Lessons in Finance (A crash course)

I recall an IBM Management Conference held at Smith College, where Fred Young was addressing the audience. He looked like the Chicago banker he was (Director of the Trust Department of the Harris National Bank) and he spoke with the wit and dry humor of Mark Twain. You couldn’t not listen to Fred. Everyone was riveted to every word and was taking notes.

Fred said he would rather be old and rich than old and poor. If the audience agreed, they should pay attention. He said that as Chief Trust Officer of the bank, he had observed three ways of getting rich: 1. Inherit wealth; 2. Marry wealth; and 3. Earn wealth. The three most common ways of earning wealth are: 1. Build a successful business, 2. Own and develop real estate, and 3. Invest money intelligently. Fred went on to say that it’s just as important to wisely manage the money you have as it is to earn it. He said it’s not only what you make that counts; it’s the difference between what you make and how you spend it that will do great things for you.

Fred’s formula for financial management was simple and doable: 1. First, invest at least 15 percent of every dollar you receive in interest and dividend-providing vehicles; 2. Next, spend income received on absolutely necessary purchases, such as health, food, housing, and transportation; 3. Next, spend income received on developmental activities, such as education, including your children; 4. Next, spend income received on reasonable discretionary purchases such as clothes, cars, hobbies, and travel; 5. Remaining money should be used to build wealth and be available for emergencies; 6. If you must borrow, do so wisely and borrow at the lowest rate you can find. Be sure to avoid late payment fees and establish a good credit record. The key is to invest first, then spend income within your means.

Fred thought happiness begins with feeling good about oneself, and fundamental to this is practicing good financial management. It helps to invest and spend wisely as soon as possible, even though there are examples of well-known people who gain wealth later in life (Fred cited Colonel Sanders of Kentucky Fried Chicken). In contrast, most rich people postpone gratification early in life to gain financial security later in life. By being wise and responsible, people can have healthy and happy families. Fred died at age 98, surrounded by family and dear friends. He would want us to pass this guidance onward – work, earn, invest, enjoy!

Suppose you are 25 years old earning $70,000. You conservatively forecast annual salary increases of 5% and decide to follow Fred’s advice investing 15% of your income annually in a tax-advantaged account until you are 65.  If you earn an average rate of return of 6%  over the 40 years, your account will grow to about $3.4 million.  If, instead, you earned an average of 8%,  you would have $5.1 million.  Albert Einstein is alleged to have said “Compound interest is the eighth wonder of the world.”

We all should know something about basic life skills such as  carpentry, home repairs, how to change tires, the psychology of working in a group, and how to be charitable.  Having basic financial knowledge also belongs on the list.  The following is a tutorial or “crash course” on finance all leaders should know, regardless of the work they do -– agriculture, engineering, business, art, science, and professions such as law and medicine.  If you can avoid money problems you will have more time to be a good leader.

”A dollar today is worth more than a dollar tomorrow.  A safe dollar is worth more than a risky dollar.“  All of finance stems from these two concepts.  Psychology and ego sometimes complicate matters, however.   Here are some ideas to ponder that should give you more agency over  your future.

Protocol and Good Behavior

• Don’t mention size.
  Don’t mention the size of your trades.  The risk of sounding like an amateur (I bought 10 shares of XYZ ) or a braggart I sold $50,000 of XYZ.”) is too great.  Say, instead, “I bought half a position in XYZ,” I bought some XYZ,” or “I trimmed my XYZ position by  a third.”
  
  
• Be careful mentioning returns.
  Avoid mentioning how well your portfolio did when the stock market had a good year.  In 2000, I once heard someone say, “My portfolio was up 87% last year.”  Given that the Nasdaq index was up 85.7% in 1999,  the performance was good, but not surprising.  On the other hand, statements about performance during declining prices  usually come from better-informed people.  If someone says “The Nasdaq was down 40.5% in 2008, but we managed to hold our losses to -35%”  they get a gold star on their chart.
  
  
• Dealing with people’s lives
  When you deal with someone’s money, you deal with their lives.  Counselors, clergy, and social workers will tell you that money problems contribute significantly to many family conflicts.  Many of these problems can be avoided with some introspection.   If you are a knowledgeable investor, don’t bite on the “What do you think of XYZ?”  question.  If you ask a doctor “What do you think of penicillin?”  The answer depends: Are you allergic to it?  Are you taking other antibiotics?  What condition makes you think you need it?  If I say ”I like XYZ”, that is a tacit recommendation to the questioner. I need to give you a financial physical before offering an opinion on XYZ’s merit for you.   Will XYZ contribute to your financial health?
  
  
• Diversification
  Jones is a great high-school ice hockey goalie, but the university team already has three good goalies and can’t give a scholarship to another one.  If your portfolio is already heavily concentrated in pharmaceutical and biotech firms, adding another similar firm is probably unnecessary.
  
  
• Distinguish between fact and opinion.
  If you are financially savvy and say XYZ is undervalued, your friends will likely take that as a given.  In your opinion XYZ may be undervalued, but XYZ’s undervaluation is not a fact.  Similarly, if someone looks at an upward sloping stock chart and says the stock is “going up.”  It has gone up (a fact based on the past), but how do you know it is “going up?” Future performance is unobservable:  investment forecasts are opinions, not facts.
  
  
• Risk adjustment
  How much money your portfolio returned is easy to talk about.  Risk is harder.  One way to double your money is to guess red or black correctly at a roulette wheel.  Guess right and you earn 100%, guess wrong and you lose your bet.  Someone who earns 100% is not necessarily someone you want running your money.  Were they lucky or astute?
  
  Would a baseball manager rather have a .330 hitter with no home runs, or a .150 hitter leading the league in home runs?  Investment home runs are exciting and make the news, but you are likely to be happier hitting lots of singles and getting on base.  If the baseball team/investment portfolio is well-built and performing well, you might be inclined to have some fun and  add a “swing for the fence” player/stock to your team/portfolio.  There is nothing wrong with this provided you recognize that you have increased the risk (meaning the chance of loss) in exchange for a chance of a really good and fun outcome.
  
  
• If you fill your safe with $100 bills you probably won’t lose them, but inflation will erode their purchasing power.  It is not correct to say they are risk-free.  You still bear the risk of inflation eroding their value.
  
  
• In the courtroom, a good investment outcome does not negate a claim of investment imprudence.  The fact that your investment had a good outcome does not mean that you managed money well.
  
  
• Inheriting a lot of money does not make you a wise investor. 

Gullibility, Illogic, and Psychology

• Beware of the fully only paradox when reading financial reports or other news. If you read “ fully 40% of people surveyed believe the stock is undervalued,”  you might interpret this differently than if the sentence had read “only 40%” believe it is undervalued.  Think about the subtle messages the wording can send.  If you are really hungry, would you rather have a 4-ounce hamburger or a quarter pounder?  (exactly the same)  The bag of chips might say “15-ounce bag, 25% larger than the 12-ounce size.”   (the math is correct, but why should the labeling influence you?)
  
  
• We are susceptible to anchoring or  attaching too much importance to a purchase price.  Consider “I bought the stock at $50; it is down to $40.  I can’t sell it now because I would have a loss.  If it gets back to $50 then I will sell it, and at least I won’t have lost anything.”  The fact that you don’t realize the loss at $40 doesn’t mean you don’t have one.  Even if you sell it at $50, you didn’t break even because of the opportunity cost of the interest you could have had if the money had been in the bank.  The price you paid for something really doesn’t matter.  Consider its investment merits as of today and don’t get anchored on the sunk cost. 
  
  
• We don’t like to take losses. Beware of the disposition effect:  our tendency to sell winners too soon and to keep underperforming investments too long.   
  
  
• Recognize the self-attribution bias, where we tend to take credit for favorable outcomes and are inclined to blame failures on bad luck or someone else. 
  
  
• If I ask a group of students “Would you ever buy a financial asset fully expecting to lose all your money?”  Almost everyone says no, but most of us do it all the time.  Do you feel bad if your house doesn’t burn and you don’t get to use your fire insurance?  Do you feel bad if you don’t wreck your car?  After a safe year with no fire or car accident, do you say “Well, we wasted all that insurance money.”  Neither the insurance company nor the individual wants  to experience a claim.  Having the policy expire unused is the best outcome for everyone.  Insurance is a hedge that, for a price, reduces an unacceptable risk. 
  
  
• In graduate school I had a friend who would say “Bob, did you see Esterline today?  It was up $1 so my 200 shares made me $200. A few days later the stock was back to the starting price.  A week later the stock is again up a  dollar, and my neighbor would say, “I made another $200 today,”  He made that same $200 over and over, having fun but also kidding himself. 
  
  
• A good company is not necessarily a good investment.  Some people believe this is one of the most important lessons in investing.  You have to read the price tag:  this is difficult with investments.  In a store, you might find a name-brand winter coat but put it back when you see how much it costs.  Similarly, another store might have a rack of off-brand seconds that are so cheap you decide to buy one.  Reading the price tag of a share of stock is not an easy skill to develop.  If XYZ sells for $50 per share, that does not mean it is more attractive than some other higher-priced stock.  At a pizza place I once heard someone ask, “How many slices are there in a large pizza?”  The clerk responded “eight.”  That is not a very good question.  A medium pizza is probably also cut into 8 slices.  The clerk could have just as easily cut either size into 16 slices.  You cannot increase the amount of a pizza by cutting it into more slices.   It is the size of the pizza that matters, not the number of pieces it is cut into.  Companies are different sizes and can be divided into whatever number of shares management deems best. 
  
  
• You can take comfort in the fact that so many people follow Fortune 500-type companies that it is unlikely you will find one that is badly priced.  The current price represents the consensus of the marketplace. Don’t overthink it. 
  
  
• Behavioral finance research finds a positive memory bias in people. We tend to remember positive events and to repress undesirable ones.  You remember the risky golf shot through the trees that lands on the green, but not the many times you tried a similar shot and the ball ricocheted around in the forest. We also tend to have a more favorable view of things that support an existing belief and to view them as more likely. This is similar to the selective forgetting phenomenon, when people choose not to remember mistakes or things that diminish their personal reputation. 
  
  
• It is easy to attach too much importance to nice, round numbers.  Imagine a box filled with ping pong balls numbered 1 to 1,000.  Someone reaches in, randomly selects one, gets number 1,000, and says “What are the chances of that?”  It is the same chance as drawing any other number, but to many of us it seems unlikely to draw #1000 by chance. Consider how investors like to set target prices at round numbers like  $50  or $100.  Why not $53 or $98?

MATHEMATICS, PROBABILITY, AND INTEREST RATES  

• Don’t forget high school mathematics.  Suppose Smith and Jones both start out with the same salary.  The table shows their pay raises for the past three years.   

• Question:  Who has the higher salary at the end of 2025? Answer: They are the same.  By the commutative property of multiplication A * B * C  is exactly the same as B * A * C. Many people have forgotten this and need to check the math. 
• Note, though, that because a dollar today is worth more than a dollar tomorrow, Smith had more spending power earlier and had a better financial experience.
• Suppose a fearless speculator buys shares in a much-hyped  new  company for $1 per share.  He promptly loses 50% in the first year.  The next year he makes 50% and says he is happy to be back to even.  His arithmetic average return is, in fact, zero, but he did not get back to even.  If you lose 50% you have to double to get back to the starting point.
• Semantics matter.  What are the chances of someone winning the lottery?  Someonealways wins the lottery, but the chances of you winning the lottery are very low.
• Suppose there are 50 people standing in a room.  Before a coin is flipped, everyone chooses either heads or tails.  Those who guess wrong sit down, and the coin is flipped again for the remaining players.  This continues until only one person is left.  Perhaps this takes 18 flips and Miller is the last one on her feet.  The probably of correctly guessing 18 flips in a row is (  or approximately 1 in 262,000.  Correctly guessing 18 flips in a row is very unlikely.  Is Miller an excellent forecaster?  Remember that someone will be left standing.  Can Miller do it again?  Not likely.  Someone in the room has to be “best.”
• Research shows that many people view the size of the monthly payment as the most important factor in the appeal of a loan.    Some people would prefer paying $50 per month forever rather than $450/month for 24 months.  Paying as little interest as possible is a better goal.  
• Suppose a $100,000 30-year mortgage has a monthly payment of about $619.  With those values, a 20-year mortgage would be about $100/month more but would save $50,000 in interest over the life of the loan.  Make your decision with full information.

Sound money management is based on the time value of money and risk-return tradeoff.  Many leaders in business, government, nonprofits, and academia have never been taught these basic financial principles. Why does financial literacy matter?  Applying the principle of wealth accumulation through savings and compounding can help improve personal  financial security and can help leaders fulfill their professional responsibilities as well:  managing budgets, approving capital investments, overseeing financial funds, running programs, building small businesses, and showing civic leadership.

Assignment

Individually or as a group, complete this exercise:

You agree to meet a friend after work and offer some financial advice.  You are skeptical about making specific recommendations but say you can offer some high-level guidance.  Your friend says, “Here is some background and my basic philosophy.”

1. I am already a pretty good investor.  My grandfather left me a nice chunk of money when I finished college
   
2. I have had excellent returns the past two years.
   
3. Going forward, I should be able to earn 15% annually without much trouble.
   
4. I usually sell anything that has risen by 25% and keep the rest. 
5. I don’t sell securities at a loss:  I wait for the stock to go back up before selling.  
6. I don’t invest in boring companies.  Who wants a company that makes washing machines or fixes telephones?
7. I think artificial intelligence is the wave of the future, so almost all my investments are in AI firms.
8. I really prefer low-priced stocks:  The cheaper the better,
9. I think risk is overplayed. It doesn’t really matter if your investment is successful; if you don’t sell any losers you haven’t lost anything,
10. I keep a log of my winning ideas and think I learn from them. The losers are best forgotten.

How should you respond to your friend’s comments?