description of a sensation you might have experienced a hundred times without ever having bothered to attach words to it. The talent for these sorts of small-bore social observations is peculiarly English—it kept Kingsley Amis in business for years, and still makes Alan Bennett’s diaries feel like required reading. Maybe it’s the bad weather. (All those hours trapped indoors, watching one another.) Or maybe it’s the literary side effect of a middle-class culture in which people are expected to be painfully self-conscious, clammy in their own skin, and alert to their own folly and deceptions, lest they be spotted first by others. Whatever the reason, the English really are just better at this sort of thing than anyone on the planet.

This strikes me as likely and true, so now I will be on the lookout for it ever after.

I also learned from Lewis that the English had a particular historic weakness, relative to us Yanks.

Lewis uses the article to point out the English historical evolution with respect to American Wall Street culture.  In the early 1980s, he argues, London exhibited a curiously uncommercial attitude toward business and finance.[1]

Sometime in the last 30 years, however, an über-capitalist mentality seized the City[2] and its new, brash, Masters of the Universe.  Lewis reviews John Lanchester’s new novel in part in order to describe the evolution of London’s new elite.

I write book reviews for this site

1. To organize my own thoughts about something I’ve read;

2. To save readers the risk of reading something they’re not sure they’ll enjoy, and;

3. Most often for the largest part, because the book review allows me to make a point about something that I already wanted to say.

The New York Review of Books is better at these latter two functions than any other publication I know of, and of course Michael Lewis is better at writing about finance than anyone else.[3]  So you can imagine my pleasure on opening up this month’s NYRB to see Lewis’ review of an author I’d never heard of, who recently published a novel Capital about a diverse collection of characters in the City, in London.

Lewis clearly admires this hitherto unknown-to-me John Lanchester, even anointing him ‘one of the greatest explainers of the financial crisis and its aftermath.’  Further praise by Lewis about Lanchester:

He has a gift for taking a reader who knows nothing about a complicated topic and leaving him with the feeling that he knows all about it, or at least everything worth knowing.  He makes you feel smarter than you are.

Which, of course, is what I would have said about Michael Lewis.  Bottom-line: I’ve got to get John Lanchester’s book, Capital: A Novel.

Please also see my reviews of Michael Lewis’ books:

Liar’s Poker

The Big Short

And

Boomerang

Please see related post: All Bankers Anonymous Book Reviews in one place.

 Capital

[1] Lewis related a hilarious (to me) anecdote from the early 1980s London, illustrating this curious lack of commercial attitude.  He writes: “There was a small grocery store around the corner from my flat, which carried a rare enjoyable British foodstuff, McVitties’ biscuits.  One morning the biscuits were gone.  ‘Oh, we used to sell those,’ said the very sweet woman who ran the place, ‘but we kept running out, so we don’t bother anymore.’”

[2] “The City” is the London equivalent of “Wall Street.”

[3] I’ve previously reviewed three of his finance books, Liar’s Poker, The Big Short, and Boomerang.

Post read (6224) times.

Posted on

Part VI – Concluding Thoughts on Personal Finance Math

conspiracy_thinkingOr, why everyone needs to know this, beyond getting rich or avoiding poverty.

Please see my earlier posts

Part I – Why don’t they teach this in school?,

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Part IV – Discounted cash flows – Pension Buyout Example

Part V – Discounted cash flows – Annuity Example

 

A further reason why we need to learn discounted cash flows as a society

Are the US government’s assumptions about future social security obligations reasonable? Or are they instead unrealistic, or based on a Ponzi Scheme, as Peter Schiff and Ron Paul claim?

If you could do discounted cash flow calculations you could begin to form an answer.  You can see how the federal government would calculate exactly what the present value of those obligations is.

But “discounted cash flows” sound so esoteric to the average citizen – since we never learned it in junior high – that pundits and politicians with conspiracy theories who casually throw around words like “Madoff” and “Ponzi” begin to sound reasonable in comparison.  Which is really not a helpful direction for us to go in, as a society.

 

It is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.

 

Conclusion

I would love for Bankers Anonymous readers to explain to me[1] why the most powerful mathematical formulas in the universe, compound interest and discounted cash flows, never get taught to junior high students, then high school students, then college students.  And then again to anyone applying for a credit card, or mortgage, or car loan, or annuity, or pension, or saving for retirement.  Or arguing about the growth of federal debt – or the rise of future social safety-net obligations.

We’re blind people stabbing each other in the dark without these formulas.

All of the consumer financial protection bureaus in the world can’t help if consumers have no tools to do their own thinking.

All the fiscal cliff negotiations and partisan point-scoring amount to a tale told by an idiot, full of sound and fury, signifying nothing, if we as citizens cannot see how money grows in the future or how future obligations get valued today.

 

“Tomorrow and tomorrow and tomorrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time,
And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!
Life’s but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.”

–Macbeth, Act V, Scene 5

Macbeth

Part I – Why don’t they teach this in school?,

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Part IV – Discounted cash flows – Pension Buyout Example

Part V – Discounted cash flows – Annuity Example

and Video Posts

[1] I’m searching for some explanation better than 1. Math teachers don’t get it and 2. The Financial Infotainment Industrial Complex doesn’t want you to know about it.  And by the way, I don’t really ‘blame’ math teachers, just like I don’t necessarily think there’s a vast conspiracy of the “Financial Infotainment Industrial Complex.”  But I do like saying that phrase, as it sums up nicely the financial crap we get inundated with all day long.

Post read (12318) times.

Posted on

Part V – Discounted Cash Flows, using an annuity to learn the math

PiggyPlease see my earlier posts

Part I – Why don’t they teach this in school?

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Part IV – Discounted cash flows – an example using a pension buyout

Preamble

In the last post I used the example of a pension buyout to show how the discounted cash flows formula worked, and I argued that discounted cash flows are the key to all investing decisions.[1]  Everything else you get inundated with – from the Financial Infotainment Industrial Complex – is just a whole lot of hype, gimmicks, tricks and tips.[2]

Which makes it all the more odd that almost nobody outside of the financial industry has ever heard of discounted cash flows, never mind actually using the formula in their investment life.

So, allow me to peel back the curtain a bit more, using the example of an annuity investment.[3]

 

“Life’s but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more”

 

Another example using discounted cash flows, to value an annuity

Is that guaranteed monthly income annuity offered by an insurance company a good deal or not?  To answer the question you’d need to know how to discount cash flows to put yourself on an equal footing with your insurance company offering you the annuity.  Which I did on my site once before.[4]

Let me break down some of the numbers, by way of example, or possibly by way of inspiration to others who want to start calculating discounted cash flows in their own life.

I just went on my preferred insurance provider’s website[5] and asked for a quote on a 15-year fixed time-period annuity.  In exchange for a $100,000 lump sum from me, the insurance company offered me $641.15 per month, guaranteed, for the next 180 months.  The question I ask is whether that is an attractive investment for my $100,000?

To answer the question I’m going to use the discounted cash flows formula Present Value = Future Value/ (1+Yield/p)N.

I offer a bit more explanation of these variables in a footnote[6]

I can discount exactly 180 different future payments of $641.15, by dividing each of them by (1+ Yield/12)N.

For the first cash flow, N is 1.  For the second, N is 2.  For the 180th monthly payment, N is 180.

This looks like this table in my spreadsheet, which contains 180 rows of numbers and discounted cash flows formulas:

N Period Monthly Payment Formula: PV = FV/(1+Y/p)N
1 $641.15 =$641.15/(1+Y/12)1
2 $641.15 =$641.15/(1+Y/12)2
3 $641.15 =$641.15/(1+Y/12)3
… $641.15 =$641.15/(1+Y/12)…
180 $641.15 =$641.15/(1+Y/12)180

 

Once I have programmed a spreadsheet to calculate 180 individual discounted values for $641.15, I next program the spreadsheet to add up all 180 payments.[7]

Next I can input a value for Y, or Yield, to try to figure what kind of deal I’m offered by my annuity company.

I compare the sum of all 180 values to my original $100,000 investment.  To come up with a comparable yield on the annuity, I input different values for yields into my spreadsheet.  For my purposes I can find the ‘yield’ through ‘iteration,’ basically trying different values until I match up the sum of discounted annuity payments to a final value of $100,000.

If I assume Y is 2%, as I’ve shown in the table below, it turns out the sum of all cash flows is too small and does not quite add up to $100,000.

N Period Monthly Payment Formula: PV = FV/(1+Y/p)N Calculation
1 $641.15 =$641.15/(1+0.02/12)1 $640.08
2 $641.15 =$641.15/(1+0.02/12)2 $639.02
3 $641.15 =$641.15/(1+0.02/12)3 $637.95
180 $641.15 =$641.15/(1+0.02/12)180 $475.09
TOTAL $115,407.00 $99,633.46 $99,633.46

 

If I instead assume Y is 1.5%, it turns out the sum of all cash flows is too large and adds up to more than $100,000.

N Period Monthly Payment Formula: PV = FV/(1+Y/p)N Calculation
1 $641.15 =$641.15/(1+0.015/12)1 $640.35
2 $641.15 =$641.15/(1+0.015/12)2 $639.55
3 $641.15 =$641.15/(1+0.015/12)3 $638.75
180 $641.15 =$641.15/(1+0.015/12)180 $512.04
TOTAL $115,407.00 $103,287.51 $103,287.51

 

 

So I keep trying to find, using my spreadsheet, the value that makes all 180 discounted payments of $641.15 equal to $100,000.  Once I find that, I know what kind of yield, or return, my insurance company offers me on my annuity investment

It turns out, through iteration, that 1.92% is the yield I get by investing $100,000 today and receiving $641.15 per month guaranteed for the next 15 years.

The fact that 1.92% is an absolutely pathetic return is not surprising, nor notable.  As I’ve written before, insurance companies are in the business of buying money cheaply and selling money expensively, and retail annuities are the ultimate source of cheap money for them.

What is notable is that we, as consumers, have no way of evaluating the return on an annuity if we can’t do discounted cash flows.

Which is why I say, ask not what you can do with your insurance company.  Ask what your insurance company is doing to you.

Just like credit card companies do not want you to know that the average American household, carrying the average credit card balance, at an average interest rate, will pay $2.6 million over 40 years because of compound interest[8], similarly, insurance companies can build massive skyscrapers in major cities because they know how to use the discounted cash flow formula to get money cheaply.

And you don’t.

Please see earlier posts

Part I – Why don’t they teach this in school?,

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Part IV – Discounted cash flows – Pension Buyout Example

Part VI – Conclusion, or why everyone needs to know this math for the good of society

and Video Posts

Video Post: Compound Interest Metaphor – The Rainbow Bridge

Video Post: Time Value of Money Explained

 

 

Be Rational Get Real

[1] Put it this way, if you’re an individual (I will exempt broker-dealers, HFT and many professional investors from this next statement because they are often doing something different) and you’re not employing a discounted cash flows formula, you’re gambling, not investing.  Which is to say, 99.5% (and I rounded down to be conservative) of us are gambling when we purchase an individual stock.

[2] Are the Chinese buying it?  Is your gym-budding selling? Will baby-boomer demographic trends boost this?  Is Bill Ackman short the stock?  Is it a breakthrough miracle drug?  Will nano-technology make it obsolete?  All hype.

[3] I’m using an annuity to illustrate the use of the discounted cash flow formula because it’s easier to talk about the straight math of future annuity cash flows than it is to talk about modeling future stock dividends and profits.  That involves a longer conversation about equities actually just being a series of future cash flows, which most people will not want to wrap their head around at this time.

[4] By the way, I just re-read my piece on annuities from six months ago.  You should go read it.  It’s good.

[5] I mentioned USAA before in my piece on annuities, because their customer service is awesome.  I have no relationship to them other than as a customer and I just like them.  I assume their quote is standard for an annuity provider, neither better nor worse than the competition.  As I wrote you before, USAA, you should totally make me your President Palmer, peddling life insurance for you.  Call me, maybe.

[6] This time with the formula I’ve introduced the variable p, which is the number of times per year that money gets compounded.  In the case of monthly payments, p is 12, because I have to take into account compounding 12 times per year.  N remains the number associated with each payment, from 1 to 180 in our example, unique to each monthly payment.  Yield, also known as Discount Rate, is the variable I’m going to solve for, to figure out whether the investment is a good deal or not.

[7] Those of you reading this who have spreadsheet experience will note that it’s very simple to create 180 nearly identical rows of formulas simply by a click-and-drag of a single formula.  Similarly, adding up 180 different discounted cash flows is as easy as typing “=sum()” into a spreadsheet cell and referencing the correct cells.  Out pops the answer.

Post read (23282) times.

Posted on

Part IV – Discounted Cash Flows – Golden parachute or silk umbrella?

golden-parachutePlease see earlier posts Part I – Why don’t they teach this math in school?

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Preamble

In the last two posts I wrote about how, using the compound interest formula, you can compute precisely how large your money will grow over time, using compound interest.  If you assume a particular growth rate (aka yield, or rate of return) and you know how frequently your money compounds (monthly, quarterly, yearly) you can model into the future what your money will become.

This post is about the reverse process, called discounted cash flows, and is – in my humble opinion – the most important piece of math for investing in anything.  The discounted cash flows formula is what you need to know in order to decide to invest in something today that will have some future value.

Despite what the Financial Infotainment Industrial Complex wants you to believe about the reasons to buy something, evaluating the true value of an investment depends on you knowing how to discount future cash flows.  The rest is just hype, spin, sales and marketing.

And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!

What about discounted cash flows?

First, let’s say what the formula is as, again, the Financial Infotainment Industrial Complex does not want you to know this stuff.

The discounted cash flows formula uses the exact same variables as compound interest, but ‘in reverse,’ solving for “Present Value” instead of “Future Value”

Present Value = Future Value/ (1+Yield)N

Where:

Future Value is the known amount coming to you at some point in the future.

Yield is the growth rate of money, also known as the discount rate.

N is the number of times money gets compounded.

Present Value is generally what you’re solving for when you use this formula.

Most importantly when you figure out how to discount cash flows, a whole series of financial and macroeconomic questions become clearer.

An example of a pension buyout showing the value of discounting cash flows

The discounted cash flow formula is what you’d need to use, for example, if your company offered you a lump sum buyout instead of a life-time pension, as GM did to many workers in 2012, and as many companies frequently do to get rid of their future pension obligations.  Let’s say they offer you a $500,000 buyout.  Sounds like a big enough number to induce many people to take a buyout.

Is the lump sum offer a good deal?  How would you know?

If you could set up a spreadsheet to discount cash flows, you’d know precisely what kind of deal it is.

You could add up the value of all of your future monthly pension payments, properly discounted by the formula above, and you could compare that to the amount GM’s pension department offered you.

Let’s say you would normally receive a $36,000 per year pension for the rest of your life, and you expect to live for another 20 years, here’s what you would do.

You might want to know the Discount rate, or Yield, on GM bonds to gauge the risk of the future pension, or you might want to just assume the government guarantees your pension, so you’d input a lower yield.  Let’s assume low, government guaranteed risk for this example and use a 2% yield to reflect government risk and moderate inflation.[1]

Next year’s payment I’d calculate by the formula Present Value = $36,000 / (1+0.02)1, or $35,294.12

The following year’s pension payment I’d calculate as $36,000/(1+0.02)2, or $34,602.08

I can calculate all of these values easily in a spreadsheet, until I added up the 20th year’s amount, which is calculated as $36,000/(1+0.02)20, or $24,226.97

When I add up all 20 years the result is $588,651.60

Which one is bigger?

Of course you can input different assumptions about your remaining life, and the discount rate, and even the pension amount, but all of this is to show that you need this tool to level the playing field and make good decisions.

I guarantee you that GM’s financial officers know how to discount cash flows, and they’re negotiating from a position of extraordinary advantage against their retired workers who cannot discount cash flows.

So, again, blame the math teachers.  And the Financial Infotainment Industrial Complex.

Please see related posts

Part I – Why don’t they teach this in school?,

Part II – Compound Interest and Wealth

Part III – Compound Interest and Consumer Debt

Part V – Discounted cash flows – example of an annuity

Part VI – Conclusion and why everyone needs to know this math for the good of society

and Video Posts

Video Post: Compound Interest Metaphor – The Rainbow Bridge

Video Post: Time Value of Money Explained

Also see related post: Using Discounted Cash Flows to analyze Longevity Insurance

 

Silk umbrella

[1] Really you can input whatever assumptions you want to derive a discounted cash flow.  Please don’t start a fight with me about whether 2% is the right assumption.  I’m just trying to show a math technique, not debate the proper discount rate for GM pensions.

Post read (32085) times.

Stay in Touch

We’ll let you know when we have new posts!

Facebook Twitter Linkedin

Copyright 2024 © All rights Reserved. Design by Sweb Development