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!).


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