Chapter 9
STEP 5—“DO THE NUMBERS”
If you have done a good job on steps 1–4, the final step in determining Present Value will usually be surprisingly easy.
Most of us are familiar with the old joke about the two guys out camping who see a hungry bear heading for their campsite. As one guy begins to put on his running shoes the other one asks him why he is bothering to do so. After all there is no way he is going to outrun the bear, even wearing running shoes. The second guy replies, “I don’t have to outrun the bear, I just have to outrun you.” Well, using Present Value is a lot like running from the bear. Most of the time we are not trying to determine what the exact Present Value of a particular future path is but rather whether the Present Value of one path is greater or lesser than that of another.
In chapter 4, the fundamental math of Present Value was described and, yes, in some cases it makes sense to estimate actual probabilities, determine an explicit discount rate, and plug everything into the simple formula at the end of the chapter or the more complete one in the appendix. But in most situations, all it takes is going through the process of steps 1–4, and the answer to step 5 will be obvious, or at least you will be able to get a “sense” of the answer, and you can make your choice with some confidence that you are following the right path.
I have tried to illustrate how exact calculations are not necessary a few times throughout this book, most notably in the Introduction when, even with no bears in sight, I had to decide how many pairs of—soon to be discontinued—running shoes to buy. In that example, after I had completed steps 1–4 of the process I felt (vs. calculated) that by buying all the pairs in stock at one store (i.e., four pairs) the “Present Value of my future running experience” minus the price I paid in dollars (about $200) would be both higher than zero (the Present Value of buying nothing) and higher than the Present Value of buying more than four after factoring in the cost of those extra shoes, the fact that the use of those extra shoes would be farther in the future (and hence less valuable), and the additional time and energy it would take to go to other stores to get them. I certainly could have bought a single pair (or two or three), but with the expectation of using all four pairs within the next few years and the fact that there was no extra time involved in buying the extra pairs, the decision seemed relatively clear.
You could say that in this case, I “went with my gut,” and while that is true, having gone through the thinking process involved in steps 1–4, it was a much smarter “gut” than it would have been without Present Value thinking. As I hope the following story shows, it’s developing that “smarter gut” that is the true goal of Present Value thinking and not learning how to do detailed calculations every time you have a decision to make. When it comes to Present Value, it turns out that once we are familiar with all the relevant factors, we are often much smarter than we think we are.
Learning to Outrun the Bear
“All you need is to keep an RPA (i.e., Relaxed Playful Attitude).”
Charlie DeWeese, FSA, explaining to the author how it is possible to complete a 100-mile road race (and anything else that seems impossibly hard)
My first boss, Mordecai, taught me what Present Value is and how it can be found almost everywhere, but it was from my second boss, Charlie, that I learned how to calculate it, or more specifically, when you need your calculator and when and how to use other means to get to the answer.
When I started working for him, Charlie was not yet forty and still over a decade away from running his first ultra-marathon. Yet, even then he was already a legend within our company and on his way to becoming one within the profession. Without a doubt, he was the smartest guy I ever worked for, and unlike me, he did pass all ten of his exams on the first try, even doubling up (taking two of the three-to-six-hour exams in the same exam session) two or three times throughout the process.
Even more impressive than his exam record was the fact that he was the only person I know who solved Rubik’s Cube from scratch—with no advice, no math, and not even a pencil and paper to assist. All he used were his hands, his eyes, and his brains. The first time he solved it, it took him a week of twelve-hour days. The next time it was three days, then one day, and then pretty soon he was able to put the cube back together within a matter of minutes. But, like everything else about Charlie, his method was just a bit unorthodox. He claimed that as complete and effective as his algorithm was, it contained three “secret moves.” These were moves that his hands knew, but not his brain. So his approach was to manipulate the cube until it reached a state where it was ready for “secret move number 1,” at which point he would turn the cube over to his quick-moving hands only taking back control when the hands were done with their business. Then he would begin working toward the position that called for “secret move number 2,” and then on to “secret move number 3,” after which he and his conscious brain could finish up the puzzle.
Needless to say, Charlie marched to very different internal music than the rest of us. How different, particularly when it came to evaluating risk, was apparent from the very first day we met. It was a hot humid late summer’s day, thunderstorm season in Hartford, and as we sat in Charlie’s office discussing my new role on his team, we could see the sky beginning to darken ominously. While I gazed out the window with only moderate interest, Charlie began to get excited. As it became clear that this was going to be an intense storm, Charlie began packing his stuff and told me we would have to cut short our discussion, as he had to go. Thinking that he simply had to run out because he’d left the windows on his car open, I offered to stay put until he returned. He looked at me with a mischievous smile and said “Don’t you understand, this is the best possible weather for wind surfing—I’ve got to get my board and get to the lake before this front passes through!” And so one of my very first images of Charlie was that of an outwardly normal businessman racing out and disappearing across the company parking lot at two in the afternoon with the wind howling and lightning flashing to go test his skill and the fates in a manner that seemed absolutely incomprehensible.
Now, the specific unit I was assigned to was a small special secret team that Charlie had been asked by the CFO (Bill Taylor) to form to analyze potential acquisition targets that the company wanted to consider. Bill had known Charlie since they were actuarial students together, and while Charlie spent his actuarial youth solving mathematical puzzles and learning to dodge lightning bolts, Bill was the consummate focused, ambitious, old-school actuary who quickly rose through the ranks and within a few years became one of the youngest CFOs in the industry. Bill’s genius was to surround himself with the smartest people he could find and tap into their skills and intelligence to achieve objectives that would be unattainable on his own. And Charlie was someone whom he kept particularly close. Personally, I found Bill scary, not unlike a small grizzly bear that you wanted to keep well fed. He didn’t say much, but his questions were always unexpected and piercing, and he had intense otherworldly blue eyes that, when turned your way, felt like they could see right through you. Charlie, on the other hand, knew just how to handle him and was able to essentially spend his days pursuing whatever interest caught his fancy as long as he was available and present when Bill needed him.
The work itself was fascinating and unlike anything I’d ever expected to get involved in when I signed up for my first actuarial exam. While Charlie and the other two members of the team scoured the landscape for large insurance companies that might be a good strategic fit with ours, I was set the task of finding a shell life insurance company with a particular tax status (Phase II negative if I recall), that the company could pick up for cheap and use to manage its corporate tax liability. I was given a big thick book with the legal and financial profiles of all the insurance companies in America and told to go find one that fit our needs. It was like a combination treasure hunt/detective mystery; maybe a little like the current search for an earth-like planet revolving around a distant sun with just the right physical and atmospheric characteristics to be a candidate for colonization. Charlie provided the ultimate in hands-off management but was generally very interested in what I found and was always willing to answer questions, as long as they were intelligent, interesting, and ones whose answers could lead to more interesting discoveries. That sense of not knowing exactly what to look for but striving to maintain that “relaxed playful attitude” of curiosity and interest in what was out there was a lesson I learned well and forms the basis of much of what I believe it takes to use Present Value effectively.
But perhaps the most important aspect of Present Value that I learned from Charlie came one day when he came back from a meeting with Bill about some big property and casualty company he was proposing we look at (our company specialized in life insurance). Bill had given him a question about some present values that were buried in the target’s financial statements and Charlie was struggling with how to answer it. Typical of Charlie, he was able to transform the question into an elegant and compact mathematical equation that he then gave me to solve. Unfortunately, it was a fiendishly difficult equation that did not seem to lend itself to any of the normal actuarial techniques I’d learned. Assuming that Charlie was anxious for the answer, and not having any better approach, I started expanding the equation, manipulating terms, and transforming it in any way I could. Eventually I was left with a horrible mess, but at least it was a mess that I had some access to. I was able, laboriously and tediously, to get a numerical answer for one piece, a pretty good estimate for another, and an argument that seemed to suggest that the residual unsolved portion was relatively insignificant compared to the answer as a whole. With some trepidation, I brought my now several pages of work to Charlie.
I could see from the moment I began to go through my work that I was in trouble. Charlie’s first reaction was one of dismay and discomfort, much like one would react to being served a plate of rancid meat. But, even worse, the longer I went on, the less interested and apparently more bored did Charlie get. He asked me, “Are you sure there is no easier way to solve it?” and when I said “No,” he said, “Well let’s forget it then.” He didn’t even want to see my final result, and to this day I don’t know what he said to Bill.
From then on, it was obvious to me what I needed to do to make Charlie happy. Whatever the problem was, my job was to clarify and make things simple, not to make them more complicated. Beyond that, I learned that if you get bored with the answer, then your audience will as well, and the answer itself becomes useless. The application to actuarial problems in general and Present Value in particular was clear. You should strive for elegance, always keep an “RPA,” and use everything in your power to get the right answer, whether it be your knowledge, your memory, your imagination, or even the secret moves that only your hands know how to make.