Introduction
THINKING ABOUT THE FUTURE IN A SYSTEMATIC WAY
It has become a cliché to say that we live in an “Information Age,” but the fact of the matter is that the amount of data available to us has exploded and grown almost beyond our ability to comprehend. At the same time, we as individuals are, more than ever, inundated with choices in our daily lives, and unlike the past, these choices now come associated with an overwhelming amount of information. Some of that information we seek and some is thrust upon us, but in total, rather than help us, the data often simply paralyzes us. From the mundane consumer choices we make every day to life-and-death medical decisions, we are given facts, figures, and recommendations but no systematic way to sort through that information and actually decide.
In almost all cases where we have an important choice, we are asked to make a decision in the present that will have consequences sometime in the future. This book is intended to show you a straightforward and systematic way to make those choices without getting lost or confused by too much information. The key tool we will use is called Present Value, and it is one that actuaries have used for over a century to do their job.
Despite any impression you may have (given by actuaries or others) that Present Value is a complicated or technical concept of only limited applicability, the idea is straightforward and can be useful for anyone—at least anyone who has ever had to make a choice between now and later, anyone who has ever had to decide whether or not to quit their awful job and follow their bliss, whether to buy that new car or increase their 401(k) contributions, whether to get married, when to have kids, and on and on.
How People Choose
Typically, people make decisions from one of several perspectives. First, they might make decisions based on the past, focusing on what has worked before or how the decision at hand is similar to one previously addressed. These people make their decisions based on experience.
Second, they might, as Eckhart Tolle in The Power of Now1 suggests, focus on what they see in the “here and now,” adhering to Tolle’s philosophy that the future “doesn’t really exist.” Such people feel that they should just be in the present moment, trusting the “power of now” to guide them. Somewhat related to this group are the people who base their choices on their faith or intuition, trusting that some unseen force (or perhaps their own “intention” or “aspirations”) will guide them to the right decision. These people make their decisions “from their gut.”
Finally, many (perhaps most) people—including those who tend to use the first two approaches—do try to think about the future in a logical way and consider the immediate and long-term consequences of the choices they face, deciding on a course of action based on intellectual analysis and a projection of future events. However, such people usually try and figure out what they think will happen and then act accordingly. In the best of circumstances, they might consider a couple of different scenarios. But even here, the decision maker will most often come to a conclusion as to what is most likely to occur and then make their choice on that basis.
In fact, there seems to be—at least for this third group—an almost universal feeling that trying to figure out what is actually going to happen is basically the only way to think about the future. There is a better way. For reasons that we will discuss shortly, I would propose that we will never know for sure what the future holds and that we need a different attitude toward what will happen and what we should do now to prepare for it.
A New Way to Decide
In the next few chapters, I will talk about a very powerful tool called “Present Value” that everyone can use to make better decisions. In a nutshell, Present Value is the concept that allows you to think about the future and the present at the same time, to put them on an equal footing, to make “apples to apples” comparisons.
Most of us live in both the future and the present. Some focus more on one than the other (I ignore for now those who live in the past), but almost all of us do so sequentially. The neuroscientists out there may say that that is because it’s physically impossible to be in both places simultaneously, but be that as it may, I would argue that by using Present Value you can come as close as possible to keeping the balance between the two front and center.
What do I mean when I say we should consider the present and the future at the same time? How does one do that and why is it useful? In this book we will look at many of the choices that face us as individuals or collectively and see how a different way of looking at these questions can lead to better decisions and arguably a better society as a whole.
We will call this approach “the actuarial perspective” because it is actuaries who most often use Present Value and it is they who originally adopted the approach I describe. The difference is that while actuaries generally use Present Value in a very narrow and limited way, the fact of the matter is that anyone can use Present Value in their own life and apply it to all kinds of decisions that actuaries would never think of using it for. While Present Value as actuaries use it has a technical and mathematical definition, you don’t need math to understand it and use it in your own life.
At its core, Present Value simply means the value today of something that may happen tomorrow. Every day we are faced with choices, and those choices all have consequences that (generally) only manifest themselves sometime in the future. Most critically, the decisions we make when we choose between two different alternatives lead to different futures. Imagining what those different futures might look like is a critical step in making the right choice.
So far I haven’t said anything new. Almost all of us imagine the future impact of the choices we make, but what distinguishes the actuarial perspective from the way people normally make decisions is that by using Present Value we can think about our choices in a systematic way that takes into account some aspects of the future that we rarely consider. In particular, when we use Present Value we try to imagine not just what we think the future impact of our choices will be, but rather consider all the possible futures each choice might lead to. And even more important than considering all the future consequences that a given choice might lead to, we consider when those future consequences might show themselves.
In summary, using the actuarial perspective means thinking about the future in a systematic way and using the idea of Present Value—the value today of something that might happen in the future—to make better choices.
In the rest of this book, I will explain in more detail what Present Value is. I will also show you how to use it and think systematically about the choices we all face every day. By the end of the book, you won’t be an actuary, and you won’t have a formula to apply to every decision you face, but you will be able to think more systematically and use a different process to making important decisions.
To get started, let’s look at a mundane example where the actuarial perspective allowed me to make a better choice than I could have if I had not known about Present Value.
The Perfect Running Shoe
For most of my adult life I was a jogger, and like most runners, I was very particular about the shoes I wear. From the moment I began running regularly, the “Saucony Jazz” was my favorite shoe. It was incredibly comfortable and “cushiony.” To get this effect, the sole contained a special kind of foam that molded to my foot and absorbed the shocks of the road better than any other shoe on the market. To my knowledge, Saucony was the only company that used this particular foam. About twenty years ago, the company decided to discontinue the “Jazz” as well as the use of its special foam (apparently most runners did not like the fact that after several months the foam compressed and lost some of its cushioning effect). So what does this have to do with Present Value? Well, after the announcement, all Saucony Jazz shoes were put on sale for 50% off and I was faced with a difficult choice—specifically how many pairs to buy. This was my favorite shoe, and after the existing stock was sold, I would never be able to purchase one again. On the other hand, I could only use one pair at a time so if I decided to buy, let’s say, twenty pairs at a cost of $50 per pair, I would be paying $1000 today for something that, under the best of circumstances, I wouldn’t be using for several years. But it was more complicated than that. I had to consider the fact that I might not get a chance to use some of those shoes. I might, either by choice or because of injury, stop running. I had to consider the space I would need to store the shoes and the hassle of packing, storing, and moving them if necessary. I also had to consider whether there would be some new technological development in shoes that would produce something even better than the Jazz.
Finally, I had to consider the economics. $50 per pair was a pretty good price. But how good? Would prices on shoes rise like the price of gas or would they fall like the price of personal computers? And if I didn’t buy the shoes, what would I do with the $1000 I didn’t spend? Would I invest it? If so, how much could I expect to earn and at what risk? My point is not that there is a clear way to incorporate all these factors into a calculation. In fact, I doubt that a formal Present Value calculation would be of any practical use in this case. My point instead is to show that when we make even a mundane decision like buying running shoes it is helpful to use the concept of Present Value to make our choice.
So how did I approach the problem? In brief, I used the actuarial perspective to make my decision.
Even though actuaries use a lot of math in their calculations, using the actuarial perspective in the real world requires virtually no math whatsoever. Instead, all it requires is a systematic approach and the use of the core concept of Present Value to equate the value of things that happen at various times in the future to the value of things today. Here—and in many future examples—I used the following 5-step process to develop and compare Present Values to make my decision:
1. Define the choices to be made.
2. Imagine all (or as many as you can) of the possible futures that might arise from each choice, focusing not just on what could happen, but on when it could happen as well.
3. Evaluate, to the extent possible, the relative likelihood of each possible future.
4. Introspect deeply and in a detailed way to consider how much more value should be placed on things that will happen in the near future vs. things that will happen in the distant future.
5. Sum up the values of the consequences of each choice (i.e., determine the Present Value of each alternative).
The only “calculation” involved in the process above is in step 5, and even here, many cases will require nothing more than adding and comparing. The really hard part of the process—and the part that most actuaries spend years learning how to do well—is in steps 2–4. We will talk at much greater length about each of these steps, including the attitudes and state of mind required to perform them well, but as my running shoe purchase illustrates, the tasks themselves are pretty straightforward.
Step 1 seems obvious, but even here, before thinking about a decision, it is important to make sure that we have identified exactly what our alternatives are. In this case, when I thought about how many running shoes to buy, I only thought about visiting my local running shoe stores and the inventory that they had on hand. I did not consider traveling around the country or contacting Saucony directly, which could have allowed me to buy 100 pairs of shoes instead of the thirty or fewer that I considered. Part of that was because I wasn’t willing to go through the immediate effort of expanding the amount of shoes I could consider buying and part of it was that I knew that no matter what, I would almost certainly never be able to use all 100 pairs even if I kept running for the rest of my life.
Step 2 is perhaps the most important part of the process and the one where, in my view, most people do not take the time to do well. Imagining all the possible consequences of a given action is impossible, but most of us attach ourselves quite quickly to one or two possibilities that we think are most likely or seem most obvious and then don’t think too much about any other factors. The range of possible futures is vast—in some ways that is what makes life interesting—and spending a little extra time considering more than just what you think is going to happen is key to evaluating the impact of what might happen. Everyone has their own way of doing this, but for me it is important to adopt an attitude of quiet, non-attachment, and curiosity as I try to imagine all that might ensue. I spent a fair amount of time on this step before I headed out to the local shopping mall. I imagined what the future might look like with only a couple of pairs of Sauconys to run in versus what I would experience with a closet full of the boxes waiting to be opened many years in the future. I tried to think about when I would be using those shoes and just how much value I would get out of them, taking into account possible injuries, the initial and ongoing cost of shoes, available alternatives, future improvements in shoe technology, and so forth, as well as the ongoing “costs” I would experience throughout those futures, such as storage, moving, and foregone investments.
On its surface, step 3 can be intimidating, but it is often simpler than it appears. After we have imagined the possibilities, it is important to consider the relative likelihood of each, but it is rarely necessary to assign actual probabilities to different scenarios. Instead, using intuition and common sense goes a long way. Here, for example, I didn’t do an explicit calculation of the probabilities associated with all the unknowns (e.g., how long my running career would last), but I did consider in a general sort of way the likelihood of various scenarios and factored my own intuition about where things were going into my determination. In some aspects I was right (e.g., I thought it likely that shoe prices would go up but investment returns—at least mine—would be low), in some I was wrong (I thought there would be a better than fifty-fifty chance I’d have to stop running within ten years but in fact didn’t get injured and have to stop running until I was in my mid-fifties), and in others I was somewhere in between (eventually, as I expected, shoe technology caught up with Saucony, but it took longer than I thought it would). When step 3 was complete and I had considered the relative likelihood of each future scenario, it seemed that I would need about fifteen to twenty pairs of shoes to last until my running career ended or shoe technology improved, but that is not how many I bought. The reason was step 4.
Step 4 is the one part of the process that is truly unique to the actuarial perspective, and we will spend quite some time on this one. In my experience (validated by scholars like Daniel Kahneman, who wrote Thinking, Fast and Slow, as well as many other researchers who have performed similar studies2), people generally do not think about the relative importance of similar events that happen at different points in the future, and when faced with choices highlighting this difference (e.g., “would you like to have $100 today, $150 a year from now, or $1000 ten years from now?”), their answers are inconsistent and respondents cannot explain their rationale.3 As you read through the book, I will be encouraging you to think hard about how you personally value benefits that you receive immediately vs. benefits that you will have to wait a modest amount of time for (e.g., a few months) vs. other benefits that will take years to come your way. By thinking clearly about this aspect of the choices we face, we can apply some rigor and rationality to how we evaluate now the choices we make today but whose effects will only be felt in the future. The technical term for what we will be doing here is to develop a “discount rate” that will allow us to work our way from the future back to the present and create the “apples to apples” comparisons that we need to make informed choices.
In the end, I bought four pairs of shoes, and while that was fewer than the number that would have lasted until New Balance came out with a running shoe every bit as good as the Jazz, when one considers step 4, it was still a good decision and a far better one than what I would have come up with had I simply got attached to a particular future. In my case, part of the reason that I only bought four pairs of shoes instead of the fifteen to twenty that I would have needed to last until the New Balance shoes were developed was that I valued the ability to run comfortably in the very near term (as well as the money I would save by not buying the extra pairs) far more than I valued my running experience five or ten years in the future. Essentially, I applied a very high discount rate to my future experience in order to compare it to the cost of buying the shoes in the present. In chapter 4, you will find a more detailed explanation of how a discount rate works, but for now just think of it as the opposite of an interest rate. An interest rate makes money grow from the present into the future, while a discount rate takes money in the future and shrinks it back to its value today.
One secret I will share with you is that as much as some in the actuarial profession may say otherwise, the fact of the matter is that, for any particular question, there really is no “right” discount rate to use, particularly when it comes to a decision that is individual in nature. Choosing the right discount rate is vitally important, but no one can choose it for you, it is too dependent on your particular circumstances and the nature of the decision to be made. That being said, my hope is that with the insights provided by generations of actuaries who have considered the problem deeply and the information and observations that follow, you will be equipped to make that determination for yourself.
Finally, there is step 5, “doing the calculation.” Again, this is a part of the Present Value determination that in some ways is the least important part of the process. There are certainly situations where such calculations are important and complicated to make. If there weren’t, we actuaries would not be paid as much as we are. However, in most real-life situations, if steps 1–4 have been done in a systematic and thorough manner, the answer will often be obvious. The important point to remember here is that we are usually not trying to determine a specific number—we are simply trying to make a decision and most times it is simply a question of which Present Value is greater, rather than what exactly the Present Value is. This was very much the case as I was thinking about my shoe purchase. In particular, I wasn’t trying to determine a precise number of shoes to buy—I was simply trying to decide whether to buy none, a couple, a few, or more than a few pairs and which of those choices represented the greatest Present Value to me. There was no magic to the number four. In fact, if I remember right, four was the number of shoes in stock at the first store I went to, and given that I knew I didn’t want to buy that many additional pairs, I decided that it wasn’t worth travelling across town to look for more. That is the way Present Value works in the real world.
If it were only relatively minor decisions around clearance sales and running shoes that called for Present Value considerations, that would be one thing. But in my view, where using Present Value becomes vitally important is when we are faced with the really important decisions in our lives, the forks in the road where the path we choose can lead to vastly different futures.
In the rest of this book, we will explore many different kinds of decisions and how Present Value can and should be factored into making them. We will also discuss in a deeper way the nature of the elements that go into present value—the present (where we live and when we have to choose), the future (when the impact of our choices will emerge), time (the bridge that connects the two), risk (the way we distinguish between possible futures), and money (the shortcut metric we often use to measure “value”). Most important, however, we will talk about how to use Present Value, what attitudes and approaches are central to actuaries’ (or at least this actuary’s) approach when they think about the future, and the process they go through to choose or recommend choices to be made by others.