My undergraduate corporate finance class concluded this week. My last lecture was about how the core financial concepts we covered this semester—the relationship between assets, liabilities and equity, time value of money, and risk and return—map to other areas of life. I liked how the lecture turned out so much that I decided to turn it into a nine-part series of posts.

This week is the introduction to the series.

Finance as a Framework

My first job in finance was trading mortgage-backed securities for the Federal Reserve. While I was happy to be hired, it wasn’t the position I wanted—I wanted to trade Treasuries (U.S. government bonds). The guy who hired me, and ultimately became a mentor, told me later that it didn’t matter what my first job in finance was, because I’d learn frameworks for thinking about finance that I’d be able to apply to any other asset class.

Dave turned out to be right, as I learned a lot about leverage, optionality, insurance, risk, and other ideas through trading mortgages. More than that, he left me with a deeper understanding of the importance of frameworks in general.

Why Frameworks Are Good

A framework is a structured way to think about a complicated idea or concept. Since I’ve already spent a lot of time thinking about mortgages, when I study a new asset class (like stocks, for example), I have a ready-made mental list of “boxes to check” when it comes to the new asset class. For example, when I am studying stocks, I can evaluate the properties of the asset class and ask myself, “does this resemble how mortgages work, yes or no” and if the answer is yes, then I already know how that piece of the “stock puzzle” works.

I’ve found that frameworks from pretty much any discipline (not just finance, but also music or biology or history or whatever) can be extrapolated and applied to very different problems. In this case, I feel that the basic building blocks of finance can be applied to non-monetary objectives, such as personal growth.

Thinking without frameworks or structure—i.e., relying entirely on intuition or gut feelings—can also lead to problems. While I generally believe that our intuition is often right, it’s not always right, and it tends to fail us more often in particular domains. Finance and investing are one of the areas in life where making emotional decisions usually leads to bad outcomes. Moreover, as I’ll discuss later in the series, the human mind tends to have very bad intuition when it comes to the power of making consistent, incremental changes as well as evaluating the true risk of actions.

 

The “Finance Frameworks for Personal Growth” Series

The Core Themes

Anytime I teach finance to someone—whether in an independent or informal setting, or a formal setting like a university—I always start with my 3 basic ideas:

1.      Assets = Liabilities + Equity

2.      Time Value of Money

3.      Risk and Return

To me, these all map to emotional or personal growth-related topics.

Assets = Liabilities + Equity, also known as the balance sheet identity, tells us that assets don’t exist in a vacuum. Assets are usually paired with liabilities—in finance terms, things that we owe, and in personal terms, demands on our time or energy. Our assets are also not equally useful or valuable. Over the next two weeks, we will explore these concepts in more depth.

The Time Value of Money is probably the single most important concept in finance and also directly connects to personal growth and development. In this section, we’ll discuss the importance of habits and consistent, small incremental gains, as well as why human intuition is so bad at making good decisions according to this framework.

Risk and Return connect directly to emotions—risk represents fear, and return represents satisfaction or pride. In finance, you don’t get returns without taking risk. This is also true in our personal lives. In weeks 6-8 of the series, we’ll discuss why people are bad at evaluating and taking risk when they rely on “gut feelings,” and also some of the strategies that financial professionals use to mitigate risk and how we can adopt those strategies in non-monetary arenas.

The Roadmap for the Next 9 Weeks

Here is what I will be writing about for the next 9 weeks. In each post, I’ll introduce the financial concept first and then discuss how it pertains to other areas of our lives:

1.      Finance as a Framework

2.      Assets = Liabilities + Equity: What You Own Comes with Strings Attached

3.      Assets = Liabilities + Equity 2: What You Have vs. What You Can Use and the Importance of Liquidity

4.      Time Value of Money 1: The Power of Compound Interest

5.      Time Value of Money 2: Why Humans Use Bad Discount Rates

6.      Risk and Return 1: No Risk, No Return

7.      Risk and Return 2: Why Humans Are Bad at Calculated Risks

8.      Risk and Return 3: Diversification and Building Multiple Pillars of Resilience

9.      Conclusion: The Emotional Balance Sheet

Conclusion

While each post will be a self-contained discussion, my hope is to have each topic build on what we’ve talked about in previous weeks. By the end, I hope that you have a solid understanding of these basic financial ideas (if you don’t already) and can clearly see where you are applying them in your life and where you aren’t. Each section (except today) will have its own exercise as well, per usual.

I would also love any feedback, or anything you want to see discussed!

Exercise

There’s no exercise this week! Enjoy your break :)