In control of your finances?

Returning to the topic of this blog; how to ensure progress in the important areas of life to ensure happiness and stress-free living, one of the things I deemed important as a student was money. This is, of course, still important to me. When we are talking personal finances, the issue of time comes up. You will have some long-term goals (become debt-free, have enough savings for retirement and so on) and som short-term goals (I really, really need a new iPod! Yeah!). How should you position yourself to ensure your goals don't slip? In order to analyze that, we need to become more down-to-earth and lay out a personal finance vision and put down a strategy for following up on that vision. I will not use the same tools for long-term goals as for short-term goals. Let us put down long-term goals first:

• debt-free before retirement
• to have $ 1 million in savings when I retire

to reach those goals, we obviously need to put money into paying down the mortgage (and other loans if there are any), and we need to put money aside. A common strategy is to put a fixed horizon on the mortgage and to follow the payment plan of the bank, to become debt-free. This strategy seems reasonable, let's keep it.

For putting money aside there are more things to choose from. We know that the expected returns from our investments are higher, the higher the risk we are willing to take. However, financial advisors tell me, not all risk is going to result in a higher expected outcome. Only risk that cannot be diversified away allows for a risk premium, says the finance guy. Ok...sounds reasonable (this is classic insight from finance and comes from the "capital asset pricing model").

We also know, from the control point of view, and from common sense, that we should be more afraid of losses as we get closer to target and the terminal time of our savings plan. Therefore, our money placements can be more risky when we are young, because we have time to recover if the market does something bad on the way (or we do something stupid). So, my strategy is to set a requirement on the expected return on investment for each decade, and then find an investment portfolio to suit that return on investment. Then, we need to compute how much to put aside each month and see if we can afford that. Possible investment return requirements:

Age 25 - 35: 15%

Age 35 - 45: 10%

Age 45 - 55: 8%

Age 55 - 65: 5&

We build up a portfolio for our current age bracket (25-35?). It will most likely consist of a lot of common stock (risky to not-so-risky), some money market funds (less risky) and some in a savings account in the bank. Mutual funds are great if you are not investing heaps of money, but beware of the conditions so you don't have to fund the fund managers when they do a crappy job.

So, when this has all been set up, how do you monitor performance and control it? Obviously, you should monitor annual returns. I would also set up a few other financial indicators, such as price-earnings ratio and earnings per share. Then, for example annually, I will adjust the profile such that it fits my desired risk. If I am earning more than expected, is this due to higher risk, or is it OK? If I am earning much less, I would reposition the portfolio (sell some stocks and buy some new ones). In any case, the most important thing is to add to the savings portfolio each month. Why? Compund interest. The sooner you get money into interest-bearing investments, the faster you earn more money. Say you have a dollar to invest. If you invest it today, what will it be worth in the future? We assume an interest rate of 15 % (quite risky!):

1 dollar invested at 15% interest is worth after

1 year 1.15

2 years 1.32

10 years 4.04

20 years 16

40 years 268

After 40 years your dollar is worth 268 dollars. If you had invested 1000 dollars, you'd have 268k available at retirement - compund interest is our best investment friend!

Next post: we'll look at short-term financial happiness

Management and implementation philoso...

Management and implementation philosophy for your life - how it started out

My professional background is as a control engineer. In addition to engineering, I have an interest in business management and how we can organize our lives to ensure happiness. In periods, especially in university, I have felt stressed about fulfilling my own expectations. I have been worried I would not be able of achieving my goals. Towards the end of my Master's degree in control engineering, I found it more challenging to determine how to stay in control of my life and my own happiness, than to solve the technical problems related to my research. Unfortunately, the research did not look good, most likely because of my stressed out state of mind. I had to deal with my inability to focus on what's important. I had to lay out a system. 

Deep down, as I was, in the theories of control engineering and performance of industrial machines under uncertainty, the natural approach for me was to take inspiration from process control when setting up a self management and motivation system. In a typical industrial process, there are several layers of decisions, separated by time (how often decisions must be made). First I explain how this system works, then how we can adapt it to less technical problems. 

At the top level in managing an industrial process is economics. Economics can be translated into a profit function, and we seek answer to the question: "how should I set up my production to maximize profit"? Using a model of the process, we can then calculate how much we should produce of our product per time (say 1000 gallons / day of diamond extract) and at what quality we should do so. This doesn't say how to do it.

An industrial process may have certain elements that are unstable. Before anything else is done, these elements should be stabilized. This is usually done using automatic control. One example of an unstable element is a tank with a drain. If we do not control the level in the tank by adding more contents, it will eventually go empty. To remedy this, in industry, we measure the level in the tank and adjust addition of more diamond extract accordingly, to ensure the tank level is within acceptable limits. 

After stabilizing all unstable elements we need to start thinking about out true goal: profit. We know how to set all decision variables (feed rates, temperatures within process equipment, etc.) to achieve optimal profit for an assumed set of conditions. Reality is, however, very uncertain. Making a plan once is not enough. Unforeseen events are going to hit our production machinery, and the question is, what to do then? Such unforeseen things can be change in the ambient temperature which can give more or less heat loss, a change in the feedstock to the process, making it necessary to add more cryptonite to get the diamond extract, et cetera. The point is, when external things change, so does the process. And the optimal way of making profit. 

There are two fundamentally different ways of looking at this:

a) we can try to estimate what all of these conditions truly are and optimize again, and then implement the new plant. Then we wait a while and repeat. In industry, this is commonly done and is known as model predictive control. It requires good understanding of the connection between our actions and their outcomes.

b) An alternative we can try, is to find things to measure that do not change much in their optimal values when the environment changes. We find something to hold constant, and when we do so, the inputs (flow rates and so on) will automatically take on their new optimal values, or at least, almost so. This strategy is often used by businesses. They call such measured variables key performance indicators (KPI).

We are going with the KPI approach. We thus have three layers; 

Optimal planning --> Adjustment based on KPI values --> Stabilization

Let us consider how we can apply this to managing how we live. Our optimal performance is most certainly related to profit, but not profit alone. The overall optimum is happiness. However, it is very hard to see the relationship between our daily decisions, and our long-term, overall happiness. We therefore divide the problem into separate problems that we hope to work with independently. When I first started thinking about happiness, I came up with a few categories that seemed important to me. Those were: 

- Love (I did have a girlfriend)

- Money (being poor is tough)

- My Master's thesis

- How others see me

I have kept all of those, and added a few more. Let us stick to those four and see how we can apply the management philosophy of industrial process to them. Let us start with the bottom one; building a reputation and adjusting your branding strategy when the social climate changes. This will be the task of our next posting. Hope to have the post ready shortly.

Life under control - new blog on self management

People today are often struggling to perform; privately, at work, in the local organizations and even when they are alone. The percieved need to be an achiever can be more than just challenging. Often, people feel bewildered and estranged, often by performance requirements set by themselves. Many of these requirements are unrealistic. Some are not reachable without a good system. When we put down goals that we cannot reach, we feel exhausted, unhappy and out of touch with society. We've all been there. I've been there. However, I've found a trick. Happiness is about systems. We need a system to organize our efforts, much like the systems used to manage companies or to control industrial processes. After all, those are processes seen to be so complex that systematic approaches are strictly necessary. This is obvioiusly true, trying to run a multi-billion-dollar corporation by intuition and no system is a sure way to ruin. But isn't life more complicated than companies are? Isn't life more complicated than industrial machines? I'd say, most definitely. What if we adapt system tools to deal with life's challenges? My experience with the system-based way of self-management has been joyfull and fruitfull. In this blog I let you in on the secret. Who knows? Maybe you will give it a shot and maybe it will make you feel more at ease and more successful. I hope you do.