On Lessons From Finance : Discount Rates, Dividends and the Leap of Faith
Finance has a funny way of being known as highly realistic, yet highly abstract. It’s realistic in the sense where it’s accurate in depicting relationships between moving parts in how we make decisions. But yet highly abstract in the sense where it isn’t too clear how the numbers are derived. Most financial decisions boil down to this — what is the initial outlay, or say investment, and what the concurrent returns are. What would you give, to potentially get? It’s effectively a quantification of a bet.
There are many other levers involved of course — but apart from the initial outlay and returns, there is, what we call a “discount rate” and “time horizon”. Now, “time horizon” is simple to understand — when are you planning to get your returns back? Sometimes, the future pay off in the future is really high — so much so that you’ll be willing to wait close to your whole lifetime for it.
And then, there’s the discount rate. Now this is something that is trickier to explain — but only because it seems more arbitrary of a number. It’s simply the amount of returns you are willing to give up whilst waiting for your future returns to materialize. You could also flip this the other way around — it’s simply the amount that you are looking to get from your investment working hard (i.e., expected returns).
What we’re willing to accept, as returns, changes based on what other options we think are out there, and the psychological difficulties that such investment might bring. The first aspect, is based on what others think — subject more to external forces such as supply and demand. But even then, this is merely the representation of the psychological representations that the collective has.
Put simply, the external forces that affect our choices are affected by collective psychological difficulties. The psychological difficulties aspect of risk perception is our perception of risk. How comfortable we are with taking a bet, making a choice. It’s one that is highly influenced by what other people think. So yes, our perception of risk is highly recursive — where other people’s perception of risk affects our perception of risk, which affect other people’s perception of risk, and on, and on, and on.
Our perception of risk is only influenced by others when there are clear signals of collective representation of psychological perceptions. An example of this, is a stock price indicator. For aspects that are not clearly measurable, however, it’s harder to capture the collective psychological perception of it. But that’s because, we ourselves, simply don’t try to quantify it.
It’s hard to quantify quality of relationships; or the significance of a travel experience. And, what can’t be measured, can’t be improved (or sold). Or that’s what the world of management wants you to think. It’s easy to conflate the immeasurable with insignificant. And it is also a mistake to think that the concepts and tools applied to valuing the measurable, can’t be qualitatively applied to the immeasurable.
Chances are, you’ve heard of the term “dividends”. It is simply a fancy way of saying “stable returns”. And how we value dividends is based on the expected returns, discounted by the “discount rate”. We then make a judgement on whether to make a judgement based on the discounted aggregated returns (I.e., net present value) or the computer discount rate that makes the discounted aggregated returns zero (i.e., internal rate of return). Both of these criterions are highly dependent on the discount rate.
The discount rate, as you know, seems to be a highly subjective factor — but we often treat it as if it’s real in finance. But, as explained above, it seems to be not as real as we think it is. It changes, fluctuates, and is based on what we ourselves are willing to accept.
I can see why it’s important to quantify the discount rate in the world of finance — as often times, you have to be able to communicate and report this to other people. In the world of asset management, we have to make it seem like we’re making sound, quantified judgements — especially so when we’re managing other people’s monies. But, in life decisions, seeing that the discount rate as objective is futile. In fact, realizing that it is subjective, is a super power.
Finance has a lot to teach us about how to make decisions in our lives — even with qualitative matters. With qualitative matters, they have returns too — such as mental well being, security, better self esteem, better health. These are benefits of making good health, relationship and lifestyle choices.
In life, there are a lot of things where it involves us having to spend something, to gain something else. For instance, spending time, energy, presence for better relationships, better health, a better lifestyle. And many such things often do not have clear feedback loops — they require a long time horizon (see above for explanation). But, rest assured, they eventually pay qualitative dividends.
In finance, we forego investments that have low aggregated discounted net dividends — even if it does eventually pay dividends. But that’s because the discount rate has been set at a certain value. But in life, we can’t apply the same thinking. With matters surrounding the heart and health, we have to learn to discount our investments severely, and discount our expectations of future pay-offs less.
In life, the dividend patterns are often not clear — but so are investments. Valuations are often times based on extrapolation of past numbers — a leap of faith, at times. So, sometimes, when making qualitative decisions, we just have to take a leap of faith too.
In finance, we want early pay-offs if possible — and the pay off should go on for as long as it can. In life, we have a set time horizon in our lives (I.e., our lifetime); so we should factor the payoff periods of qualitative dividends in our lives. There are things where if we start early, we’ll get the pay offs for longer. Like working out, going to therapy, or calling your mother.
The concept of dividends in finance, albeit seemingly quantitative, requires a lot of subjectivity too. Because of that, it’s often not as clear cut as we would like to think. And hence, if we see that, we’ll understand that our live decisions cannot be as clear cut too. But rest assured, the general principles are that — if we take risk and spend some effort with consistency, eventually, it’ll pay off.
And most importantly, in all decisions, we have to take a leap of faith.
