Monday, December 17, 2018

The Financial Knowledge Stack

Image result for tcpip stack

I came across a very interesting article on financial knowledge from Psychology Today which made me think deeper about the financial knowledge that is required to make good financial decisions. For those who might be curious, you can access the article here.

The author created an epistemology for financial knowledge and created six categories of financial know-how. The moment I read this article I had this eureka moment about about the kinds of the financial knowledge that is out there.

To me the closest analogy to financial knowledge is the TCP/IP stack that underlies all Internet-working traffic. Financial knowledge comes in layers.

At its most basic level, we need to have the statistical and mathematical tools to understand how money works. This broad theoretical level of knowledge would cover concepts like compound interest and net present value discounting that is taught in many classes. But clearly operating at this level is not enough.

At the second layer is category level information - information about various asset classes and what their properties are. Information like general returns of equities and how business owners are prioritised compared to debt owners in an insolvency event belong to this broad category. If you know that generally speaking, stocks provide better returns belong to this layer of information.

At the third layer is where you learn about specific investment options. At this level, you know that buying some ETFs in SGX can provide a diversified exposure to global equities. You will also know that a diversified commodities ETF does not exist in SGX. It is also at this level that become aware that stocks like SPH gives you exposure to a media monopoly.

At layer four is where you learn about procedural matters when it comes to investing. How do you open a CDP account ? How does a margin account work ? How to you execute a limit order trade ? Education at this level is best done by an individual broker.

At layer five is what I would consider the harder aspects of your investment capability. At this level, you need to be intimately familiar with how much you can earn a month, how much you can save and whether you might qualify to be an Accredited Investor status. This is the level of knowledge where you determine your ability to maintain a proper budget.

At layer six is where you learn about the softer aspects of your investment personality. What does retirement look like to you ? What values do you attach to money ? What is your personal risk appetite. At this level, you ask really personal questions as to whether can money make you happy.

At the lower levels, the human population would be bound by the same rules of finance. The Rule of 72 is consistent no matter who you are. But as we move towards higher levels, the knowledge you gain becomes much more personal and training takes on a bespoke quality.

I think this model is useful for someone who aspires to be a good trainer for financial concepts. Creating a program that covers all six levels of financial knowledge is a difficult because, at the higher levels, it is really up to the individual to determine what they want out of their financial decisions - this may not be in alignment with an individual trainer.

We should also be clear about which layer we are operating at.

In the last blog post, I looked at the issue of what a good REIT sponsor is.

At the surface level, it really looks like a level 3 problem because a good REIT sponsor looks initially like an objective exercise that can be gleaned from reviewing balance sheet numbers. But after a round of discussion, the question of whether a a REIT sponsor is a "good" one may be a function of the investor's personality - a REIT sponsor is good because the investor feels comfortable investing in the REIT.

The next time someone spouts a truism in value investing, you might want to take a step back to review whether what to look out for is something that can be objective determined and can be universally agreed upon, this is knowledge that operates on layer 3. Question the person further and you might even come to the conclusion that value investor is operating at layer 6 - subconsciously making a decision that is ultimately based on their own personality and feelings towards a particular counter.

But don't look down at Layer 6 - George Soros is known to develop some kind of back pain before knowing that a position may turn out a wrong way and is able to develop a sixth sense of an inflection points in financial markets. 

Ultimately, it is hard not to operate on multiple layers at the same time when making financial decisions.




2 comments:

  1. Reminds me a bit of the "personal finance pyramid"

    E.g. Sample picture

    Proponents argue that for the average joe, they should focus on the lower layers first aka getting their shit together. Before even thinking about messing around with "investing".

    Yours would be squarely in the "addressing investments" layer.

    Despite the overwhelming amount of universal education and tertiary education, most of people aren't really well versed in most of the layers, let alone the investing layer.

    School (from Pri to Uni) mainly focuses on the 1st layer --- and I would say only about 30%-40% of it i.e. basic literacy and employability. Fundamental things like risk mgmt, insurance, protection, family planning, housing affordability are simply not covered & left to OJT and trial & error.

    ReplyDelete
  2. Thanks for sharing the pyramid.

    I can work with weaving it into the Stack. I am likely to make a substantial presentation for the Seedly event in 2019.

    ReplyDelete