Monday, October 14, 2013

Emergency Fund - It's What's for Dinner

Wikimedia Commons

Robert Mitchum was the spokesman for the Cattlemen's Association advertising campaign, "Beef, it's what's for dinner."

Now I don't want to offend my vegetarian readers, but the Cattlemen didn't need to tell me that - I just about always have beef for dinner.

But when it comes to emergency funds, I like to think of this ad campaign. Here's why!

What is the Purpose of an Emergency Fund?

If I were to do an ad campaign for emergency funds, it might be, "The Emergency Fund - It's What's for Dinner."

This is because the main function of an emergency fund is to be there for you - like the name says - in an emergency.

If bad times hit, an emergency fund's job is to put dinner on the table and pay the mortgage or the rent, get the car repaired, pay the electric bell, and such.

An emergency fund's primary role is to provide for the necessities of life in an emergency or during bad times.


Where Should Emergency Fund Monies Be Held?

One of the more controversial issues regarding emergency funds is whether they should be invested or kept in a cash vehicle.

The traditional view is an amount equal to three to six months living expenses be kept in cash or cash equivalents such as savings accounts.

But there are also those who argue that by investing emergency fund monies a better long term return may result. This argument is being exacerbated by the current low interest rate environment.

In situations where emergency funds may be necessary, I believe investing the monies is not the correct approach. I commented on this topic in a recent Wall Street Journal article, "Keep Emergency Funds in Cash or Invest?"

One Size Does Not Fit All

In the world of financial planning, everyone is different. This also applies to emergency funds.

For example, Warren Buffett probably does not need an emergency fund. Nor does a retiree with a pension, Social Security, no debt, and a low cost of living (although it would still be a good idea).

But a young family with a mortgage, high health insurance deductibles, debt, and little liquid assets and savings, very much needs one.

If You Need an Emergency Fund, Keep the Monies in a Cash Equivalent

The moral of the story is if the monies really are needed in the event of an emergency, keep the funds in a checking or savings.

Here's a look at why. Let's consider as one alternative for investing an emergency fund: Corporate bonds. Here a look at look at the Dow Jones Equal Weight U.S. Issued Corporate Bond Index over the last ten years.

Note what happened during the Great Recession of 2008. The asset class was down significantly.

When, as a general rule, are you likely to need an emergency fund the most? When times are bad - such as during a Recession. This is also when invested funds are most likely to be down. So investing an emergency fund can mean your emergency fund could have an emergency, and just when you need it most.

The moral of this story is if you need an emergency fund, for many, the best option is to keep the monies in a cash equivalent which is not subject to market fluctuations.

That way your monies will be there if you really find the emergency fund is what's for dinner.

  • Disclosure: Past performance is no guarantee of future results. Investing is subject to risk which may involve loss of principal. The value of bonds will decline as interest rates rise. The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings. Real estate involves unique risks and may be subject to illiquidity. There is no assurance a diversified portfolio will outperform a non-diversified portfolio. Diversification does not ensure a profit or guarantee against loss.
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Wednesday, October 9, 2013

Credit Card Debt and the Liquidity Trap

TournamentPlayersClub Sawgrass17thHole.jpg
Golf Course Water Trap - Wikipedia Commons

I'm not much of a golfer, so I know when I come upon a water obstacle, I can say goodbye to my golf ball.

No one made me go to the golf course, and the water hazard was clearly visible. I have no one but myself to blame for transferring ownership of my golf ball to the golf pond.

Like golf courses, credit card companies also have some tricks up their sleeve. Their version of the water obtacle is what I like to call, "the liquidity trap."

The Credit Card Liquidity Trap

The "liquidity trap" occurs because we can charge more each month than we are paying in service on the debt. Even when making payments on credit cards, the debt can be cash flow positive to us and continue to accumulate.

In a sense, the monthly payments are just a shell game as debt can continue to grow and draw us in - until it's too late.
For example, let's say we have a credit card with a $10,000 limit. Say the interest rate is 15%, it doesn't really matter (a red flag). We'll say the balance is $3,000, and the minimum payment $100 per month.
So if we make a payment of $100, and charge $300, there's net positive cash flow of $200. We also just went $200 more into debt. Debt that will from then on acumulate compounded interest.

Our Credit Rating Remains High While Being Drawn In

Meanwhile, since regular payments are being made on the credit cards, our Credit Rating remains high or even increases.

Society, through the Credit Rating system, is kind enough to pat us on the back as we rack up more and more unsecured obligations. We may have loads of debt, but our Credit Rating tells us we are good people - and from the lender's perspective we are.

So rather than feeling burden from the growing debt, we receive positive cash flow. And we can tell ourselves we're good lendees, as we're making our designated payments on time.
All seems well with our financial world.

Stein's Law

Herbert Stein is famous for his observation - dubbed Stein's Law - that if something cannot go on forever, it will eventually stop.
Credit card debt cannot go on forever (unless you happen to be the Federal Government), and what will one day happen is all available credit gets maxed out.
At this point, everything hits a wall. Because once there is no new credit - and only the sea anchor of existing debt - the cash flow must go negative.

Then we see the liquidity trap for what it truly is, a system for gradually drawing us into onerous debt. 

Sort of like when the golf course pond dries out, and we see thousands of golf balls lying at the bottom. All those golfers fell for the trap. But at least they could see it first, and they don't have to pay compound interest on lost golf balls.


Avoiding the Liquidity Trap

The liquidity trap is by design built into the very structure of the credit card concept.
Credit cards should require payment of the full balance at the end of each month. But what would that do to the credit card business? And to other retail businesses that depend on easy credit?
Some consumers try to avoid the liquidity trap by paying off their credit card balance in full each month. However, that's a risky strategy. Sort of like hitting that golf ball over the water obstacle is risky.

It's too easy to get drawn into to letting the balance acumulate, especially when difficult times come, and they will.
The only way I know to avoid the Liquidity Trap is to avoid credit cards. Hey, there's an idea - avoid credit cards and you'll avoid the liquidity trap.

Monday, September 30, 2013

Three Levels of Financial Maturity

Three levels of maturity. Photo: Creative Commons.
It's a jungle out there - so it's important to have the financial world working with us rather than against us.

In evaluating individual financial situations, I find it helpful to use three categories. For want of a better term, I call these "levels of financial maturity." (Financial maturity, as I define it, and personal or psychological maturity are completely different matters.)

The goal is to rise from one level to the next. The definitions below are my own:

  • Financial Independence: Able to survive without employment income. Although we think of financial independence as being wealthy, many are not. The majority in this group are retired and on Social Security and Medicare. These government programs do a lot for financial independence (although they cannot do it alone).

  • Financial Maturity: No junk debt, probably no Home Equity Line, although perhaps an automobile loan. There likely is a mortgage. A 401k or IRA is being funded.

  • Financial Immaturity: Characterized by the presence of junk debt. Junk debt is any debt which is unsecured, such as credit card and department store cards. I would include a Home Equity Line here as well.

Note: these terms are not judgmental! We can be personally mature, hard working, etc., but in the "financially immature" stage or vice versa. For example, many families and students have credit card debt, and these individuals are foundations of society. It's part of life.

At the Financial Immaturity Level, the World of Finance Works Against Us

What I really mean by Financial Immaturity is that at this stage the world of finance works against us. "It's arithmetic," as someone famous recently said, and the arithmetic is not in our favor.

Here we're paying compound interest, perhaps at exorbitant rates. This makes it difficult or impossible to get ahead. It's not a fun way to live life. Don't expect help though: there are plenty of financial institutions that are likely happy to have folks remain in this stage.

The question is how to break out. How to move to financial maturity, where financial instruments begin working in our favor. Where we'll be swimming with the current rather than against.

The Solution is an Emergency Fund

In my next post, I'll talk about the single most important step to take to move out of financial immaturity This is the development of an emergency fund. An emergency fund may sound boring, but it's not if used as I'll discuss.

An emergency fund may be the single best thing that can happen to personal finances.  The good news is, with the information which I'll share, the transition may be easier than most of us would imagine. Stay tuned.