Wow. Who knew cartoons from 50 years ago were this educational?

Many thanks to Get Rich Slowly for this one.

Here’s a 1957 cartoon about the virtues of stock market investing from the New York Stock Exchange (NYSE). Fred Finchley is a family man with a good job, a lovely wife, two rambunctious children, and all the conveniences of modern life. What he doesn’t have, however, is enough money to pay for his dream vacation.

When Finchley’s boss gives him a raise of $60 a month, he faces a dilemma. Should he use the money for savings? For a couple of nights on the town with his wife every month? The NYSE suggests that Finchley put his money to work in the stock market with a “monthly investment plan”.

“Working Dollars” does a good job of explaining how dollar cost averaging works. The cartoon makes a case for small, regular investments. Investing isn’t just for tycoons — using a monthly investment plan, even the average family can begin to acquire wealth.

It may not seem like it, but this cartoon was extremely well thought out, and the personal finance advice it offers is just as applicable today. Of course, I’m not sure how excited anyone would be with a $60/month raise right now, but I’m pretty sure the point is made with $600/month or more.

The most interesting subtlety is highlighted well by Get Rich Slowly, and I couldn’t agree more. The biggest danger in personal finance is lifestyle inflation, the tendency to increase expenses with any increase in income. The danger is, of course, that income is hardly reliable, but once you get used to a certain lifestyle, it’s incredibly hard to dial down expenses. This is particularly topical for people who work in high risk/high volatility jobs, like technology and sales. Even if you have steady pay, retirement often involves a shock to the system in terms of income.

A neat find.

I haven’t posted a lot about personal finance lately, and I’ve been meeting to get back on the horse soon.  In the meantime, this is a fun one for those of you who may not have heard it before.

When investing for a long term goal, like college or retirement, it’s often very useful to be able to quickly determine how long it will take to double your money.

Enter the Rule of 72.

Now, the Rule of 72 is shorthand, and not completely accurate.  But it’s accurate enough to be immensely useful.

The Rule of 72 says that if you divide 72 by the rate of return on an investment, you’ll get the number of years required for that investment to double.

So, if you find an investment that returns 8%, 72 / 8 = 9, so the investment will take 9 years to double.

I learned this rule about 15 years ago from my grandmother, and I’ve been using it for quick shorthand ever since.

For example, let’s say I want to know how much a $50K 401K might be worth over time.  Assuming an 8% rate of return, I can quickly determine that it will double in 9 years, quadruple in 18 years, octuple in 27 years, and be worth $800K in 36 years.

This also works, unfortunately, for loans, but in reverse.  If you take a student loan out at 7.2% for 10 years, well, you can expect to end up paying double what you borrowed in total.

I’ve also used this rule in business environments, especially when you are looking at compounding growth rates for business metrics like sales, revenue and costs.

Once again, the rule is really a shorthand, and not completely accurate.  Obviously, a 72% return doesn’t double in 1 year.   And a 1% return doesn’t double in 72 years.  However, it’s surprisingly accurate in the middle ranges, which apply to most situations.

This article in Get Rich Slowly has some variants that are fun. But for me, the basic Rule of 72 lets me quickly an easily assess what a return will really mean to an investment, in those rare moments when I’m away from Excel.

So enjoy this tidbit, and I’ll get to some meatier topics this week.

It has been quite a while since I’ve posted as part of my personal finance education series, but it hasn’t been for lack of desire to do so. This is the first post that starts getting into topics on investing, and as a result, it has taken me a bit of time to collect my thoughts.

If you haven’t had a chance to review the previous two posts on Saving and Emergency Funds, please do so. It only makes sense to start talking about investing for the long term when you have the basics of good financial hygiene in place. It makes no sense to own stock in Google or money in an exchange-traded fund if you are having trouble paying off your credit card.

Of all the chapters to come in this series, however, this one is probably the most important to take to heart as you manage your own long term investments.

It turns out that the most important decision for your investments is not trying to find the next hot stock nor trying to find the savings account that pays the highest rate. It’s not finding the best new type of bond to own, and it’s not finding the lowest expense ratio. These are all important, but most likely not the biggest determinate of your investing success.

It turns out the most important decision you make with your investment dollars is how you divide your assets between different types of investments. This one decision tends to explain the majority of success and failure that people see in their investment portfolios.

Let me explain, at a high level.

It turns out that there are many different ways to invest your money. These different types of investments have different characteristics. Some people over-simplify this to whether one type of asset is “riskier” than another, but it turns out that risk comes in many flavors.

Some investments have returns that are very unpredictable in the short term. Others are extremely predictable. This is sometimes referred to as volatility.

Some investments require your money to be locked up for long periods of time. Others provide you easy access to your money. This is sometimes referred to as liquidity.

You have probably heard the names of a lot of different types of investments thrown around:

• Cash
• Bank Accounts
• CDs
• Money Market Funds
• Bonds
• Stocks
• Mutual Funds
• ETFs
• Gold
• Timber
• Real Estate
• Commodities
• etc…

There are no shortage of different types of investments out there. Each has its own characteristics; its own strengths and weaknesses. What makes it even more confusing is that some types of investments, like mutual funds and ETFs, are really just structures that invest in other types of investments (like stocks & bonds).

The whole idea behind diversification is a reflection of that age-old advice “don’t put all of your eggs in one basket“. By spreading your money around to different types of investments intelligently, you increase the chance that when one of your investments goes down, another will be up. This smooths out the ups and downs, and makes it much more likely that you’ll hit your investment goals.

For most people who don’t have truly large sums to manage, there are only three types of assets that are applicable to most savings goals like retirement or college. They are:

• Cash
• Bonds
• Stocks

Cash investments can take many forms. Some people keep their case in bank accounts or money market funds. Historically, cash investments tend to barely return any money after inflation, which means that they pay interest rates that increase roughly at the same rate that prices increase. They are the definition of liquidity, typically offering you access to your money easily and on extremely short notice.

One of the common mistakes that people make when investing for long term goals is keeping too much money in cash. Because of the low returns, over long periods of time, cash can act like a big anchor on your portfolio, limiting your ability to compound your returns over time.

Assuming you have an emergency fund of three to six months in cash, the purpose of cash in your long term portfolio is really just for three things. First, it cushions downturns in the market, since your cash portion never goes down. Second, it provides you with extra money to invest when other assets become relatively cheap. Third, it provides you with liquidity. It’s terrible for your returns to be forced to sell other assets when they are down, just because you need the money. Cash is always there for you, protecting you from yourself, making sure you don’t end up buying high and selling low.

Bonds come in many different flavors, but fundamentally all a bond is a loan. If you need to borrow a large amount a money, one way to do it is to sell bonds. For example, a company can easily “borrow” $1 Billion by selling 1 million $1000 bonds. The buyers of the bonds get a piece of paper that promises them their money back, sometime in the future, plus interest.

Bonds have been around a very long time, and as a result, there is every imaginable variety. You can find bonds from governments and companies, bonds based on mortgages or utility revenue. There are bonds that pay interest every 6 months, or only at the end of the term.

Historically, bonds have returned an average of about 1.7% above inflation, so while you will see your money grow, it won’t grow quickly. This number, of course, is a horrendous average – there are many varieties of bonds with their own histories and returns. Fundamentally, however, most people turn to bonds when they want to see higher returns than cash, and they are willing to sacrifice liquidity to get it. By locking up your money for a longer period of time, you hopefully will see higher returns.

Bonds have a lot of unique risks. There is the risk that the company will default on the bond, and never pay it back, known as default risk. There is the risk that interest rates will go up, making the bond you bought at a low rate less valuable, known as rate risk. There is the risk that inflation will grow, effectively erasing the value of your bond interest, known as inflation risk. If you want to get fancy, there is even currency risk, since your bond will tend to be denominated in only one currency.

Right now, the interest rates available on cash investments are so high relatively to bonds, that some people advocate not putting any money in bonds right now. Most financial planners, however, will tell you that keeping a set mix of stocks & bonds will smooth out your long term returns significantly, and lower the risk that you’ll end up missing your investment goals. Historically, there have been long periods of time where bonds outperformed stocks, and having money in bonds can ensure that when stocks are underperforming, your portfolio will survive to fight another day. Ben Stein captures this really well in his recent book, which I reviewed here.

Personally, I tend to group cash & bonds together in my asset allocation, since I find it useful to think of cash as just another type of bond that happens to have very high liquidity, and relatively lower returns. Sometimes, however, cash can be the best place for the “fixed income” portion of your portfolio at times. Right now, it’s hard not to like the 5.05% you can get at E*Trade or EmigrantDirect on a bank account with no minimums and liquidity.

Stocks are the most common basic investment in modern personal finance for achieving long term investment goals. Historically, they have returned approximately 6% over inflation, meaning that they are one of the few asset classes to aggressively grow your spending power over time. Stocks are really just pieces of paper that give you part ownership in a business. When a company like eBay has 1.7 Billion shares, each share is like owning a little piece of the overall business.

Stocks are incredibly liquid, and are now freely traded world-wide. Stocks are also incredibly volatile, with prices moving up and down every minute, every day. Because of this, stocks have a reputation for being risky. If you have all of your first house down payment in stocks, it is possible for that account to drop more than 20% in a single day, and that’s bad news if that’s the day before closing.

In the long term, a diversified portfolio of US stocks has been an incredibly rewarding investment. As a result, people have a hard time balancing the short term risk of stocks with the long term risk of not owning stocks.

For most people, even those in retirement, a significant portion of your portfolio likely belongs in stocks. However, it is extremely important to balance that investment with other assets, and to be realistic about how much volatility your investment goals will allow for.  Most Americans have too much of their long term savings in cash, and too little in stocks.

There are over 9000 public stocks in the US alone, and there are many different kinds of stocks.  There are giant companies like General Electric & Microsoft, and tiny companies you have never heard of. As a result, having a diversified portfolio of stocks is likely the most important aspect of this asset class.  I’ll post a whole separate chapter on this topic.

This has been an extremely long chapter, and we haven’t even scratched the surface on some of these topics.  There is one last topic I want to illustrate, and that is the benefit of rebalancing your portfolio based on an asset allocation strategy.

Let’s take a hypothetical portfolio of $10,000 broken down as:

• 10% Cash:  $1000
• 30% Bonds:  $3000
• 60% Stocks:  $6000

Let’s assume that the Bonds and Stocks are represented by broad, cheap index funds from Vanguard.

Let’s say that Year 1 is really bad for stocks, and mediocre for bonds and cash.  Stocks return minus 10%, and bonds return 4%, and cash returns 5%.  Your portfolio becomes:

• $1050 Cash
• $3120 Bonds
• $5400 Stocks

No question, it’s bad news.   Your portfolio is now worth only $9570.  However, if you had been 100% in Stocks, you’d be down to $9000.   The Bonds & Cash cushion the blow of a bad year on the market.

Since your goal is a 10%, 30%, 60% split, you want to rebalance your portfolio once a year.  This means moving your money around so that you now have:

• $957 in Cash (10%)
• $2871 in Bonds (30%)
• $5742 in Stocks (60%)

Basically, you move money from the assets that did well this year, into the assets that did poorly.  This may seem counter-intuitive to those who believe in going with their winners and selling their losers, but this single act encapsulates one of the most practical benefits of a good asset allocation strategy:  it forces you to sell assets that are high, and buy assets when they are low.  Assets tend to regress to their average performance, so this rebalancing has been proven to be a winning strategy to avoid the very human mistake of buying investments when they are high, and selling them when they are low.

Let’s look at what happens in Year 2, assuming that an “average” year happens.  Cash returns 3%, Bonds return 5.5%, and Stocks return 10%.

• $986 Cash
• $3029 Bonds
• $6316 Stocks

As you can see, by moving money into Stocks after the down year, the portfolio is set up for better performance when stocks do, inevitably, recover.  This wouldn’t be possible, however, without having money in different asset classes.  It also assumes extremely good diligence and fortitude to rebalance every year.

Whew!  Long chapter.  A lot of great topics.  For those of you waiting for more detail on each asset class, I plan on having the next few chapters focus on individual asset classes and investment goals.

This is just a reminder that tomorrow, Tuesday, April 17th, 2007, is your last chance to fund an IRA for the 2006 tax year. After tomorrow, you will have lost the chance forever to make your contribution for 2006.

You can contribute up to $4000 in 2006 towards an IRA if you are under 50. If you are 50 or over, you can actually contribute $5000 in 2006.

Many people don’t realize that even if you have a 401(k) or 403(b) plan at work, you can still qualify to contribute to an IRA.

Assuming that you are not opening an IRA for your partnership or business, there are four IRAs to be aware of:

• Deductible IRA. This is what most people think of when they think of an IRA. This is a retirement account where you get to deduct your contributions for the year off your income on your tax return. The problem? You can’t deposit into this type of IRA if you have a 401(k) or 403(b) plan at work, and people over a certain income are disqualified.
• Roth IRA. The hero of the hour. This is the IRA that everyone is talking about. You don’t get a tax deduction this year, but you get a better bonus down the road. All gains on this IRA are tax-free, forever, as long as you withdraw them after the age of 59 1/2. Problem? You can’t contribute to this IRA if you make more than $110,000 as an individual, $160,000 as a married couple filing jointly.
• Rollover IRA. You can’t contribute to this type, but this is a great place to move your 401(k) money from your old company. It keeps the tax status of the old 401(k), and it usually gives you access to a much wider variety of investment options. Better yet, you have the option of either converting this IRA to a Roth IRA, if your income permits, or you can roll it into a future company 401(k) if you’d like.
• Non-Deductible IRA. This is the over-looked gem of the IRAs. Anyone can contribute to these in any year, regardless of income. You will owe taxes on the gains when you withdraw them in retirement, but they get to compound tax free until then.

There are several good reasons to consider an IRA contribution this year, even if it’s non-deductible:

• You never get the chance to go back and make contributions for past years. You lose your option to make a 2006 contribution tomorrow, forever.
• You can now make IRA contributions for a spouse that does not work, up to $4000 for a year.  A great addition if you are in a one-income household, and you are concerned that your retirement savings are limited.
• In 2010, thanks to the 2006 budget, you will get the ability to convert a non-deductible IRA to a Roth IRA, regardless of income! Check out my post on the 2010 Roth IRA Conversion Loophole for more information.

Reasons not to make an IRA contribution for 2006:

• You can’t afford the drop in liquidity of having your money locked up for potentially decades.
• You forgot about the April 17th deadline, and read this post too late.  🙂

Opening up a new IRA is extremely low cost, if not free. E*Trade offers free IRAs. Vanguard offers IRAs for only $10. You can open them online, with a transfer direct from your checking account.

Happy Saving!

One of the blogs I read regularly is The Finance Buff.  This past week, he has posted four times on the topic of inflation-protected bonds, TIPS and Series I Savings Bonds.  As a result, I thought I’d post some pointers and comments here.

First, as I mentioned in my personal finance series, Series I savings bonds are an interesting option for an cash emergency fund.   Series I savings bonds have the following advantages:

• After 12 months, you can cash them in at a moment’s notice.  Great liquidity.
• You can buy up to $30K of them in any year.
• You can buy them direct from the government with no fees at the Treasury Direct website.
• You owe no income taxes at all until you sell them.
• You never owe state or local income taxes on the gains, even when you do sell them.
• You won’t owe federal income taxes on the gains if you use the money towards a qualified educational expense, like college tuition.
• Your money is guaranteed to grow above the rate of inflation, re-adjusted every 6 months, for the next 30 years.  You are given a fixed rate above inflation, measured by the CPI-U index, which measures inflation in urban areas.

Right now, Series I Savings Bonds pay 1.4% + inflation.  Given that historically, money market funds have basically matched inflation over time, and bonds have only beaten inflation by about 1.7%, that’s a pretty good deal, by historical standards, for something that is at least as liquid as a 1-year note.

In any case, the Finance Buff doesn’t like the Series I Bond rate.  In fact, because inflation is so low, he sold his Series I Bonds in November, taking the 3-month interest penalty.

Instead, the Finance Buff likes TIPS, which are the inflation-protected version of normal US Government Bonds.  TIPS are offered in terms of 10 years and 20 years, and right now they are paying a whopping 2.63% over inflation!  Given that the historical return of bonds is below that amount, I can see why he likes them.

Unfortunately, TIPS do have a down side or two:

• While you are paid the interest every year, the inflation value accrues every year to the bond principal.  What that means is that you owe taxes on the inflation gain every year, but you don’t get the cash to pay the taxes.
• TIPS are only available in high dollar amounts.
• TIPS, like other bonds, can be sold before maturity.  However, there is no guarantee of the price you’ll get if you sell them before they mature.  To guarantee your return, you have to hold them the full 10-year or 20-year period.

Here is a great post from the Finance Buff on TIPS.

I have to post this great snippet from his follow up article on pricing TIPS.  It’s fairly complex, but I love seeing the hard math posted for some reason.  Check it out:

I tip my hat to you, sir, for posting that.  🙂

In any case, I had to think about why I’m still such a fan of the Series I Savings Bonds.  I think it is because of the context that I use them – as a cash-equivalent emergency fund.  I’m not looking at them as a bond investment, but as a form of cash.

As I stated, cash equivalents, like money market funds, over time have returned an average of 0% over inflation.  So the idea of getting better than that on my “safety money” appeals to me.

That being said, the rates on high yield internet savings accounts, like Emigrant Direct, are well over 5% now.  With inflation as low as it is, that’s a serious yield also.  With no risk, money available at any time.  Government protected, even, up to $100K!  Hard to argue with that.

The problem is, there are penalties around selling Series I Bonds too early, and there are significant tax advantages to consider.  Interest on a bank account goes on your 1040 every single year, and is taxed at federal and state levels.  There is also no guarantee that these type of high-yield savings accounts will be around forever, although they’ve been pretty consistent over the past 5-7 years.

I’m lucky, because the Series I savings bonds I purchased in 2002 have a 2.0% premium over inflation, so they are paying a higher rate that the bonds you can buy today.  As a result, I’ll be keeping mine for a while.  Sometimes, like this period, they pay less than 3% interest.  Other periods, they have paid almost 8%!  In the end, to be comfortable with them, you have to be comfortable with earning a fixed amount over inflation over time, and leaving it at that.

You can find out more about TIPS and Series I Savings Bonds on the Treasury Direct website.

I noticed a lot of coverage today about the $370M Mega Millions Lottery jackpot. I found some of the trivia in the coverage interesting, like:

The odds of picking the six correct numbers and taking home the mountain of cash are 1 in 175,711,536. That’s “175,” as in millions. Those odds are even worse than one of those carnival booths where you pitch a dime and try to get it to land on a piece of glass.

1 in 175,711,536. Astonishingly small. Of course, it’s $1 per ticket, and with a $370 Million jackpot, it seems like the expected value of a ticket would be higher than $1… assuming that you don’t end up splitting the pot with someone else.

Personally, I’ve never been a big fan of the lottery. I do have a little libertarian voice in my head that says, “Go ahead. If people want to gamble, it’s their money.” Of course, I have this other voice, call it my nagging sense of social justice that says, “This is just a regressive tax on people who are bad at math or have a low-level gambling addiction.”

I never play, which is why when I ask my wife,

“What would you do if we won the lottery?”

She tells me,

“You have to play to win, honey. You have to play to win.”

In any case, I’ve always been fascinated with the stories of lottery winners who blow many lifetimes worth of money in a matter of years. Similar to professional athletes who blow fortunes after they retire, I’ve always felt that these cases prove that no amount of money can substitute for being educated in personal finance, and being prudent with money.

Well, there is an inspirational story here of a lottery winner who actually handled his money well. Graceful Flavor, which I typically read for Apple-related news, had a nice write-up on this story. The original article actually breaks down what this winner spent his money on:

$45 million: Safe, low-risk investments such as municipal bonds $35 million: Aggressive investments like oil and gas and real estate $1.3 million: A family foundation $63,000: A trip to Tahiti with 17 friends $125,000: Mortgage retired on his 1,400-square-foot house $18,000: Student-loan repayment $65,000: New bicycles, including a $12,000 BMC road bike $14,500: A used black VW Jetta $12,000: Annual gift to each family member

Let’s just walk down the understated brilliance of how this man, Brad Duke, actually allocated his money after winning a $220 Million jackpot. You see, Brad spent time researching the stories of other lottery winners, and I think there are lessons here for all of us who may (hopefully) be faced with a small windfall someday.

1. Municipal Bonds. This is exactly right. Largely risk-free, this guarantees Brad a tax-fee investment that will provide regular income, indefinitely, and will likely match inflation over time. This provides a wonderful base of income for him, indefinitely.
2. Aggressive investments. This is likely his riskiest endeavor, but with a base level of income guaranteed, he has freedom here to be more aggressive, and try to scale his assets over time.
3. Family Foundation & Gifts. Nice clear breakout of what he’ll be giving to charity, and gifts to family members. Note the lack of family members “on the payroll” – a sure-fire track to the money problems.
4. Trip to Tahiti & Bicycles. You have to celebrate. $128K is not a large amount here, and it represents some fun with the winnings. Most personal finance experts agree that if you try to save every single dime, you can end up feeling deprived, and it can lead to impulsive behavior. This trip sounds like a great way to have fun, do something extravagant
5. Student Loan & Mortgage Paid Off. In the world of debt, student loans and mortgage are the best possible forms of leverage. Low interest, with tax advantages, and typically a large payoff on the investment. Still, once you have ample assets, reducing debt reduces risk. It’s that simple.
6. The Used Jetta. This is probably what impresses people the most. He sold his 2005 car, and bought another used car! This is a good sign of someone who isn’t frugal because they have to be, but because they just don’t like to waste money.

It’s hard to say what you might do with a windfall of $100,000 or $100,000,000. Oh, I guess it’s easy enough to guess, but I have a feeling that reality is always more complicated than idle dreams.

Living in Silicon Valley, it is not uncommon to have friends and family who come across fairly large windfalls. A company goes public, or is sold. A relative passes on an inheritance. The fact that so many people who have large windfalls in their lives end up losing the money in short order is a warning. Managing money is difficult, and the right habits and the right attitude towards it will likely benefit you at any asset level.

Of course, you do have to play to win.

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.