Advanced Personal Finance

There’s near unanimity in the belief that you should have a cash emergency fund.  The problem with that supposedly inviolate rule is that in low interest times like we’re now in, your emergency fund gets smaller and smaller every day.  I advocate alternatives to the large emergency fund thesis.

In times of low interest rates and high inflation, there’s an awful effect for savers - negative real interest rates.  Like a job where you never get a raise, negative real interst rates happen when your income (in this case from interest on your savings) declines after the effects of inflation.  For a recent example, consider that in a typical ‘high-interest’ savings account, you are offered 3%.  With official CPI running at 4%, you’re losing 1% of your emergency savings in real purchasing power terms.  To make things worse, I haven’t even included the effect of taxes on those interest payments.  To make things much, much worse, I’m using the CPI put out by the federal government which many, including myself, think is a fiction.  (I believe true inflation is much higher and if you’ve bought food, gas, health care, or day care recently, I think you’d agree.  See Shadow Stats for more information.)

The bottom line is if you have a cash emergency fund, it gets smaller in real terms every day.

Fine, you say, but a 1% decline isn’t so bad.  And besides, what’s the alternative?  I think there are two decent alternatives to an ever-shrinking emergency fund - a fully-funded Roth IRA and ready credit.

Among the great features of a Roth IRA is its withdrawal rules.  Without getting into all the various tax treatments for withdrawals before retirement, for our purposes you only need to know one thing.  You can always get access to your initial investment.  That is, if you fully fund a Roth IRA in 2008, you can always get at your $5,000 initial investment without tax or early withdrawal penalties.

With that in mind, I think a Roth IRA is a very good vehicle for emergency savings (beyond a small to medium size cash account for ‘mini-emergencies’ like car repairs).  You can invest the money with an eye toward growth (i.e. not in a passbook savings account) that should earn a higher return.  But in a true emergency, you can still access the money.  When the emergency passes, you can begin putting the money back into the Roth (for that year only).

The second alternative to a large emergency savings account is ready credit.  Some people will recoil in horror at the thought of using credit in any form as an emergency fund.  But I believe ready credit can make an excellent emergency backstop.  I’d call any widely-accepted revolving credit line ‘ready credit.’  Examples are unused credit card balances and HELOCs.

The great advantage to using ready credit as an emergency backstop is that it puts the interest rate risk onto the bank.  They bear the 1% loss you’d incur if you saved as in my example above.  (Mind you, the bank doesn’t actually suffer a loss.  They obviously invest that money into higher-than-inflation investment vehicles.)

The disadvantage to this technique, and it is admittedly a big one, is the possible sudden loss of those credit lines just when you need them.  Recently, people have experienced a decreasing credit line on their credit cards.  And in the event of a job loss, banks are known to pull or reduce HELOCs.  I don’t deny this is a problem.  However, I would point out that not all emergencies involve the loss of a job (the most common reason for a loss of credit).  Examples of situations where you’d want access to a good bit of money without having lost your job abound.

Do I think you should abandon a cash emergency fund?  No.  I just think, ideally, the ‘emergency fund’ should actually be a set of concentric rings around you.  Closest to you is money kept for day-to-day expenses and any extra in a checking account.  Beyond that is a smallish cash emergency fund.  Beyond that is ready credit and/or saleable investments.

What do you think?  What’s your emergency fund technique?

This post only published at Advanced Personal Finance.

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Moving to a lower cost of living location is a popularly advocated means to cut expenses and live below your means.  But does moving to a cheaper area really save the kind of money most people would need to save to make such a dislocation worthwhile? 

Maybe not.

People interested in personal finance advocate lots of different methods to either increase income or decrease expenses.  There has been a plethora of stuff (too much) written about the ever-ellusive ‘alternative income streams’ to do the former.  The latter garners an even greater amount of attention.  Free Money Finance has written several times about the idea of moving to another city to cut expenses.  My family just did it earlier this year.  Now David at My Two Dollars is planning on moving to a much cheaper area this summer.  But there’s excellent evidence from behavioral economics research that this isn’t the money-saving move people think it is.

One of the basic principles of the new field of behavioral economics is something called ‘anchoring.’  Basically, anchoring means once you’ve gotten used to the cost of something, you compare similar things to that cost.

Anchoring is relevant in this context because when people move to a lower cost of living area, they’re expectation of the cost of housing (among other things, I suppose) is anchored to their previous (more expensive) location.  So it’s been shown that when people move to a place with cheaper housing, they keep sinking the same amount of money into where they live.  A family moving from Dallas to Des Moines spends what they used to pay for their old house; they buy more house in Des Moines because they’re used to a certain mortgage payment.

Interestingly, it also works the other way.  If they move from a cheaper area to an expensive one, people typically just squeeze themselves into a smaller house and keep roughly the same size mortgage payment.

So maybe the advice to move to a lower cost of living city isn’t as automatically beneficial as I thought.  I can tell you, though, that in our case we did cut our payment by a third for a similar house when we moved.  Of course, everyone thinks they’re the exception to the rule, don’t they?

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Here’s a new spin on debasing the currency.  According to this story, a Congressional bill due for a vote soon would instruct the US Mint to start stamping pennies and nickels in steel instead of their current alloys.

The cost of a penny is currently over one cent (1.26 cents) and a nickel costs 7.7 cents to mint - 50% more than it’s worth.

The rising cost of metal commodities is to blame.  Copper is near record high prices and zinc costs four times what it did in 2003.

So not only in the Fed debasing the currency, so is Congress, in a manner of speaking.

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Warren Buffett is well known for a couple of things - his love of hamburgers and Cokes, his folksy whitticisms, and being one of the world’s best investors.  That last one is why, when he says something, I listen.  I read about Berkshire’s latest annual meeting recently and, as always, it was enlightening.  And, like a bucket of cold water, sobering.

Buffett and his partner Charlie Munger said flat-out that the days of Berkshire returning far superior returns are over.

“We would be very happy if we earned 10%, pre-tax” on the additions to Berkshire’s equity portfolio, said Buffett. “Anyone that expects us to come close to replicating the past should sell their stock; it isn’t going to happen. We’ll get decent results over time, but not indecent results.” Added Munger: “You can take what Warren said to the bank. We are very happy at making money at a rate in the future that’s much less than the past… and I suggest that you adopt the same attitude.”

This follows in line with some other things I’ve been reading from well-respected writers like Peter Bernstein and Kevin Phillips (whose new book, “Bad Money” I’ll shortly be reviewing).  These people, not known for gloom-and-doom perma-bear sentiment are saying things will be middling to bad for a good while. 

Bernstein believes the economy won’t turn around until after 2009 (!) and when it does, it will be a long, slow recovery.  I tend to believe him.

Kevin Phillips lays out an equally dim view of the situation going forward.  He is even more pessimistic than Buffett and Bernstein.  Ditto for bond king Bill Gross of PIMCO.

When heavy hitters like these guys tell you to adjust your expectations down, you’d better do it.  I know I am.

 This article published only at Advanced Personal Finance.

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