Monday, August 08, 2022

Thinking and lifestyle design using real options and annuities

This post came about because of MissFITFI's podcast with the owner of Saturday Kids. You can listen to the podcast here.

I want to focus on one important idea mentioned in the podcast which is the idea of placing little bets in life that have a small probability of success but can pay off in a large way. This idea can be broadened quite significantly on this blog.

Consider the term life insurance. This is basically a put option on your human capital. If you die, the insurance pays off a fraction of the loss of your human capital to your family. If you outlive the insurance, it expires worthless. 

There is a class of life strategies that exploit a myriad of real options that behave like term life insurance. Advanced education qualification is a call option on your human capital. If there is a strong market demand for people with such advanced degrees, you can enjoy a higher salary or a boost in your human capital. If your advanced degree is in something that society does not value, it can remain dormant or "out of the money" until there is a shift in industry trends. Options gain value when the underlying security goes up in value or even when the situation is very unpredictable or volatility is very high. 

If you are a fan of Nicholas Taleb's Antifragility, living an anti-fragile life is all about embedding real options in your life. 

Now we consider the opposite of term life insurance, the annuity. An annuity hedges against longevity risk. If you live too long, the annuity pays a monthly stipend every month until you die. 

If we consider term life insurance and annuity as a spectrum, then our lifestyle design based on real options is incomplete. While we need to make many tiny bets to get ahead in life, we need systems that pay out a predictable amount every regular time interval, at least to survive. The importance of having a steady job, some royalty payments, and dividends which are uncorrelated to market cycles are vital to survival in modern society. 

Lifestyle design is all about having both real options and regular cash flows to suit your personal needs. 

One way of approaching lifestyle design with this insight can be as follows:

a) You need to know your absolute base essential lifestyle and find ways to match this using earned and passive income. When doing this, you need to think like a landlord. Ideally, if you need to work harder to do this using passive income, do it as the payoff of getting time freedom is extremely high if you can meet this threshold.

b) Once basic needs are covered by earned or passive income, you can start to think about tiny bets that pay off in a big way. This way you can think like a VC. You can earn a qualification that will be valuable in the future, or put in some capital into a startup. In this example, it is better to do position sizing and make uncorrelated bets so that one big win would cover all your losses elsewhere.

c) Income-generating assets and real options should be interchangeable. Maybe some dividends are used to signup with a new Skillsfuture course or advanced degree. Once the advanced degree gets you a higher salary, you can farm extra proceeds into a bigger dividends portfolio. Balancing the two is an art and you can decide how to allocate your capital based on your own capabilities and personal situation.

Some readers will note that in a discussion that straddles between real options and cash flows, where do capital gains that are analogous to growth stocks stand in this spectrum? Stocks belong at the centre of this continuum. Some stocks pay a dividend and it has an option to grow if their valuation goes up. 

( For the absolutely pedantic, stocks are also a written put option, it can drop in value when the underlying business loses money )

1 comment:

  1. Hmm I tot stocks more like call options.

    Longshot bets include Toto & Big Sweep.