Chapter 5

STEP 1—CLARIFY THE CHOICE

If you are going to use Present Value to make better decisions, the first and arguably most important step is to be clear on what your decision is. Too many times when we find ourselves in a quandary, we ask ourselves “What should I do?” and then try and formulate a plan of action. By now it should be clear that there is another more precise question that should be asked, and that is “What are the alternatives that I am trying to choose between?”

One thing I don’t want to do is to characterize Present Value as a magic bullet that can solve all of your problems. There are plenty of issues and choices we face where Present Value thinking is not helpful, but in many more cases than might be apparent, Present Value thinking can provide a systematic way of approaching decisions that leads to better outcomes. Fundamentally, Present Value allows you to compare and evaluate different alternative paths that you already see. It does not allow you to develop new answers to questions that arise.

Therefore, the first step in clarifying the choice is to make sure there is a choice to be considered. Sometimes you will face problems where it will be necessary to come up with creative solutions from scratch, but more often than not, even if there is no perfect solution, there will be alternatives that just need to be identified and clarified.

To see this, consider my friend Mark.¹¹ Mark is a classical musician/composer by profession and makes his living performing, teaching, and scrambling for commissions to compose and produce new pieces. He is not a numbers guy, and the last thing he wants to do is a bunch of calculations every time he has a decision to make. But Mark is also pragmatic and a few years ago he realized that classical music, as rewarding and valuable as it is, is a highly uncertain way to make a living and would not provide the steady income he needed to support his family. He needed a way to generate a stream of money that would not take too much of his time and yet be consistent and predictable enough to rely on in those times when the economy was down and composition gigs were hard to come by.

The business/investment he found (with some Present Value thinking of his own) was residential real estate. He began to buy little houses in very depressed markets. He bought a few in Texas and a few more in Indiana. For a while things were going well; the rental income was coming in and after paying his property manager, the taxes, and his mortgages, there was still plenty left over. The only small problem was that while his tenants were reasonably responsible when it came to paying their rent on time, they were somewhat less so when the lease expired and it was time to move out. Yes, there were security deposits, but often the tenant would fail to pay the last two months’ rent and leave the house in conditions that required significant clean up and/or repairs before it could be rented out again. After this had happened to him three or four times, Mark came to me and asked, “What should I do?”

I don’t know much about managing real estate, but to me this seemed like a case that just screamed out for using Present Value. So the first question I asked Mark to think about was “What are your alternatives?” It turns out that there were only two realistic ones. The first alternative was to take the tenant to small claims court and the second to simply let it go and absorb the loss. Once the choice was clarified and the alternatives outlined, the determination of which path to take was quite simple. The cost of pursuing the tenant would be about $500 in hard dollar costs and at least that much (according to Mark) in time and aggravation. The potential judgment to be obtained would be at most $1500 (the limit for small claims) and the probability of both getting the judgment and being able to collect was less than fifty-fifty. Combine that with the fact that the $500 would have to be paid up front and the recovery from the tenant would take at least a year and probably more, and it is clear that it made no sense to pursue these ex-tenants. Present Value helped Mark to see that each time this happened, he should let go and accept the loss. In concrete terms, what this result meant is that Mark needed to recognize that the actual return on his investment needed to be viewed as slightly lower than what he had originally anticipated.

As unpleasant as the above realization was, it was an important insight and Present Value helped him gain it. Present Value is a great way of dealing with denial and learning to be realistic. Too many times we get locked into a rigid view of what will happen in the future even after it turns out we were wrong. That is what happened to Mark. He had in mind a fixed idea on how his investment was working and needed Present Value to realize that his return expectations had not fully included the “friction” associated with irresponsible tenants. When we talk about steps 2 and 3 of how to use Present Value (imagining and then evaluating the future possibilities) we will talk about how important it is to stay unattached to any particular scenario. Well, the same holds true if, as was the case with Mark, your Present Value evaluation shows you that you were wrong about the future consequences of decisions you have already made in the past.

Sometimes, decisions are as straightforward as Mark’s decision to maximize the Present Value of his time and money by choosing among two alternatives—one of which was to do nothing—but sometimes the situation is far more complicated.

Let’s say you come home from work one rainy night and find that the roof is leaking badly and water is pouring down the walls of your living room. There is a message on the phone from your tenant downstairs who says that her bathroom is flooded (a problem that may be related to the rain but certainly not to the hole in your living room ceiling). Not wanting to deal immediately with the crisis, you stop to bring in the mail. Included is a bill from your son’s college reminding you that this year’s tuition needs to be paid. There are various payment plans that are available, but not being ready to work through any numbers, you put it aside and open the other envelopes which include two offers that alert you to the fact that interest rates are at an all time low and now is the time to refinance. Just as you are thinking about how the refinancing might help you with the tuition bill, your wife comes home and announces that she has had it with this weather and thinks that the family needs to go somewhere sunny and soon for a vacation that is long overdue. And by the way, she also wanted to remind you that with your son leaving for college in the fall and house prices on the way up, it’s time to start thinking of selling the house and moving to a smaller place in the city—just like you promised.

Maybe I’m exaggerating and you’ve never had a day like that, but the fact is that we are constantly inundated with financial challenges (and opportunities), and much of the time the decisions that have to be made are multiple and interrelated. Now, more than ever, you need to use Present Value. But first you need to clarify the choices.

How do you do that? Well, there is no set formula, but what I do is first try to separate and sort out the key questions, making sure to organize them in terms of when the costs and benefits of each issue will emerge and then identify which ones can be looked at independently and which ones need to be combined because they are so interrelated. In the case above, it is tempting to say that all the decisions are related because whether it’s fixing the roof, fixing the downstairs apartment, or finding a way to go on vacation while still being able to pay for college, all of those tasks require money and since we only have a limited amount, we need to consider all those decisions together. In a very general way that’s true, but I still think separating out and prioritizing the questions will sometimes make the answer to other decisions obvious.

Faced with a deluge (figuratively and literally) like the one described, different people will make different issues their top priority. For me, dealing with my unhappy tenant and the water in the living room would be the first priority. First, I would want to determine what the extent of the problem was, and how much it would cost to fix. The Present Value implications of not doing so are simply too dire to ignore as the problem, and its consequences would be immediate and potentially long lasting (loss of tenant and rental income, the destructive impacts of moisture in the house, the potential for further damage during future rainstorms, etc.). The need for a vacation is also, of course, related to the weather, but the planning for—as well as the actual—vacation would need to wait until after we knew what was entailed in fixing the roof and the plumbing downstairs. The constellation of decisions around paying for college, refinancing, and/or eventual downsizing of our real estate holdings are clearly a set of related and longer-term decisions where Present Value would play a critical role, but those choices would have to wait for another (hopefully less rainy) day.