Monday, February 1, 2010

Founding Assumptions of Finance

Fred Wilson is promising to add a regular schedule of MBA lessons to his blog. I think it is a terrific idea. I'd like to add my small input to this effort by sharing the first lesson of my first day of Finance class.

The most profound lesson I learned in this class (and a point that Fred mentions, but doesn't expand on in his post) was what my instructor called "The 4 Founding Assumptions of Finance." I think that if you get these conceptually, everything else is just the mechanics of how to calculate or apply them. Here they are:

1. A dollar today is worth more than a dollar tomorrow.

2. Investors are risk averse. (You have to pay them to take a risk).

3. More money is better than less money. (Not in a greedy way, just in a "I'd rather make money than lose money" way.)

4. People are rational and markets are competitive.

These ideas were really important to me, because they really do encompass all of modern finance. All of the complex quantitative methods you read about in the Wall Street Journal are just ways of applying these four principles to complex situations. Any math you do in Finance is just to convert one or several of these ideas into a specific number that you can compare to a number from another project (or company, or deal).

Fred's first lesson is on the Time Value of Money, where he starts to talk about how to determine the value of an investment. What he is really talking about is points 1 and 3. If you are going to invest money today, in the hopes of getting some money tomorrow (or every year for the next few years), you want to add up all the future money and see if it is more or less than the money you are investing (Hint: you don't want to invest $100 in a deal that will only return $90 - see point 3). Less obvious is that you need to apply a discount to the money you will get next year (point 1). Fred's lessons on Present Value answer these two questions so that you can be sure that you are getting a good deal, in line with the points above.

Think of investors as customers in a store. If some of the stuff has scratches and dents, they will ask for a discount. Think of all the points above as potential dents. So if the investment opportunity (a stock, or a piece of real-estate, or a start-up business) wants to take your investment today, but wants to pay you back over time, see point 1 - we need to get a discount on how much we invest (or, equivalently, get a higher return). If there is some uncertainty about how much return we will get in any given month or year, we want a discount for that. We certainly won't invest if we don't think we will get all our investment back - and prefer investments that seem likely to return more (point 3).

Point 4 has taken some hits in the media lately; marketers and psychologists remind us that we don't always make rational decisions, and the recent market events have made people re-think the idea that markets are efficient. But the premise is that if one deal is better than another, people will notice this, and if there is a limited supply of those better deals, people will compete for them. What this ultimately means is that there is no source of free money in investing - if there was, people would see it, and quickly bid up the price of it until it was just an ordinary good deal.

I am looking forward to Fred's posts - hopefully he will do a better job of making things simple than I have (so far, he has been great at this!).

Thursday, October 8, 2009

1,000 Words of Nonesense is Still Nonesense

I really love the good infographics that illustrate the relationship between complex data. A picture really is worth a thousand words. But like good written journalism, good infographic journalism requires some understanding of the subject matter, and an effort to remove bias. Most of my training in critical thinking focused on looking for loaded words in an article; but didn't cover images in much detail, so this is an area that may be ripe for abuse (through malice or incompetence).

Fast Company's article on CEO Pay infographics (the graphics were actually commissioned and ranked by Good Magazine) really illustrates this point. The graphics are very attractive, and do a great job conveying a point. But they don't actually make any sense - they are like a well written article written by someone who has no understanding of the subject.

For example, the first graphic, which was judged best by Good Magazine, and which I agree is the most compelling and information rich image, make no rational point that I can discover. It compares CEO pay with the number of minimum wage employees it could support. Why not compare CEO pay with the number of oranges it could buy? I think it would be just as meaningful. I doubt that anyone really believes that a company could exchange its CEO for a whole pile of minimum wage employees and get the same results, so why compare them?

To me, the only metric that makes any sense for measuring CEO pay, is to ask "would the company be better off if it didn't spend the money?" For example, you wouldn't compare the most expensive machine in a factory to the least expensive machine, and you certainly wouldn't wonder how many of the inexpensive machines you could buy for the price of the expensive one. The only consideration you would have when purchasing a $10M machine is whether the business will benefit by at least (and hopefully more) than $10M.

The second graphic compares the CEO pay to their company's profits. This gets closer to the mark, but of course, since the CEO's actions may take time to benefit the company, you have to consider their pay and the company benefit over time - one year is not nearly long enough. Moreover, you still don't know how the company would have done without paying the CEO, or more practically, by spending half as much on the CEO. If spending an extra $1.00 on the CEO makes the company more valuable by $1.10, this is a good deal, and you should pay as much as you can, until the effect wears off.

Finally, the last graphic is nice for promoting the idea that CEOs are back-room, cigar smoking, old cronies, but it doesn't do a good job of presenting the data - it completely wastes the horizontal axis. The graphic purports to compare age with salary, but it just slaps an age label next to the salary amount - there is no graphical comparison between those two numbers. If, for example, the artist had made the horizontal axis indicate age (the vertical already indicates salary), then we could have looked for a trend or a grouping. As it is, I have to read all the numbers (which are inconveniently written sideways) to determine even the simplest concepts, like does the oldest person make the most money, and does the youngest person make the least? From the data, it appears that there is no relationship between age and salary, although the graphic doesn't highlight this fact either.

I really like good infographics, because they have tremendous power to make complex relationships obvious. I really hate bad infographics, because they give nonexistent relationships tremendous credibility. If we are going to have a contest for the best, we should be judging them on their ability to make the truth apparent, not to make misinformation more appealing. Good magazine is making infographics worse by honoring bad images. Fast Company is making itself look like a business magazine that doesn't understand business when it highlights these as good examples of how to understand CEO pay.