Building ‘real options’ in financial planning

In finance, the term “real option” refers to having the ability to make an economically-valuable choice (see here for quantitative explanation). There is considerable literature on real options in many areas of finance, but I have yet to see a discussion of how this concept applies to personal finance. I have come to believe that financial planning should explicitly consider real options. There are some jobs that you can do if you lose a limb, for example, and there are others that you will not be able to perform if an injury limits mobility in a finger. A job that can be adapted to a reduction in physical abilities has embedded real options. Living somewhere that you can function without owning a car provides another type of real option. In a financial crunch, you could reduce your household overhead by not driving. And, of more recent relevance, there is a valuable real option in being able to work from home rather than at a centralized office or factory.

A simple example of having a real option with work is that of drivers for Uber or Lyft. The driver can decide to drive or not, depending upon demand and whatever else he has on his agenda. More generally, there are many freelance jobs that allow people to vary the number of hours they work. To the extent that a freelancer can scale her work hours as needed, this is a significant real option that traditional employees typically lack.

Here is a list of a number of desirable real options in personal finance:

  1. Ability to relocate
  2. Ability to work from home or remotely
  3. Access to public transportation / living in a walk-able or bike-able place
  4. Ability to quickly and substantially reduce monthly expenses
  5. Ability to vary work hours and income, as needed
  6. Having a diverse set of skills

Note that several of these relate to human capital, a person’s skills and know-how. Some forms of human capital are richer in optionality than others.

While freelance, consulting, and contract work (referred to in economics as contingent work) lacks some benefits of traditional employment (steady paycheck, employer-provided benefits), this type of work arrangement often has substantial optionality. Discussions of contingent labor highlight the lack of security but ignore or discount the value of optionality.

The well-known 50/30/20 budget requires that households have the ability to rapidly cut out expenses that require 30% of their income. This ability is an example of a real option. Financial fragility is related to lack of optionality in household finances.

I have been thinking about the importance of real options in personal finance for several years, but the emergence of COVID-19 really brings the point home. Households that have the ability to flexibly respond and adapt to substantial dislocations or changes in circumstances are far better off. COVID-19 suggests that we have evolved into a society in which many people have relatively few real options in their personal finances.