Finance: An Approach to Relationships

Alright, I've decided on a theme for this blog. As a finance major, I have a very particular lens through which I see the world. And since we happen to be in the middle of a worldwide financial crisis, I thought it might be appropriate to explain finance principles and concepts by relating them to experiences we all share. Accordingly, my posts on this blog will focus on relationships, as well as life in general, from a financial perspective. I hope readers will find it entertaining and perhaps educational. (I've created a different blog for more general stuff: Chippy.com)To start off, I'll use one of the most common methodologies for valuing an investment - the income approach.

The income approach seeks to measure the future benefits that can be quantified in monetary terms. The process generally involves forecasting the future cash flows expected from an asset, and then discounting those cash flows to the present value using a discount rate that considers the inherent risks of obtaining those cash flows. So we will liken a relationship with another person to an asset or investment.

Before we enter into a relationship, we have to consider the "cash flows," a.k.a. benefits we might receive. How hot is the other person? Are they a good kisser? Can they cook? Will they make a lot of money? Would their family members make good in-laws? But wait; what we really want is net benefits, so we have to factor in their weaknesses. Are they a shopoholic? Do they have bad gas? These things decrease the value of our investment, so we can't forget them. Once we have the best possible knowledge we can obtain, we then project the net inflow of future benefits.

Now of course, predicting the future always involves some degree of uncertainty. We account for this by discounting the future benefits back to the present using our discount rate, which we'll call the WACC (weighted average cost of commitment). This rate considers the inherent risks of our decision. What if they get fat? What if they lose their job? What if their mom goes psycho and decides to hate you? All these things must be weighed in the calculation of our WACC, which should essentially represent the opportunity cost of our next best alternative.

Using the WACC to discount our future benefits will give us the net present value (NPV) of our relationship. If you want to get a more accurate calculation, you should factor in the tax benefits of children. Now in theory, you should only make the investment if the NPV is positive, but the higher the NPV the better. You can also compare your initial investment (engagement ring, time spent, etc.) with the flow of future benefits to calculate your internal rate of return (IRR). This rate should be higher than your WACC for the investment to make sense.

Now of course, a relationship decision should not be entirely based on the benefits you receive from the other person. In reality, you should invest in a relationship because you love the person simply for who they are, and perhaps who they can become. But let's be honest, the other stuff matters. The income approach can provide valuable insight for all relationships.