I’ve been doing a lot of business travel lately, and am thus meeting all kinds of interesting people on the road, in hotels and on airplanes.
Two weeks ago, I had the good fortune to sit next to Jerry Wagner on a flight from Oakland to New Orleans.
I was traveling to the GEOINT 2010 conference, which was all about geospatial intelligence. Jerry asked me what I did for a living in the space, and I explained that I don’t work in the intelligence community, rather I research the industry in my job as an associate stock analyst.
Then I proceeded to explain to him what stock analysts do.
He politely let me finish and then informed me that his PhD is from Harvard Business School, and his dissertation was on portfolio theory. (Bio here.)
“Now I’m going to quiz you,” he said.
Seeing as how I was in the middle seat of a single-aisle Boeing 737 — there was no escape.
Jerry proceeded, “Suppose you invest some money and make 100 percent return the first year, and then in the second year, you lose 50 percent. What’s your average rate of return?”
This one was easy. I replied, thinking out loud, “Well, in year one, you double your money. Then, you cut it in half. So, you’re back where you started. So, zero.”
Next up: “Suppose you invest a sum for 10 years and you know that you will earn a 10 percent return for nine of the 10 years. And one of the years, you will be flat, with no gain. Do you want the flat year to come in the beginning, the middle, or the end of your investment.”
I struggled with this one, without a scratch pad. I guessed the beginning, assuming that it’s better to skip the 10 percent return on a smaller sum. But it is a trick question, because the answer is that it doesn’t matter. You end up with the same amount anyway. (Had, ‘It doesn’t matter’ been an option, I think my brain would’ve been more primed to give the right answer. I unnecessarily restricted myself by only considering the three given options: beginning, middle and end.)
I don’t quite remember his third question, but, it dovetailed into a discussion of the Rule of 72. Do you know it?
The rule lets you figure out easily how many years it would take you to double your money. You simply divide 72 by the interest rate, and you get the years.
So, if you invested a sum at 8 percent annual interest, it would take nine years to double your money. (72 divided by 8 = 9)
If you invested a sum at 10 percent interest, it would take 7.2 years to double your money. (72 divided by 10 = 7.2)
If you invested a sum at 6 percent, it would take 12 years to double your money. (72 divided by 6 = 12)
At today’s going interest rates at banks, of less than 1 percent, it would take about 90 years to double your money!
I’d known that this rule worked because of a logarithm, which helps reverse the effect of compound interest. Here’s an online explanation, from MoneyChimp.
Or, Jerry ripped a page out of his book, pulled down his tray table and drew it out for me. I scanned it for you, here: