Advanced Personal Finance

Several months ago, I wrote about how I was dividing up the money I’d put into ETFs in my rollover IRA after I left my previous job.  While I wasn’t positive at the time, I’m now a strong believer in diversification including bonds - even at my relatively young age.

When I settled my allocation, I put 50% in a US total market index ETF; 40% in a World index ETF; 10% in a bond index ETF.  At the time, a commenter wrote that he would cut out the bond portion.  I couldn’t disagree. I’d wrestled with the idea myself.  With hopefully about 25 to 30 years until retirement, I ’should’ have the great majority of my retirement assets in equities (and, at 90%, I do).  So the inclusion of the bonds was just me following the standard advice, which I thought sensible if not optimum.

So how’d that work out?

Well, I’m now even more of a believer in diversification.  While the total market ETF has returned -14.5% YTD, the international stock -14% and the bonds?  Year to date almost 2%!  Woohoo!  Let’s hear it for not losing money!

Who would have thought earning not quite 2% would elicit a cheer?  Go figure.

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Undoubtedly, the most appealing feature of money market funds is their extremely low risk.  For all intents and purposes, it’s nil.  But last week the SEC proposed new rules that would allow money market managers to take greater risks with investors’ money.  More risk isn’t exactly what you’re looking for in a money market, so how might this new rule affect you?

Grading debt

First let’s take a look at the proposed new rule.  Last Wednesday, the SEC put forth a proposal that would allow money market fund managers to invest in debt not rated by one of the major ratings firms.  Moody’s, S&P, and Fitch make their money rating, among other things, bonds.  But with everything that’s been happening lately in CDOs, people are wondering just how relevant those ratings are.  Stuff that was rated AAA has completely blown up, soaking the holders of those debt instruments.

Money market funds generally must buy only short term, investment grade debt.  The new rule would allow fund managers to determine just what is and is not ‘investment grade.’

This is not a defense of the ratings firms by any means (the whole ratings system is pretty warped to begin with), but is it a good idea just now to give fund managers a greater ability to ratchet up risk?  Money market managers are probably pretty decent guys and girls, by and large.  But their pay is aligned with greater return and as we all know greater return usually involves crime or greater risk.

Is your money market at risk?

Keep in mind the SEC only proposed this new rule.  It’s not law yet. 

Secondly, nothing says the management of your money market fund will take on greater risk.  But the pressure’s sure going to be there.  I mean, a money market is a money market right?  Safe and stodgy.  Why not put your money in the one with the best return?

I don’t think there’s anything to worry about, though.  The bottom line is that if a money fund ever ‘breaks the buck,’ there’s going to be hell to pay.  Only a very serious incident would give rise to that happening and even as pessimistic as I tend to be, I don’t think any major fund will ever do that.

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In the past two days, there have been two very important court rulings you should know about.  The first involves US currency and the second involves municipal bonds.

Yesterday, the US Court of Appeals DC circuit upheld a lower court ruling saying the US Treasury is violating the law by maintaining a currency that is not easily distinguishable to the blind.  If not overturned on appeal, this would mean America will have to redesign its currency, probably varying the size of the different bills.  While I don’t have a problem with that, I think many Americans would.  After all, despite the fact that it costs more to make a penny and nickel than they’re worth, a large majority of Americans still want to keep it.

The second important ruling came from the US Supreme Court.  By a 7 to 2 margin, the Justices struck down a lower court ruling that municipal bonds violate interstate commerce.  What that means is that muni markets can continue to function as before.  The lower ruling had threatened to shut down the widespread practice of states not taxing municipal bond income.  Even if you have no munis and no interest in them, this ruling is important because the lower court ruling would have significantly changed bond issuance in total.

That’s all for now on the law front.

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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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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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