Edgar Sanchez

As another year approaches, most us will inevitably be faced with making some big financial decisions. Wouldn’t it be nice to be able to look into the future and make the right decisions?

In this month’s blog, we provide you with a framework. A framework that has been proven since the early 1980s. The ideas were developed by Ron Dembo and is explained and illustrated in his book “Seeing Tomorrow”. Dr. Dembo is the founder of Algorthmics Inc. His former company provides risk management software to the biggest banks, insurance companies and other financial companies.

This framework was developed primarily for making large financial decisions but it can be applied to any decision.

The framework is best explained through a way of an example. We will use the Afterword example in Seeing Tomorrow.

In this example one of the authors was faced with the decision to keep his house or sell it. He was to be posted abroad for a work for three years. Realizing that the rent received would be less than the mortgage payments the author decided to sell his house. As it turns out his decision turned out to be disastrous. Property values increase 70% and the author was priced out of the market to re-enter.

His family and friends urged him to keep the house but he decided to sell the house based on the following reasoning:
• He would not be able to cover the mortgage with the rent payments
• House prices had stabilized and he did not foresee house prices going up or down

At first his decision seemed to be correct. In fact it turned out to be correct for 18 months. Nothing did happen to house prices in the particular area where the author lived. However after two years, the area was in great demand due to middle class families chasing large house where state schools existed and house prices rose by 70% due to the limited supply.

Could have the author foreseen this demand? Perhaps, if the demographics were analyzed. But in most likelihood no one could have seen this coming.

But if he would have being aware of Dr. Dembo’s forward looking risk adjusted framework he would have most certainly made the decision to keep the house and as a result would have reaped the 70% increase in his home. He could have made the following analysis:

1. The Benchmark (point of comparison) against which the decision should have been made was owning a house in the current neighborhood, not the difference in payments between the rent and mortgage
2. The Time Horizon he was working with was not the immediate future or months. But the time he would decide to go back. So the correct time frame to consider would have been the three years to be posted abroad.
3. Rather than focusing just on one Scenario, that prices where going nowhere He ought to have considered other scenarios. Yes, house prices had stabilized. But what if they went up. His failure to consider all scenarios cost him
4. Finally, he needed to Measure the Risk. Had he been aware of the risk-adjusted way to measure risk of Upside minus Risk-adjusted Regret he would have realized that difference in rent payments to pay the mortgage was not the true regret but the true regret was that of not being able to buy back into the market.

We hope this helps you make better decisions in 2012. Happy New Year!

Three practical rules anyone could benefit from are the 80/20 rule, the rule of 72 and the rule of 150.  Alone or together these rules provide an easy way to make better business decisions.

The 80/20 rule was developed by  Pareto.  An Italian economist who observed that 80% of income in Italy went to 20% of the population.  Today, this rule is widely applied.  When in doubt it is a good rule of thumb.  For example, 80% of sales comes from 20% of the customer base.

Rule of 72 is a financial investment rule.  Perhaps the most important rule when it comes to understanding the power of compounding interest and investments.  It is powerful for its simplicity, yet quickly gives you a good grasp in understanding your money.

The rule of 72 simply states that if you invest your money at a certain rate of return, you figure how many years it will take for your money to double, by dividing 72 by the rate.  For example, if you are getting an 8% return on your investments then your money ought to double in 9 years (72/8).  It also works if you want to know what rate of return you need in order to double your money.  For example, if you want to double your money in 6 years you will need a rate of return of  12% (72/6).  Please note this assumes that the rate is consistent throughout the life of your investment.

The Rule of 150 states that the optimal size for a group is 150. Humans could only properly maintain proper relationships in a group no bigger than 150.  Perhaps the best example of the use of this rule is Gore Associates, the maker of Gore-Tex fabric.  When asked when do they know to build a new plant, the answer is simple, when all 150 parking spots are full.

Three simple, practical business management rules that help.