Personal Finance Education Series: (4) Setting up an Emergency Fund

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  There is an excellent blog post on the topic, from last year, on

Personal Finance Education Series: (3) It All Starts with Saving

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.

The Product Wars: Video Games & High Definition DVDs

Fun website I found today, as I was reading about the ongoing battles between HD-DVD and Blu-Ray DVD, the two competing high definition DVD formats on the market currently.

The website is called “The Product Wars”, and it basically just scrapes for data (not sure this is the best indicator vs. scraping eBay, but I digress…)

In any case, they have pages that show a lot of statistics about how well the competing systems are doing.  Here is the page for the DVD Wars.

Takeaway?  Blu-Ray is doing much better than expected, given the PS3 shortages and the cost advantage of HD-DVD players.  In fact, right now, it looks like Blu-Ray has the edge.

The website also has a page dedicated to the next-generation video consoles: Nintendo Wii, Playstation 3, and Xbox 360.

Takeaway?  The Xbox 360 is still outselling everything, although the Wii seems to have eclipsed the Xbox 360 in terms of popularity on a few key measures.

Fun data, if you are into those two markets.


Joost Now Available for Mac OS X Intel

Just posted on the Joost blog last week.  Joost, previously known as The Venice Project, is now available on Mac OS X.

As reported on GigaOm, In an interview earlier this year the CEO Fredrik de Wahl had explained how easy it was for the company to port their client to other operating environments. He had promised a Mac client in less than two months.

I will self-admit to being biased, but I always believe that it is an exceptionally good sign to see a client-software company go cross-platform almost immediately.  Supporting multiple platforms requires well thought out architecture and code decomposition, and I’ve found that the engineers that know how to do this tend to be on the high end of the scale.  Not only that, the code they produce tends to also stand up better over time.  Blizzard, makers of World of Warcraft, are the ultimate examples of this.  Every release of every product comes out simultaneously for Windows and for the Mac.

You can argue about the reasons why, but to me, it’s because they are just that good.

I’m excited to play with Joost first hand.

Book Review: Empire, by Orson Scott Card

Does the idea of a book about a near future American civil war between conservatives and liberals sound interesting to you? Complete, of course, with a George Soros-clone turned militant leader, and mechanical robots policing New York and EMP laser weapons taking down F-16s?

Before I get into reviewing this book, let me just say that I’ve been an Orson Scott Card fan since I was 12. I’ve read almost every book he has published, even the way-far-out-there LDS material. Ender’s Game is one of my favorite books of all time.

This book, unfortunately, left a bad taste in my mouth, the same way that all of Michael Crighton’s books have since somewhere around Disclosure. It’s blunt, predictable, and seems written more for screenplay or a video game than as a full fledged novel.

There have been a lot of flame wars about this novel online, mostly from people who haven’t read the full book. Orson Scott Card has, for the past decade, developed a habit of sharing early chapters of books, for free, online, to solicit opinion and feedback from his fans. I think it’s safe to say that most science fiction fans, who skew to the left, didn’t take to kindly to a world where a “Progressive Restoration” raised its own army to “liberate” New York from the false US Government in power since 2000.

You can check out the fun at, in their book reviews. Liberal blogs like Lean Left skewer Card for his conservative mentality, although it turns out he’s a registered Democrat (My favorite part of that one is the fact that the author had not actually read the book. Sigh.) Here is a Podcast of an interview with Orson Scott Card. More interesting, here is an interview with Card about the state of video games on Wired.

Back to the book.

There are some redeeming elements worth noting.

First, maybe I’m just in a “Rome” state of mind these days, thanks to the HBO series, but I liked the idea that the United States of America is not currently comparable to the end days of the Roman Empire. Instead, the book posits that America today is like the last days of the Roman republic, in the immediate years before Octavian rose to power, quelled civil discontent, and established an Imperial line as Augustus Caeser.

Second, most critics haven’t read Orson Scott Card’s afterward to the novel, which really seems to make a heartfelt entreaty to move past the currrently hyper-partisan atmosphere. There is no doubt that Card skews conservative, but he states that there are dangerous extremists on both the left and the right, and that too many issues have been arbitrarily grouped together (abortion & global warming?) in order to villify and divide people as “red” or “blue”. This book is a clumsy expression of these sentiments, meant to highlight the dangers of such radical polarization, but it seems earnest.

As a side note, Card begins each chapter with quotes from one of his characters, a historian turned proto-dictator. Some of them are pretty neat:

If you always behave rationally, then reason becomes the leash by which your enemy pulls you. Yet if you knowingly make irrational decisions, have you not betrayed your own ability?

It is possible to be too much smarter than your opponent. If you give him credit for more subtlety than he has, he can achieve tactical surprise by doing the obvious.

In war planning, you must anticipate the actions of the enemy. Be careful lest your preventative measures teach the enemy which of his possible actions you most fear.

My prediction? Card uses these to write the next great trendy business leadership book, based on these pseudo-Sun-Tzu dictates… 🙂

In all seriousness, Orson Scott Card’s novels have become caricatures of his original style. Maybe it’s the price of success and insolation, maybe it’s just lowest common denominator publishing. I don’t know. I’m not unhappy that I read this book, but it felt about as deep and impactful as a reality show… within weeks I expect that I’ll have forgotten most of it.

Summary: If you like Orson Scott Card, reading this book isn’t worse than reading any of his other most recent novels. But you’d probably be better off going back and re-reading Ender’s Game again.

WordPress: Easy as PI

Sometimes, just impresses me.

An announcement today that WordPress now includes inline support for LaTeX. If you’re not familiar with LaTeX, it’s a typesetting language, designed to easily produce complex, mathematical statements for sophisticated academic documents.

I don’t know LaTeX, but it’s going to be neat to be able to properly represent mathematical equations here on a simple blog, particularly when I post about how to evaluate investments, etc.

For now, I’m just going to close with my all time favorite equation:

e^{\pi\i} + 1 = 0

The five most important numbers in math, all together in one equation. Euler’s Identity.

Blogging with math is going to be fun.

Goodbye, Studio 60 On the Sunset Strip. We Hardly Knew You.

Super quick post, but since I made a big deal last week about listing the shows I’m watching, well, it seemed topical.

One of them has bit the dust…

Sorkin’s ‘Studio 60′ yanked early; wealthy, TiVo-happy Scarsdale residents outraged

Can’t say I’m surprised, but I actually thought the show was OK. Technically, the show isn’t cancelled, but it’s a really bad sign when you get bumped early in the middle of your first season.

Still, this will save me an hour per week, so I’m going to file this one under potentially a good thing.

Now, how to deal with the Tivo Triple Conflict of SmallVille vs. My Name is Earl vs. American Idol on Thursdays for the next 3 weeks…