My oldest child, a daughter, is now 23 years old with a fresh undergraduate degree and a new finance job at a regional bank in another city. When she and her siblings were young, I would occasionally have reason to tell them that, “one day we’ll be friends, but today isn’t that day. Today I’m just your dad.” What I meant then and is proving to be true now is simply that being a parent to a child is fundamentally different than being a parent to an adult. So, while I am still parent (noun) I do very little parenting (verb) anymore. I don’t have to remind my children about personal hygiene any longer, but we do talk about financial health, and sometimes they remind me that what I just said is “an inside thought” instead of the other way around. Our relationships and our conversations have changed and for that I am grateful but old habits die hard, and I have to remind myself to make suggestions instead of directives, to provide more philosophy and fewer ultimatums.
A recent conversation provided just such an opportunity as we were discussing the concept of options and optionality. An option, for the non-financially minded, is a legal instrument that affords the holder the right, but not the obligation, to take some action in the future; to “exercise the option”. Perhaps you own a call option which gives you the right to purchase 1,000 shares of TSLA at some predetermined point in the future for a predetermined price or a put option which gives you the right to sell 1,000 shares of MSFT. Such options are widely traded, and robust Nobel Prize awarded financial mathematics exist to help both sides of the trade understand what owning (or selling) that option is probably worth. Other options, like a right of first refusal to purchase your neighbor’s home are less frequently traded, but no less useful.
Another form of option that we encounter everyday but don’t often recognize are embedded options. Those are options which are embedded in some larger mechanism and often go overlooked and undervalued. An easy example of an embedded option exists in a residential mortgage, most of which allow the borrower to prepay in whole or in part at any point in time. If you have a little extra money, you can pay down your mortgage faster, shortening its total life or you can refinance for a lower rate and pay the loan off entirely. This is an embedded option that is owned by the borrower, sold by the lender, and has real financial worth though the borrower rarely, if ever, thinks about it that way.
Very often the exercise of an option is a zero-sum game where the exerciser wins and the counterparty loses. Exercising the call option on the TSLA shares means you’ve bought them, and the seller sold them, at a price below the current market rate. You win, he loses. Not exercising an option may also be zero-sum when the option holder has paid an upfront premium for it as in the case of the call option or may simply be a foregone opportunity cost as when you choose not to prepay your mortgage. The opportunity costs of exercising or not exercising embedded options are the ones we should pay the most attention to however, as it’s the hidden, unquantifiable costs that can inflict the most damage.
Embedded options are everywhere and not only in financial instruments, but as the daughter and I were discussing, we usually have to be searching for them to see them. But contrary to what the financial math might say, I’ve come to believe that sometimes the most valuable option we have in a situation is the one we don’t exercise or better, don’t even acknowledge owning.
Cars ◆ Jobs ◆ Relationships
The first embedded option the daughter and I discussed, the exercise of which tends to burn many a 23-year-old* with a shiny new finance degree is whether to keep or sell their old car for something new, expensive, and probably German. It’s easy when you start making a little money to decide that the car mom and dad gave you as a high school graduation present, or that you saved up and bought on your own, has “seen better days” and decide that you deserve something new and more reflective of your new station in life. I am not arguing that point, it may all be true and valid. What I am suggesting instead is that once you notice the option is there, it’s going to nag at you like a pebble in your shoe until you exercise it. Once you’ve decided you own the option you’ll begin to notice every little shimmy, shake, and rattle the car has always made until it drives you mad. In time the car that you loved and named and is full of great memories will become an object of scorn and derision. The car, too, will know that you know you own the option and it will start to hate you as well. Before you know it, you’re in a car dealer on a Saturday morning buying a car you don’t really need and probably taking out a loan to do it. This newly purchased vehicle will one day also be the subject of an embedded option and the doom loop continues. So, here is an example when ignoring the option for as long as possible will likely yield positive financial rewards.
A second example of an embedded option that is often best to ignore is in your career path. I have known lots of people, many of them young but not always, who routinely and too quickly exercise the option to move from one job to another, often earning a little more money in the trade. My experience, however, has shown that over the long term you’re often better served to stay in the traces, to avoid to quick flip, and to develop deep expertise that only comes with time. It’s the pebble in the shoe analogy again. I’ll just talk to a recruiter and it’s good interview experience, you think. Your foundation has subtly softened though, and imperceptibly your attitude changes. The pebble in the shoe continually reminds you of how much better you could be doing somewhere else…maybe. A quick flip may get you a few thousand dollars per annum more, a fancier office coffee machine, and perhaps a better but meaningless title (what does Chief Transformation Officer even mean?!?), but it also begins to erode your value when a prospective employer wonders why you move so often and how much mastery you’ve really attained. Your career is more of a long-term investment than an actively traded one and it takes time for compounding to work. Move too soon and too often and before you know it, execution costs have eaten away your long-term gains. So, exercise the career option sparingly, if at all.
I believe though, the ultimate embedded option, is in your relationships. Your friendships, your business partners, and most importantly with your spouse or life partner. At some point that hot burn of a new love fades a bit. It doesn’t go out entirely, but the novelty passes and the love between two people can become routine and comfortable. There are people who, at this stage, become bored and begin to cast about for someone new, some one exciting, someone “who gets me.” The fact that he doesn’t rinse the toothpaste out of the sink or her damn cat that pees on the carpet become unbearable and grow to become sources of ire completely disproportionate to reality. The pebble in the shoe becomes you in someone else’s bed and everything built to that point is destroyed. But importantly, when you talk with people who have been in relationships, happily, for 30, 40, 50 years or more and ask them how they did it, the core answer is invariably the same. They never exercised the option. They never believed there was an option to exercise in the first place. They simply kept going forward as if there were no other option even when there is. One foot in front of the other, one day at a time, loving and being loved endlessly and forever. And in most cases, they realize a return on investment that far outweighs the costs.
Optionality is useful and can be very valuable, but often the best choice with the embedded options in our lives is to simply live as if they don’t exist.
*I’m not a complete fool. This behavior is not isolated to 23-year-olds. It happens to me – full-cycle – with shocking frequency.