I have so many things to post about today, I doubt I’ll get to them all.

However, I couldn’t let the day close without commenting on the big financial news, namely the fairly large drop in global stock markets today. The AP Wire has a nice summary of the financial metrics from the day:

It began Monday with a 9 percent slide in Chinese stocks, which came a day after investors sent Shanghai’s benchmark index to a record high close, setting the tone for U.S. trading Tuesday. The Dow began the day falling sharply, and the decline accelerated throughout the course of the session before stocks took a huge plunge in late afternoon as computer-driven sell programs kicked in, and also as a computer glitch caused a delay in the recording of a large number of trades.

The Dow fell 546.20, or 4.3 percent, to 12,086.06 before recovering some ground in the last hour of trading to close down 416.02, or 3.29 percent, at 12,216.24, leaving it in negative territory for the year. Because the worst of the plunge took place after 2:30 p.m., the New York Stock Exchange’s trading limits, designed to halt such precipitous moves, were not activated.

In the grand scheme of things, today’s move in the stock market was neither unusual nor extremely worrisome for a long term inventor with a well thought out asset allocation. However, people are not rational with money, and loss aversion is one of the best documented aspects of behavior finance. Most research available on the topic demonstrate repeatedly that people tend to value the loss of a dollar three times more than the gain of a dollar. It’s amazing, really. The joy you likely feel seeing your portfolio up $1000 is likely 1/3 the pain you feel when you see it drop $1000. That is not a recipe for rational decisions.

I’ll be writing my next article in my personal finance education series soon, most likely on the topic of asset allocation and long term investing. Days like today can be extremely stressful if you are in the stock market for the wrong reasons, with the wrong goals, or with the wrong expectations. However, days like today can be a blessing if they force you to really embrace what risk really means in terms of the day-to-day unpredictability of the stock market.

In the meantime, however, I’d like to share an article written today by Vanguard, the puts market volatility like today’s in perspective. Here are a few lines that I felt were extremely well put:

“There’s no doubt that a big drop in stocks can be tough on your nerves and your account balance,” said Gus Sauter, Vanguard’s chief investment officer. “But after a day like Tuesday, it’s more important than ever to maintain a long-term perspective…”

Tuesday’s decline put the stock market’s return so far in 2007 into negative territory. But over the past 12 months, the broad stock market has still produced a total return—price appreciation plus dividend income—exceeding 10%. That gain, coincidentally, is roughly the long-term average annual return for U.S. stocks….

“We’ve had a very nice rebound in stocks since the long bear market that began in early 2000 and stretched into 2002,” Mr. Sauter said. “So it’s not surprising to see a pullback…”

As investors digest the volatility of the market and the flood of commentary that always accompanies such events, it may be helpful to reflect that no one can say whether stocks will continue to decline or whether they’ll soon rebound. What is clear is that few, if any, investors have a demonstrated ability to consistently pick the right times to get in—or out—of the markets…

“The stock market never goes straight up,” Mr. Sauter said. “To be a successful investor over the long term, you need to understand this fact and you need to react rationally when the market doesn’t go your way.

“Successful investing is a rational, not an emotional, pursuit. If you’ve made conscious, deliberate decisions based on your personal financial goals, time horizon, and your tolerance for risk, there’s no reason to change your plans.”

One of my favorite pieces of advice that I give about investing is that for most people, you know when you are doing it well because it will be boring. For people who do not make their living in the financial markets, it should take very little time to pick a well-balanced, diversified portfolio of assets, and then add money to it regularly. Rebalance once, maybe twice, a year, and you are done.

Enough warm up.  It’s time to get to some real asset allocation.

In my third article, I spent sometime highlighting the importance of setting up a good savings plan.  Fundamentally, this ensures that on a regular basis, you will have extra income that you can dedicate to saving & investing.  For those MBAs out there in the audience, this largely means your assets will be going up and to the right in your favorite little two-by-two charts.

Unfortunately, this is where the complexity really begins, because as you start seeing money accumulate in your checking account, many people freeze up.  They don’t know where to put the money.  Retirement?  Real Estate?  Stocks?  Bonds?  ESPP?  What do you do with the excess cash every month?

Well, this subject of this article is meant to point the way to the very first thing you should do with your excess cash.  You need to set up an emergency fund.

No, an emergency fund will not make you rich.  No, an emergency fund will not be invested in commodities, real estate, or sexy ETFs that mimic the movements of a long/short strategy.  They will not go into straddles or complex derivative strategies.

But, an emergency fund is likely the most important part of a sound savings & investment strategy.  Why?  Because job risk is real and liquidity is king.

Before I get into preaching, let me give you a brief definition of an emergency fund.  The perfect emergency fund is:

1. Approximately 3-6 months worth of living expenses
2. Kept in highly liquid, cash-equivalent assets
3. Available almost immediately, when you need it, for unforseen events

Example.  Let’s say you make $80,000 per year, but your basic living expenses (rent, utilities, dining, student loans, auto costs, etc) comes to $2500 per month.    A good emergency fund would likely be between $7,500 and $15,000, set aside into a high-rate savings account or money-market fund.

I know what you might be thinking here.  That sounds like a lot of money to not have invested for the future.  $15,000 could be $30,000 in just a few years if invested aggressively.  $100,000 in a couple decades.  $250,000 by the time you retire.  Why lock it away into something like a money-market fund?  That will barely cover inflation!

Two reasons really.

First, job risk is real.  You have to be the judge of this personally, based on your field, education, company, and risk tolerance.  I personally work in the high tech industry, and this is a field that can move hot and cold relatively quickly.  In a hot job market, jobs come knocking on your door.  Unfortunately, people most often lose their job in exactly the type of environment where you don’t find jobs that easily.

Your emergency fund is your safety net.  It is a guarantee that you can continue to lead your life, relatively securely, as you search for new work.  3-6 months is a good average for people who think that, for the most part, that represents a successful job search time in a down market.  When I worked in venture capital, it was not unusual for people to be “between firms” for over 12 months.   The modern workplace has very little job security, and this is where you protect your downside, not shoot for a big upside.

Second, liquidity is king.  When the unexpected happens – whether it is an unforseen medical issue, job loss, or other unforseen crisis, you learn a painful truth about your finances.  That truth is that no matter how much money you have on paper, it is liquidity that rules the day.  Liquidity is defined as your available to translate your assets into cash, quickly, to make needed payments.

Cash in your wallet defines liquidity.  Cash in a checking account can be accessed almost immediately.  A Certificate of Deposit (CD) is a bit harder – you usually have to go through a processs to cash that out early, with penalty.  A stock?  You have to sell it, and wait days for the money to clear.   An IRA or 401(k)?  That takes time to break, and there is a stiff penalty for withdrawals.

When I graduated from business school, my student loans were at their peak, my wedding expenses were coming due, we relocated back to the Bay Area, my wife was looking for work, and I had just kicked off my new job in venture capital.  I was fortunate to have stashed away enough liquid assets to cover everything, but it was close.  You don’t want to get to a place where your remaining liquidity options are consumer debt, breaking into retirement savings, or other expensive sources of funds.

My top personal finance priority at the time, as per my learnings from books and magazines, was to build an emergency fund.

Many people keep their emergency fund in an extremely liquid account, like a local bank checking account.  You do not want to count on high interest options, like credit cards, or options with large penalties, like retirement accounts, when you are in a pinch.  Personally, I think there are a few more options that can help make sure that your idle cash is still extremely liquid, but still beating inflation for you.   The best options, in my opinion, are the following:

When banks compete, you win!  Ah, free markets.  Got to love it.  Every bank that wants to break into the consumer market does it by offering, for several years, a very high interest rate savings account.  Three years ago, ING Direct was the best.  Last year, Emigrant Direct.  This year, who knows, even E*Trade offers over 5% on their cash balances!  The point is, it’s very easy to find a high-interest savings account, and with electronic transfer between banks being free for sites like E*Trade, you can put your funds in any account that pays alot, and still have access to your funds within a few days.

Series I Savings Bonds.  Guaranteed to Beat Inflation.  Savings bonds are not as liquid as they used to be.  In fact, there are penalties if you try to cash them out in less than five years, and you can’t actually cash them out in under one year.  So why do I recommend them?  The rates on Series I bonds are subsidized by the US Government.  They are guaranteed to pay out a fixed amount above inflation, which is calculated every 6 months.  For example, I have some from 2002 that pay 2% above inflation.  So if inflation were 3.4% this year, the bonds would pay 5.4%.  But here’s the bonus.  You don’t owe taxes on the gains unless you cash in your bonds!  That means, they accrue value, for up to 30 years, with no tax bill.  Also, for parents out there, if you use the bonds toward education expenses, there is no tax due, ever.  Also, no state or local income tax.  It’s a good deal, and if you can get through the first year, they are very liquid, since you can cash them in at any time after that.

Everyone’s comfort-zone with emergency funds is different, but if you don’t have an emergency fund accumulated, it should be your very first savings goal.  Saving up 3-6 months of expenses isn’t easy, so you want to put away your monthly savings into your fund until it reaches your goal.  Don’t forget to “top it off” every year as your income and expenses likely increase over time.

Remember, the emergency fund is in place to protect you, your family, and your investments from unexpected problems.  Some of your best investments, like stock funds, are designed to provide optimal returns when invested for the long term (5-10 years).  If you are constantly withdrawing and then re-adding funds into your long term investments, you will wreck your returns.   If you end up hitting your IRA or 401(k) during a tough time, you can set back your retirement goals by a decade or more.

An emergency fund not only protects you, it also protects your long term investment strategy from dark times.

So don’t focus on the fact that you could be making more on that money.  Focus instead of that money as the enabler of the rest of your investment portfolio.

All of my upcoming articles will assume that you’ve done the right thing, and built your emergency fund up first.  In fact, I will argue that building up an emergency fund is even more important than repairing the ultimate sin of personal finance – carrying a balance on your credit cards.

Here are a few articles that are worth reading on emergency funds.  I like this piece, on BankRate.com.  There is an excellent blog post on the topic, from last year, on GetRichSlowly.org.

I thought it was important to dedicate a chapter to probably the most fundamental basis for any great personal finance & investing plan: saving.   The truth is, without a strong desire and dedication to saving, the rest is just decoration.

Saving, at least in this context, has a very specific meaning.  It means spending less than your income on a consistent basis.

It sounds easier than it is, however.  We live in a society that completely surrounds people with millions of things that they can’t afford, but that are sold to them as if they must have them.  Peer pressure makes this worse, because in our society you get to publicly see people’s possessions (cars, houses, gadgets) and not their bank statements.  As a result, the people who have spent the most money on publicly visible things look the wealthiest, even if they are up to their eyeballs in debt.

Don’t confuse having a lot of financial assets with saving.  The average baby boomer has $52,000 in their 401(k), but also has thousands of dollars in credit card debt.  It is very easy to fall into the trap of using debt from credit cards to cover expenses, and then feel like your saving by contributing to a college fund or a 401(k).   In the end, that debt will catch up to you.  In most situations, saving means covering all of your expenses with your income, and then having money left over.

I’ve spent some time on this blog talking about behavioral finance, and some of the ways that people are irrational with money.  As a result, I thought I’d point out at least a couple of popular ways that people seem to find ways to consistently spend less than they make.  Please feel free to share your own techniques below in the comments.

The first way is to always focus on value, and to begrudging spend regardless of income.  If you were fortunate enough to grow up with grandparents who lived through the Great Depression, you likely are familiar with this approach.  Many people are often suprised to find out how many wealthy people, who don’t need to worry about spending an extra $10 for dinner, actually fit into this category.

This approach may seem miserly to some, but it’s not always unhealthy.  In fact, at its heart, this approach focuses on the basic fact that very few things, in fact, are “needs” vs. “wants”.  You may have the extra $20,000 to buy a luxury car, but do you really need it?  Isn’t there something else you’d rather spend that money on?

The problem with this approach, of course, is that taken to the extreme, it can lead people to save everything, and enjoy nothing.  Every now and again, you hear about the old widow who left $20 Million to a University, even though she lived with no heat and ate oatmeal every day.  Sad, really.

The reason this approach does work for many people, however, is that typically if you are judicious about all of your spending, you regularly will avoid an awful lot of impulse buying.  In general, like in dieting, it’s the impulse spending that really does in many people’s budgets.  Things that feel like “needs”, but really are “wants”.

While I’d like to think that I’m judicious about spending, I’ve never been able to make the first approach really work for me.  I believe in saving, but I also believe in spending to an extent to enjoy life with your family.  That leads me to the second approach.

The second approach is a form of strict mental accounting.  The idea here is to have a strong understanding of your income, and dedicate fixed percentages of it to different savings goals.  This approach has been put into practice extensively in the past twenty years for 401(k)s, but can be used for almost any savings goal.

In order to make this approach workable, many people find that they need to make it a little stronger than a mental promise to put money away.  To give it teeth, people now use automatic deductions from their paychecks or bank accounts, to help siphon money away before it’s spent.

Some companies will let you do this with your paycheck.  If your company doesn’t, most online banking services will let you set up monthly (or even weekly) withdrawals.  You can easily set up automatic withdrawals to fund savings accounts, retirement accounts, college savings accounts, health care accounts, and dependent care accounts, just to name a few.

In fact, the reason that owning real estate often works well for most people is that in can be thought of as a forced savings plan, with a certain amount every month going to principal.

If you fit into the category of someone who really want to get a handle on their personal finances, make sure that you are set up for success on an ongoing basis.   The easiest way to do this is to produce a quick Income Statement for yourself.

It’s really fairly easy.  Start by looking over past bills, credit cards, bank statements, and paychecks.  Make a quick tally, say for the last three months, of:

• Income (Salary, Gifts, etc)
• Expenses (Mortgage, Utilities, Dining, Groceries, etc)
• Saving (401(k), ESPP, college, etc)

All of your income went somewhere, so it’s important to tally up how much you spent, and how much you saved.  Don’t be surprised if, in fact, your “saving” and “expenses” add up to more than your income.  What that probably means is that some money effectively came out of your bank accounts, and went to fund something else (hopefully another savings vehicle, like a 401(k), and not a new dining room table).
Most personal finance magazines recommend that people save around 10-15% of their income, but the actual number will vary depending on your income, your circumstances, and your goals.  Obviously, the higher percentage of your salary you save, the quicker your assets will grow.   As a regular reader of magazines like Money & Smart Money, you’ll often read about people who save 20, 30, even 40% of their income by living frugally.  There is no right answer.

When you start crunching the numbers for goals like buying a home, saving for college & funding retirement, you start realizing that it takes a fairly large percentage of your salary to achieve those goals in the time frames that make sense.   As a result, 10-15% seems to be a sweet spot in terms of balancing short term needs with long term goals.  Personally, I recommend that people not pick a single magic number, but instead really think through their different long term goals, and then pick a number for each that will actually lead to success for those goals.

Once you have your savings plan in place, then the next step is to start breaking up the money across your different goals.  In my next post, I’m going to talk a little bit about one savings goal that often goes overlooked, and yet is likely the single most important goal of all – the emergency fund.