Tuesday, June 12, 2007

Plans, Goals, Forecasts, and Estimates

This entry on the Overcoming Bias blog got me thinking.

Bosses just want the number.

I see a lot of confusion between planning, estimating, goal-setting, and forecasting.

Forecasting as often used in business is simply giving someone the number that represents business performance. Forecasting accurately is impossible, except maybe in the very short or very long term. Nonetheless, you still at some point need to come up with a number. Forecasting is best done using probabilistic techniques and reporting events as probabilities. Simply predicting a number, even if you are right is of little value in most circumstances.

Can you imagine a weather forecaster simply saying, "Rain"? Without a percentage and a timing, it's simply not a real forecast.

Likewise when you estimate business performance, wouldn't it be better to say, given the manpower and marketing budget, there is a 10% chance that we can sell 10,000 units, and a 90% chance that we can sell 8,000 units. Wouldn't that provide more information than just 10,000 units. It is a richer way of expressing a "forecast" and helps put reality into the process of planning for contingencies.

Ah, but goal-setting is important and helps people keep focused. That is true, but goals are not good forecasts. Also the goal setting process is usually based on an arbitrary standard, and negotiated without good information. There's a lot of push, pull, and sandbagging that occurs. Any resemblance of a goal to a forecast is unintentional.

Plans set up a sequence of events or actions that can be taken towards achieving those goals. Plans like forecasts are never accurate, but they do help clarify your path. Plans can and should include resources, cash, timing, contingencies, and risks. There is usually a number that comes out of it, but that number is never a good forecast. Never. No never.

I have two references to point you towards:
The first is Why Can't You Just Give Me The Number? An Executive's Guide to Using Probabilistic Thinking to Manage Risk and to Make Better Decisions by Pat Leach. If you care at all about the topic in this entry, buy the book. In fact, buy a few and give them to your bosses and colleagues. Pat explains in straightforward terms why probabilistic approaches are better. (Disclaimer: Pat and I worked together at Texaco. Chevron does a lot of business with his current employer, Decision Strategies.)

The other is The Strategy Paradox: Why committing to success leads to failure (and what to do about it) by Michael Raynor. In particular, chapter 5, "The Limits of Forecasting" is really good. Other parts of the book didn't quite work for me, but that chapter should be required reading for anyone in business.

Monday, June 04, 2007

Why Paying Off Your Mortgage Early Might Be A Bad Idea

I work with portfolios of real assets. One of the basic concepts of portfolio analysis and management is that you must know what you value. Very seldom does an organization have one single goal that it pursues to the exclusion of all others.

It is a useful framework for looking at the mortgage problem that I wrote about earlier.

If your single goal in life is to minimize the amount of interest you pay in your life, paying off your mortgage early may be a good strategy. For most people their house loan is the biggest loan they will ever get, typically paying hundreds of thousands of dollars in interest over the life of the loan. These are big numbers, exagerrated by the size of the loan and the time period.

However, most people have goals besides minimizing the interest paid. If you take it up to a higher level, most people want to maximize their wealth, which in simple terms is simply money in minus money out. Money in that equation can represent any form of value including house appreciation, stock appreciation, etc. We normally also have other goals that are not financial. We look for things like free time, strong family bonds, raising healthy, happy children, pursue hobbies, travel, a circle of friends, health, etc.

In this framework, the mortgage interest expense is one part of the money out equation, which feeds into the wealth maximizing goal, which is one of many priorities that you have in your life.

In that framework, minimizing the interest paid on your house becomes a part of the overall goal of reducing costs (so you would probably choose to pay off your high interest credit cards first). That is a part of maximizing your wealth, so you might choose to invest the money instead. Then you have the less quantitative pieces of your portfolio goals--lifestyle choices, hobbies, family issues, travel, etc--any of which may have a higher priority than the financial ones.

All I'm saying is to sit back and look at the big picture before you make this kind of investment.

Sunday, June 03, 2007

Do NOT Pay Off Your Mortgage Early

The pay-off-a-little-more-each-month-on-your-mortgage fallacy has been around for a long time. The deal is that the numbers are big, so they are really impressive.

Yes. It builds equity faster. (But it's just converting your cash from a flexible form of equity into a less flexible form.)

Yes. You pay less interest over time. (But you lose opportunity to invest).

Yes, you pay off your house sooner. (How many of us will live in our house for 20+ years though?)

There are several ways to look at this prolem though. First, from a strictly financial perspective, the right way to look at this is to consider the alternative uses of the extra money you would be putting into the equity.

For example, a 6% loan has an after tax 4% rate. Instead of putting the money into your house, why not put it into a SP500 index fund? It will get you 8% over time (5.33% after taxes). So by putting $1000 into your house, you lose $13.33 each year. Put it into the IRA that you haven't been funding and it looks even more attractive, because it is tax-deferred (net $40.00/yr/$1000)

If you haven't paid off all those 20% credit cards, and the non-deductible 8% car loan, don't even think about putting extra into your 6% deductible mortgage.

From a risk and contingency standpoint, putting the money into your house is a low-risk way to earn 4% after taxes. At the same time, you effectively lose the use of that money. If you get laid off or need money to pay for medical bills or something, it will be more difficult to get at it. You can do a home equity loan, but now you're paying to get at your own equity.

Alternatively, maybe you take that round-the-world trip that you have always wanted to do, invest in a good personal trainer to enhance your health, or maybe get a good therapist to help you get your emotional act together. You can't put a value on those, but in any case, the pay-off-your-mortgage-faster idea is only for people who do not otherwise have the discipline to save in other ways.

It's kind of like the people who advocate extra withholding from their paycheck so they get more back in April. It makes no sense financially, but if you otherwise lack the discipline, it can be a plus.