I'm reading an amazing book on economics, “New Ideas from Dead Economists”by Todd Buchholz. If only this is the prescribed A level economics textbook. It is useful, filled with insights and gives a great overview of different economic theories and life of economists. It is extremely useful to know in what context are these theories developed in as it allows us to understand the theories in the right context.
Alfred Marshall, who brought the idea of Supply and Demand, Marginal Utility and Cost to economics was one of the most influential economists of his time. Something that he wrote really make sense;
(1) Use mathematics as shorthand language, rather than as an engine of inquiry.
(2) Keep to them till you have done.
(3) Translate into English.
(4) Then illustrate by examples that are important in real life
(5) Burn the mathematics.
(6) If you can’t succeed in 4, burn 3. This I do often.
In today's world of spreadsheets and high computing power, we often over rely on the false certainty that numbers provide us. A common risk management tool is called Value at Risk (VaR). Essentially it seeks to quantify the maximum loss of capital with a given confidence interval. However, some problems such as the normal or non-normal distribution of the underlying securities and the ability of the model to sufficiently captures low probability high impact events plagues VaR. Essentially, it is a tool which works well under most condition but fails when you need it the most (in times of financial turmoil).
When it comes to the issue of value investing, the core concept is simply buying assets at a price less than the 'intrinsic value'. But what is intrinsic value?
Alfred Marshall, who brought the idea of Supply and Demand, Marginal Utility and Cost to economics was one of the most influential economists of his time. Something that he wrote really make sense;
(1) Use mathematics as shorthand language, rather than as an engine of inquiry.
(2) Keep to them till you have done.
(3) Translate into English.
(4) Then illustrate by examples that are important in real life
(5) Burn the mathematics.
(6) If you can’t succeed in 4, burn 3. This I do often.
In today's world of spreadsheets and high computing power, we often over rely on the false certainty that numbers provide us. A common risk management tool is called Value at Risk (VaR). Essentially it seeks to quantify the maximum loss of capital with a given confidence interval. However, some problems such as the normal or non-normal distribution of the underlying securities and the ability of the model to sufficiently captures low probability high impact events plagues VaR. Essentially, it is a tool which works well under most condition but fails when you need it the most (in times of financial turmoil).
When it comes to the issue of value investing, the core concept is simply buying assets at a price less than the 'intrinsic value'. But what is intrinsic value?
Intrinsic value can be expressed in the following formula:
This expression is Step (2) of the second paragraph, but it holds no meaning to the normal person.
A great definition is given in Berkshire Hathaway's Owners Manual,
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.
Applying Marshall's principle of “burn the mathematics”, the above definition is at step 3, and illustration – step (4) is as follow;
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
I hope that the intrinsic value of our education is worth way higher than the book value, if not we are not getting our money's worth.
If we can reasonably estimate the intrinsic value of an endeavor, be it a security or an expedition, and have to discipline to consistently pay a price less than that, we should do quite well. Maybe the above exposition may also help Chee Guan in deciding if he should give up his certain pay and employment in pursuit of an uncertain payoff from full time education.
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