Weighted Average Cost of Commitment

As mentioned in a previous post, the weighted average cost of commitment, or WACC, is the rate we use to value the expected future payoffs of a relationship. Looking at it another way, it’s the rate of return we would expect from a relationship given what we have to invest. The rate is referred to as a “weighted average” because there are two components: the cost of equity and the cost of borrowing.

Cost of Equity (Re)
The cost of equity is the return you expect from your investment in the relationship – love, companionship, stability, bragging rights, conjugal rights, status elevation – whatever it is you envision the ideal relationship to be. The cost of equity also reflects the risk of whether or not and to what extent these benefits are ever realized. A higher risk means a higher cost of equity, and subsequently a lower present value.

The cost of equity can also be broken down into multiple components. The first component is the risk-free rate (Rf). The risk-free rate should be the rate of return you get from the safest investment possible. For most people, it’s a mother’s unconditional love. Anything above and beyond that is the return you expect for taking on additional risk.

This additional premium is calculated by subtracting the risk-free rate from the expected return on the market (Rm), which is simply the average return you get from all the relationships in your life. The difference is then multiplied by the person’s bipolar coefficient (β), which represents their emotional stability relative to most people. A person with a high beta will be really happy during the good times, but really miserable during the bad times.

The formula for computing the cost of equity is known as the Companionship Applicant Pricing Model (CAPM). Putting everything together, it looks like this:

Re = Rf + β(Rm – Rf)

In some cases you may need to add an additional asset-specific risk premium to account for risks not always captured in the CAPM formula, such as their age, maturity level, fat potential, etc.

Cost of Borrowing (Rd)
The second component of the WACC is the cost of borrowing. You’re not the only one with skin in the game; in-laws, relatives, and friends also have a stake in the relationship. When your companion receives unsolicited advice or turns to these sources for support, the relationship could be severely affected. So you have to factor in the cost of external sources of capital and what kind of strain they will put on the relationship.

Weighted Average
After you’ve computed both the cost of equity and the cost of borrowing, all you have to do is determine to what extent each component plays into the overall cost. If you think you’ll have to spend half your time together with the other person’s family, then you might want to give the cost of borrowing a 50% weighting. But if you live in a different state than the in-laws, you may only give it a 10% weighting. You then use this weighted average discount rate to determine the net present value of investing in the relationship.

Discount Rates and Present Value
Some may not be familiar with the concepts of discounting future benefits to compute a present value, so a brief explanation is in order (focus on the concepts rather than the math). Suppose someone promises to give you $110 a year from now if you give them $105 today. Based on past experience with this person, you know that there is a chance that he won’t deliver the full $110 as he promises. So you decide that if you’re going to take the risk, you want a 10% return per year. So what is the present value of his promise to pay you $110 in a year? The answer: $100. Accordingly, given your required rate of return (or discount rate), you should not give him the $105 he is asking for. If you were to use this same 10% discount rate for a promise of $110 in two years, you would only be willing to give him about $91 today.

Options

All of us know that the dating world is full of options, but few people are aware of the methodology used to actually value and compare these options. In the world of finance, options are contracts between an issuer and a buyer that gives the buyer the right to either buy or sell a particular security (like a stock) at an agreed-upon price (strike price) on or before an agreed-upon date (exercise date) from the issuer. The value of these options is determined using what's called the Black-Scholes option pricing formula. The actual formula involves a lot of statistics and calculus, but we can supplement our understanding of relationship options by applying the Black-Scholes logic to the dating world.

The Analogy
Suppose all of your dating prospects are like stocks that you are interested in buying. Some seem more promising than others, but you can never be sure which investment will bring the biggest payoff. So rather than putting all your eggs in one basket, you invest in options that give you the ability to enter into a relationship at a lower-than-market-price should the value of dating a particular person increase over time.

For example, you’re thinking of pursuing a relationship with one of two girls. The first girl is drop-dead gorgeous, bodacious blonde girl with all the right dimensions. She’s fun with a great personality, but she’s also really high maintenance. Investing in a relationship with her is inherently risky because if she gains weight, she loses much of her appeal along with the basis of her self-esteem. Should this happen, you’ll have to deal with a host of emotional problems and you could lose a great deal on your investment. Alternatively, however, if she maintains her good looks over time and grows in character, the value of the relationship increases dramatically and your investment pays off big time. Thus, the volatility of this “underlying security” is quite high – meaning that her value can fluctuate dramatically, either up or down, within the specified time period. Accordingly, the value of an option for this relationship is relatively high and requires more of an investment – more time, more money, more commitment, etc. – because you’re probably not the only one who wants this option (bringing into play the principles of supply and demand). But should the value of pursuing a relationship increase, you’ve already got an in, so you won’t have to start from scratch; hence, the “lower-than-market-price.”

On the other hand, the second girl you’re considering is only moderately attractive, but much more stable in terms of character and emotional demeanor. Plus, if she gains weight or loses physical appeal for one reason or another, the value of the relationship won’t change much and she’ll maintain her self esteem because your relationship is based on more fundamental qualities. In essence, the value of a relationship with her is much less volatile, but at the same time, the probability of a huge payoff is not as high either. Subsequently, the value of an option for this relationship is less and thus requires less of an investment on your part (partially because she probably doesn’t get asked out as much as the other girl, therefore she’d be more willing to enter into a relationship). But since you’ve invested in the option to date (time, money, attention, etc.) and established the basis for a relationship, you still get a “lower-than-market-price” should you choose to date her.

If we wanted to get more technical about the pricing of these options, we could factor in the current price of each relationship, the strike price that your option gives you, and the risk-free relationship (i.e., the unconditional love of your mom). But that would complicate the analysis, and I think we’ve hashed out the basic logic of options with our simple example.

The Benefits
Options are an attractive investment alternative for many reasons, one of the most significant being the limited downside. Should either of these options prove worthless, all you’ve lost is whatever you paid for the option, rather than investing entirely in the relationship only to lose it all when you decide she’s not worth it anymore. Additionally, even if most of your assets are tied up in an existing relationship, you can still make small investments in options that will hedge against the risk of your exposure to this one relationship (somewhat similar to a credit default swap, i.e. rebound boyfriend/girlfriend).

The Real World
In reality, options are derivative financial securities, in that their value is derived from the price of an underlying security, such as a stock. To illustrate the basic logic behind an option, we will examine a theoretical call option. Suppose you believe that the price of IBM’s stock will rise from its current price of $80 a share to $100 a share within the next six months. So you call up Goldman Sachs and by a call option on IBM’s stock with a strike price of $90 and an exercise date six months from now. Also suppose that the option cost you $5 to purchase. If IBM’s stock does in fact rise to $100 a share within the next six months, the option gives you the right to buy the stock from Goldman Sachs at $90 a share. If you exercise that option, you can then take that share of IBM stock you bought for $90 from Goldman Sachs and sell it in the open market for $100. You instantly make $10 on the transaction; however, after subtracting the $5 you spent to buy the option, your net gain is $5. A put option follows the same logic, but in the opposite direction (you have the option to sell high and then turn around and buy low). As mentioned before, the great thing about options is that the upside is unlimited, while the downside is limited to the amount you paid for the option in the first place.

(I actually had an assignment for one of my classes to explain a complex idea from my major in terms everyone could understand. So I thought, what a perfect blog entry!)

Stocks vs. Bonds

Investors face many choices when trying to construct the optimal investment portfolio. Among them is the choice between stocks or bonds. Each security has different risk and return characteristics, so there is almost always a trade-off between the two. We face similar choices when pursuing relationships.

Stocks
Think of all the extremely popular, good looking people who everybody notices. They're charming, engaging, and drop-dead gorgeous. We'll call these people stocks. Everyone has heard stories about people who made a fortune investing in the stock market. Because of this, most people perceive stocks as a sexy, high-profile investment. We'd all like to hit it big in the stock market, but along with the potentially high returns comes an associated degree of risk. You never know when a stock is going to tank.

For example, you may invest in a relationship with a bodacious blonde girl only to discover that she has relied solely on her beauty to advance through life, and is wholly lacking in character and basic life skills. Girls can end up in a similar situation with a guy who turns out to be a huge jerk with no ambition, ultimately turning into a lazy, beer drinking piece of white trash. Truly a sad situation.

On the upside, stocks don't always crash. Actually, on average, the stock market is one of the best performing long-term asset classes in the market. But the key phrase is LONG-TERM. Many investors play the stock market on a short-term basis hoping to strike it rich but end up getting burned. So your best bet is to approach these relationships as a long-term commitment. You may score once in a while through day trading, but most people ultimately find that they've just been wasting their money.

Bonds
Now think of your average Jane or Joe: not strikingly attractive, but not grotesquely ugly either. Their main draw is their strong and steady character. We'll call these people bonds. Although less well-known among the general public, bonds make up a huge portion of the capital markets and generally produce a steady, albeit relatively modest, return. But this is their main draw - their steady, long-term return on investment.

Since these people can't necessarily rely on their charm and good looks, they develop themselves in many other ways. Consequently, they usually provide solid support in relationships and make decisions with the long-term horizon in mind. Of course, bonds have their downside as well, but the risk is much smaller, especially if you invest in AAA rated bonds (i.e., they have good credit).

Hybrid Investments
You may also want to consider some alternative investments like preferred stock, debt with warrants, or convertible bonds. These securities combine the best of both worlds - someone who is good looking AND has a strong character.

The only problem is that these investments are much less common. The nature of capital markets results in the issuance of many more stocks and bonds than hybrids. Typically, only insiders or specialized investors, like venture capital and mezzanine groups, have access to these investments. But if you work hard enough, you just might find yourself in the right place at the right time.

A Word on Fund Managers
Whatever your strategy, make sure you take an active role in managing your own investments. Don't rely on setups or blind dates. On average, less than five percent of fund managers outperform the market, so the value-add for their service is questionable. Perform adequate due diligence on all your investments, and you will eventually find a winner.

Credit Default Swaps

A lot of people have been talking about credit default swaps (CDS) these days. What exactly is a CDS? Well, suppose we compare your relationship to an investment in a fixed income security, such as a bond. This is a pretty steady relationship, but there's always a possibility that everything you've invested could go to waste. To avoid this unfortunate scenario where you lose your entire investment, you might consider investing in a CDS, also known as a rebound boyfriend/girlfriend. This person is someone who you've maintained a reasonably close relationship with, and who could immediately provide the benefits of a relationship to minimize the hurt and loss felt after a breakup.

Ideally this person has had a crush on you for a long time, and requires little attention in order to keep their hopes up of potentially hooking up with you. However, the amount you should invest in a swap or rebound depends on the riskiness of your current relationship and the degree to which you need them to replace the flow of benefits. Different swaps promise different gaurantees against default. The great thing about swaps is that they can be traded on the secondary market. If the cost of your swap doesn't make sense given the riskiness of your relationship, you can always trade for a different one.

In reality, a credit default swap is basically an insurance policy against the possibility that your fixed income investment will default. For example, Goldman Sachs owned billions of dollars worth of mortgaged backed securities (MBS), which are essentially investment products comprised of thousands of home mortgages all packaged together. When people started failing to make their mortgage payments, a lot of these investments went sour. But Goldman, along with many other banks, had purchased credit default swaps from AIG to hedge their investment. So when the credit crisis hit, AIG owed billions of dollars on the swaps they issued, which contributed to their rapid downfall. This was one of the major controversies surrounding the bailout, because most of taxpayer money was used to pay off AIG's obligations to banks who owned the swaps.

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.

The Portrayal of Women in the Media

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