Chapter 3

MAKING BIG DECISIONS

Sometimes the decision is minor and the calculation is as straightforward and clear as the ones described in the last chapter, but sometimes there is a lot more at stake than just the cost of a new appliance or where to go on vacation. In many of these more important decisions, there are many more factors to consider and more uncertainty about the future, which makes the determination of what to do more interesting. It is in these complex but vital areas where the power of Present Value and its application in our day-to-day lives begins to show its true worth.

Some of the most important decisions in our lives revolve around whether to make a major purchase or financial investment and, as I said before, these clearly could benefit from a Present Value analysis. In chapter 2 I showed how basic Present Value thinking can help you navigate your day-to-day life and decide among actions whose financial consequences are straightforward to imagine. Most of the major financial commitments that we consider can be looked at in the same basic way as I looked at my refrigerator purchase and the other more investment-oriented examples described earlier. In most cases the only difference is that the dollars are bigger, so the amount of energy you put into the analysis should also be greater.

There are also some important decisions that even though they have little or nothing to do with money (medical decisions, dietary and lifestyle choices, etc.), can and should be looked at from the perspective of Present Value. We will spend all of chapter 11 and some of chapter 12 discussing decisions where money doesn’t matter at all, but in this chapter I want to turn to two other types of decisions that are extremely important to both our financial and emotional well-being and that almost all of us have to face at least a few times in our lives. Those two areas are career choices and when to invest in your own education. For both of these kinds of decisions, I believe using Present Value can make a huge difference in the quality of the choices you make and hence the quality of your future life.

What follows are two examples that illustrate just how powerful Present Value can be when used appropriately and how equally confusing it can be when used in the wrong way.

Changing Jobs

The first time I changed jobs (and to a lesser degree every time I made a career move), I made my decision, in part, because I judged that the Present Value of my future earnings would be higher if I left than if I stayed where I was. I say “in part” because there were other reasons to change, as there almost always will be for all of us. I’m also not saying that no one considers the financial aspects of competing job offers. People do. In fact, sometimes it’s the only thing they consider. But, even when money is the issue, most only consider the immediate financial impact of the change, or perhaps decide to leave because they have some vague sense that the new job might offer them more potential for future growth. Without being overly prescriptive, I believe almost everyone could benefit from taking a more systematic approach when considering a career move.

For me, the first time I was faced with such a choice was a little more than two years into my tenure in the insurance world. I was on a fast track. I had passed a few actuarial exams, impressed some senior actuaries, and was tagged by management as someone to “watch.” In short, my prospects for future salary increases were bright. In addition, virtually all of the top positions in the Company (CFO, CIO, etc.) were held by actuaries, so there seemed to be some chance that I might rise to a very high-paid position.

Some insurance companies are run by salesmen, a few by underwriters, but most are run by actuaries.⁸ Actuaries founded the industry,⁹ and to this day I believe that all young actuaries interested in becoming high-level executives have a higher chance of attaining their goal at a large insurance company than in any other business. And the rewards of attaining such a level are substantial with total compensation running well into the millions of dollars. So why did I turn my back on this bright future and choose instead to join a consulting firm? Simply put, I looked at the future scenarios, considered the likelihood of each occurring, and then tried to put a Present Value on each possibility. Specifically, two years into my career I was offered a job by a major consulting firm and—while I had no doubt that I wanted to become an actuary—I had to decide what kind of actuary I wanted to be.

The choice was clear and so step 1 was not an issue, but steps 2, 3, and 4 were both critical and tricky. Starting with step 2, I tried to imagine the possible futures associated with each path. First, I looked at the actuaries within the insurance company who were about ten to fifteen years older than me, those that ended up in senior management, those relegated to technical backwaters of the company, and those that were just bouncing around from one operational job to another (noting also the number who had disappeared completely, having been let go by the company). I knew that each of those roles entailed very different streams of future income, and so the critical variable to think about was the possible paths that awaited me in the insurance world. Two things struck me as I looked at the very successful actuaries in the company. The first was that they were all very disciplined, hardworking types who had directed their efforts to getting to the top right from the beginning. This suggested that pursuing this path would entail a considerable near-term investment of time and energy on my part. The second, far more troubling thing I noticed was that for every senior level actuary, there seemed to be about three or four others who had almost the same characteristics but hadn’t been tapped for senior management, suggesting that there was an unpleasant degree of randomness in determining who got the prize and who didn’t. It may be—and probably was—the case that there were concrete factors (e.g., personal relationships and ability to think strategically) that drove the decision. However, since I couldn’t determine the relevant characteristics (let alone whether I had any of them), I figured my best bet would be to treat these unknown factors as random and just assume that if I wanted to become CFO there was an 80% chance I wouldn’t get it even if I gave it my fullest effort.

Turning to the other alternative, to leave the insurance world and become a consultant, the analysis was much easier. Almost all successful consultants followed the same track—pass your exams, pay your dues, and become a partner. The typical consultant’s earnings stream was relatively steady and somewhat higher than the nonmanagement actuaries at the insurance company for a while, but then after eight to ten years, assuming that one became a partner, one’s compensation jumped a bit and settled in at a very comfortable level (perhaps $200,000–$250,000 per year in 2012 dollars). The biggest variable was how quickly one could obtain partnership, but even that did not vary by much more than two or three years up or down.

In addition to the fact that consulting appealed more to me at the time and that the near-term effort required to become an insurance company CFO seemed quite a bit greater than what I would need to do to become a consulting firm partner, almost no matter what discount rate I chose in step 4, the Present Value of my compensation if I left was far greater than if I stayed for two reasons. First, after discounting the seven-figure CFO salary by the probability of attaining it, its expected value was relatively modest and second, the fact that I would have to wait so long for that payoff at the insurance company versus the potential near-term attainment of partnership at a consulting firm meant that the Present Value of this big payoff was even less.

We will talk much more about step 4 and determining a personal rate of discount in chapter 8. We have already talked about this essential idea, but just to review, let’s remember that some of us would rather have $500 today than a promise of $1000 payable three years from now, while others will demand $800 for the same promise. The important thing is to be clear in your own mind as to how to equate the two for yourself.

Needless to say, though I have no idea if I would ever have become CFO had I stayed in the insurance world, I believe I made the right decision and have never regretted my choice. Furthermore, even in those times when I do wonder about life in the corner office, I take comfort in the fact that I made my decision in what to me was the most rational manner available given the information I had.

But can using Present Value mislead you? Absolutely, and this next story illustrates that.

Investing in Your Education

About twenty-five years ago, a friend of mine came to me with a problem that he thought called for some Present Value analysis. It seems that his wife, Elise (a young and successful analyst for a large finance company in Los Angeles), was on the verge of deciding to quit her job and enter an MBA program 3000 miles away in Philadelphia. To him, this seemed like absolute madness. Putting aside the disruption to their lifestyle, the extreme hassle of traveling back and forth across the country (they would become a bi-coastal couple), and the delay in their plans to start a family, he believed that the decision made no economic sense whatsoever, that the financial benefits of getting an MBA (the main reason she was considering business school) were more than offset—at least on a Present Value basis—by all the added expenses (school tuition, maintenance of two households, foregone income and career opportunities at her current company, the possibility of not working when their future kids were small, etc.). It was this cash flow and Present Value analysis that he wanted my “expert” assistance with.

Feeling not only compassion for my friend, but convinced that his intuition was correct, I enthusiastically started in on the project. I did my due diligence, looking into the average compensation for newly minted MBAs and their potential career tracks, gave some thought to Elise’s prospects and likely salary progression at her current company, identified as many of the sources of additional expense and risk factors (upside and downside) associated with each alternative that I could think of and then sat down to figure out what assumptions to use in the analysis.

I decided that to be most fair and also to address the obvious uncertainty of the outcomes, I should not use any probabilities to discount various contingencies (like Elise’s chances of losing her current job or having trouble finding a new one after getting her MBA). I would instead develop several alternative scenarios and calculate the Present Value of each. For this purpose, I equated the present to the future (i.e., used a discount rate) based on the assumption that any additional money she could save now by not getting her MBA would be invested in a balanced portfolio of stocks and bonds. Specifically, I compared the Present Value of each alternative income stream (net of expenses) using this discount rate. Like a good actuary, I created a reasonably conservative best estimate, as well as a pessimistic and an optimistic scenario, each varying mostly by the future salaries she would receive under each path as well as the time it would take to reach her maximum earnings potential. Most of the expenses were pretty easily estimated, and I didn’t bother to quantify the non-financial costs/benefits associated with the move, as clearly these were already a big argument against her move. Then, just to make sure I didn’t miss any possibilities, I developed a best-case and worst-case scenario. I would leave it to Elise to judge for herself what the likelihood of each scenario was.

Not surprisingly, the analysis confirmed my original expectations with the Present Value of her projected net income if she stayed at her current job exceeding the Present Value of her compensation taking the MBA path by several hundred thousand dollars under all scenarios except the best case where the values of the streams were essentially the same. Not only that, but the break-even point, where her annual pay became higher as an MBA than what it would likely be if she stayed put seemed depressingly far (at least five years) in the future, and therefore if Elise used a higher personal rate of discount than I was assuming (as most people do), then it would be even clearer that she should stay where she was. Feeling pretty confident that she was a rational thoughtful person, I expected Elise to quickly agree that her idea of going back east was misguided and she would thank me for helping her avoid a big mistake.

Elise patiently listened to my presentation, smiling sweetly and attentively the whole time. When I was done, she thanked me and said she was impressed with all of my analysis. She asked no questions, and though I assumed I had done my job, a few months later she packed up and headed to Philadelphia to start her fall term at Wharton Business School.

It turns out that the largest economic and financial market expansion of our lifetime was just gaining momentum, and when she graduated two years later, the investment companies came begging. Soon, Elise was running a moderately sized mutual fund, and within five years of getting her degree, she was effectively managing almost a billion dollars in assets and making a multiple of my best-case scenario. Needless to say, her income was also a multiple of what I was earning as a consulting actuary. To this day, every time I see her, she reminds me of my “expert” analysis.

So what went wrong? I think part of the answer is that I didn’t spend nearly enough time on step 2 of the Present Value process—imagining all of the possible futures. I was hopelessly narrow and unimaginative in my visioning and—perhaps even worse—way too attached to what I was predisposed to believe (i.e., that the future payoff couldn’t possibly justify the current investment). It is very hard to envision all the possibilities and impossible to do so when one is attached to a particular scenario. Step 2 requires time, curiosity, and an unbiased attitude—and I had none of those. I also made a basic mistake when I attempted step 4—setting a discount rate to compare the future to the present. I made the completely unwarranted judgment that Elise should use some “objective foregone investment return” as a means to produce an apples-to-apples comparison. In fact, that factor—how much to value the future versus the present—is a deeply personal matter, and no one should presume to tell someone else how to make that judgment.

Clearly for Elise, her long-term future was far more important to her than her current compensation, and hence she was, I suspect, using a much lower discount rate than I was assuming. At one point, I asked her if she used Present Value in making her actual decision and she replied, “Of course I did; I just used different assumptions.” And that is the main thing I missed—that Elise simply understood the problem much better than me. She not only could see—or perhaps sense—far more of the possibilities that would be open to her with her MBA, but also knowing herself, her intentions, capabilities, and ambitions far better than me, she was much better able to judge the actual probabilities of the possible earning streams stemming from each option and, even more important, how best to judge the value to her of the future benefits compared to the immediate consequences of choosing one path or the other.

This is perhaps the most important message of this book. Don’t let an “expert” make your decisions for you. Present Value works—but only if you take responsibility for owning the process and doing it yourself.

I have dealt with two common types of important decisions that most us will face at one time or another in our lives, but there are many others that are equally important that I haven’t addressed here, and that is because most of these other decisions have a very significant non-financial component. In chapter 11, we will take a look at some of the most critical and ubiquitous of those decisions, but now I want to circle back and take a closer look at Present Value and the 5-step process I’ve outlined for how to use it.