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.

The first question I often get about personal finance and investing is usually about what sources I would recommend for people who are looking to learn more.

It may be surprising, but despite the incredible variety and depth of information available online, some of the best sources for ongoing learning are still regular, printed magazines.

I began reading personal finance magazines around 1994, and over the years I’ve sampled most of the commonly available ones. The following represent my favorites, some of which I have subscribed to for over a decade.

Personal Finance & Investing

1. Money. Money magazine is published by Time Warner, and continues to be my favorite personal finance magazine. I think the reason I like it so much is that it takes a much more human approach to personal finance – the magazine always features the personal finance stories of one or more families, and you learn a lot month-to-month about how real people approach very real financial questions. I find it much more interesting to understand how a family who hasn’t saved much for college might approach the problem now that junior is entering high school, than about whether or not I should have a commodity ETF in my portfolio. If you are looking for stock picks, this isn’t the place, but as an overall well-rounded magazine, if you were only going to read one issue a month – this would be the magazine to read.
2. Smart Money. Smart Money magazine is one of my all-time favorites. Published by the Wall Street Journal, this magazine blends insight into current investing trends, fund managers, and personal finance tips. More investment focused than others, almost every issue features at least one or more “stock pick” lists. I have gotten a few good stock ideas from the magazine, but that really shouldn’t be the focus of the reader. Instead, as you read about the “case” for each stock, it helps hone your own thinking about how to approach investments.

Despite the fact that I have subscribed to the above magazines for over twelve years, I still look forward to each issue every month. Over time, I feel like one of the things you learn is to differentiate the trendy, popularity driven material from the real insights. The biggest danger reading investment magazines is that they always feel compelled to explain and promote the latest trends, and in investing any trend is usually a sign of over-investment. Over-investment typically means high costs with low returns.

Business

1. Forbes. Most people think of Forbes as some sort of conservative Republican vehicle for Steve Forbes. But if you skip the first few pages of editorial, what you have is a magazine that repeatedly finds unique and interesting angles to entrepreneurship, business, economics & investment. Some of my best investment insights and ideas have come from the columnists in Forbes, and among all of the business magazines I read, Forbes has the highest number of unique stories.
2. Business Week. Business Week is, in fact, a weekly, and as a result, it turns out to be almost like an aggregated business newspaper with slightly deeper reporting. Very timely, they tend to cover a wide breadth of business & investment issues. It’s light stuff, however, so the signal to noise ratio is not great. Still, several of the blog posts I’ve made here have been inspired by little 1-page articles in Business Week.
3. Fortune. Ah, Fortune. Glossiest of the Business magazines. This is like the People magazine of business. Several times over the past decade I have discontinued my subscription, only to find out, months later, that I missed some interesting article on a company, industry, or CEO that I really would have liked to have read. Take it for what it is, but I read it regularly.

There are a wide variety of other magazines out there that I have subscribed to from time to time. Kiplingers. Worth. Red Herring. Business 2.0. Entrepreneur. But none of them held my interest for more than a year, and in the end, I find myself coming back to the five I list above.

The Economist is probably the one great, relevant journal that I don’t read regularly. It has a far more global viewpoint, and less actionable investment insight. It’s dense, and I never seem to have time to finish it regularly.

Newspapers

I know this article is called Magazines, but the truth is that some of my favorite periodicals are daily newspapers. I’m going to call out the big three here.

• Wall Street Journal. I haven’t had time to read this daily in years, but I have never been sorry that I picked up a Wall Street Journal. This is the one paper to read if you want to really be in the flow of finance & investing.
• New York Times. Excellent Business section every day, capped off with the famous “Sunday Business” section every week. If you could only read the paper once per week, you should read the New York Times “Week in Review” and “Sunday Business” every Sunday. This is also my recommended cure in case you accidentally read a San Francisco Chronicle or Los Angeles Times one day, and you need to flush your brain out with something intelligent.
• San Jose Mercury News. This is not the largest or most comprehensive paper in the world, but if you follow high tech, this is the best business section in the nation. It has deep coverage of Silicon Valley companies, and its columnists are just one level deeper into high tech than others. It is roughly 1000x better than the other local paper, the San Francisco Chronicle.

Whew. That took longer than I thought. I’m going to follow this article with a post on the top 10 investment books that I recommend, and then I’ll get into specific topics. More to follow…

I caught a very interesting article in this week’s Business Week on a new Currency ETF that launched in September. The original article is here:

Trade Currencies Like a Hedge Fund | Business Week

It doesn’t look like they’ve released the article to the free portion of the site yet, so let me summarize a bit here.

The new PowerShares DB G10 Currency Harvest Fund (Ticker: DBV) has grown to about $180 Million already, allowing individual investors, for the first time, the ability to easily invest in the “long-short trade”. The long-short trade is when you buy the currencies of countries with high interest rates, and you sell short the currencies of countries with low interest rates. Normally, countries with higher rates see their currencies appreciate relative to those with low rates, and this strategy lets you capture the difference. You can think of it as borrowing cheap money (the short against the countries with low rates) to buy investments that pay higher rates (the countries with higher rates).

For example, right now New Zealand is paying interest rates of 7.6%, and Japan is paying just 0.5%.

This trade is a common one, but it’s not without its problems. There have been many times, historically, when large hedge funds used leverage to play this game, only to have the market move against them. Usually, however, the implosion involved big bets in emerging markets.

This fund only invests in the currencies of developed nations with high credit ratings, and employs only 2:1 leverage, so it’s relatively safe.

Here are the current holdings of the fund:

Long Positions:

• Australian Dollar
• New Zealand Dollar
• US Dollar

Short Positions:

• Japanese Yen
• Swedish Krona
• Swiss Franc

The fund is based on the new Deutsche Bank G10 Currency Future Harvest Index, which has been backtested to produce a 11.4% annualized return over the last 10 years. That being said, it’s a new index, and how it will behave in real life may vary.

What is interesting about the index, however, is that it has returned 3.2% more than the S&P 500 over the same time period, but with only half the volatility. Not only that, the carry trade has very little correlation with stocks, so it’s a natural for diversification.

Previous Currency ETFs, launched by Rydex, have allowed investors to buy into individual currencies:

• Euro (Ticker: FXE)
• Mexican Peso (Ticker: FXM)
• Swedish Krona (Ticker: FXS)
• Australian Dollar (Ticker: FXA)
• British Pound (Ticker: FXB)
• Canadian Dollar (Ticker: FXC)
• Swiss Franc (Ticker: FXF)

Unfortunately, the structure of these ETFs has built in high fees and spreads, making them poor ways to try and “own” that currency.

If you are interested in the new new PowerShares DB G10 Currency Harvest Fund, be aware that the strategy does have some limitations. As covered in TheStreet.com:

I’m convinced that the strategy has merit, but as with all strategies, there are flaws that should be understood before purchasing.

Higher yields do tend to make a currency more attractive, but that overlooks an important point: Currencies whose interest rates are moving up tend to be strong. A currency starting from a low base interest rate that is headed higher is likely to be a strong currency, but it could be overlooked by the ETF’s strategy.

However, if you are looking for a currency component to your asset allocation, this fund is definitely worth considering. There are some tax considerations as well, because the fund uses futures to do its trading. As a result, it might be best to hold this in a tax-advantaged account, like an IRA.

There was an article in the Saturday New York Times (1/27/2007) that really got me thinking. It was called:

A Contrarian View: Save Less and Still Retire with Enough

I must admit, my initial reaction to the title was extremely negative. In a country where private pensions are quickly becoming a thing of the past, and Social Security continues to float in a bizarre state of political denial, telling Americans that they need to “save less” seemed irresponsible, bordering on criminally negligent.

The article didn’t initially endear me either with its analysis. Witness the third paragraph:

Nevertheless, a small band of economists from universities, research institutions and the government are clearly expressing the blasphemy that many Americans could be saving less than they are being told to by the financial services industry — and spending more — while they are younger. The negative savings rate, they say, is wildly distorted.

A small band of economists from universities, you say? No names, of course, of either the economists or the universities. But it’s good to know they are in a band, albeit a small one. Maybe they work with Robin Hood, and his merry band of thieves.

Of course, it’s rare for the New York Times to be this shoddy with reporting, so I move on through the article.  And it turns out, the article does have a point.  Look at the graph that was included with the article:

Aha!  Real sources, real numbers, and credible analysis.  It turns out, this is a legitimate piece, just written in a fluffy, air-headed style.  There is real financial analysis here to this question, and there are some issues raised by it which are worth considering.

One of the biggest innovations in personal finance in the last decade has been quick and easy access for individuals to sophisticated planning tools that previously were only available to professionals.   For example, many people used to just take a basic percentage of return, like 8%, and then project what their savings might be by the time they are 65.  (In fact, many people still do.)

Now people have access to tools, like at Financial Engines,  that do Monte Carlo analysis.  Monte Carlo analysis, like it’s name-sake city, is focused on risk & gambling. With Monte Carlo analysis, the computer will run through thousands, if not millions, of randomized versions of the future, based on the historical performance of different asset classes like stocks, bonds, and cash.  These simulators don’t tell you how many dollars you’ll end up with when you turn 65.  Instead, they give you probabilities you’ll end up with “enough money”, however you define that.

This New York Times article didn’t go into too much detail, but based on the tidbits in the piece, my guess is that the “band of economists” are focusing on a few ways that these models could demand “over-saving”:

1. 1929-1937.  All Monte Carlo simulators worth their salt include, as part of their randomization programming, historical extremes, like the Great Depression.  In fact, the book I read by Ben Stein constantly refers to this period as the ultimate measure of a good strategy.  However, is it prudent to base your planning on what seems to be more and more of a historical outlier?
2. Social Security. Almost all calculators that I’ve seen tend to evaluate your portfolio with no assumption of Social Security.  Now, I’m personally pretty negative on the idea that I’ll be collecting anything resembling the currently promised Social Security benefit, but in fairness, if you took the US Government at face value, that promise is worth a significant chunk of change.  Roughly $812,000, if you buy my earlier analysis.
3. 85% of Income Needed.  Almost all planning tools tend to estimate your needed income in retirement as 85% of your pre-retirement income.  This assumption is actually based on the idea that normally you save 15% of your income, so when you retire and you stop saving, you don’t need that 15%.  Fine.  But this assumption is likely faulty in two regards – first, it likely differs based on your expected lifestyle in retirement (travel, health), and second, it’s unlikely to be a flat 85% through the rest of your life.

So, there are points to be made here, and it is something to think about.  I personally have been faced with difficult choices for saving that don’t have immediate, obvious answers.  What do you prioritize – saving money for a larger house & family, for retirement, for college, or travel & family fun?  What’s the right balance?  There is some truth to the fact that you could, in fact, over-save for retirement, and miss out on your life with your family while you are young.  You could live to 125, but you also could also die tomorrow.  I’ve had close friends and mentors who have died before ever seeing retirement, so these aren’t just theoretical questions.

In the end, I probably agree more with critics that say that the last message Americans in general need to hear is anything that sounds like save less.  No, in general, Americans are already getting an A+ in that class.  They are getting a D right now in save more, so while their are nuances that are worth discussion here, this article was the wrong way to present them.

As personal finance tools grow more sophisticated, however, it is also worth noting that in the end, they are just tools.  Garbage in, garbage out.  If you put in bad assumptions about the market or your goals and values, you will get bad answers out.  Sure, they’ll look pretty.  But they won’t steer you toward happiness.

11 Basis Points. Not one percent. Not one half a percent. Not even one quarter of a percent.

0.11%. That’s the new expense ratio on the Vanguard Bond ETFs. These were announced this week on the Vanguard RSS Feed.

$11 for every $10,000 you have invested. Combined with the 9 basis points you pay on the Total Stock Market ETF, you could have a 50/50 balanced portfolio for the total cost of 0.10% every year.

I know that things like this don’t excite everyone, but I see this as more than just a good deal. I see empowerment for everyone. People forget that 30 years ago, you couldn’t get index funds unless you were a large institution with millions to invest. Even then, you couldn’t get one with an expense ratio under 0.5% until 15 years ago. And getting one freely, with no fees save commission, like this, with no minimum investment? Forget about it, until now.

Now the small investor, with just a few thousand saved, can have access to the tools previously limited to massive institutions. And it seems to only be getting better every year.

From the Vanguard website:

Vanguard has filed a registration statement with the U.S. Securities & Exchange Commission (SEC) to offer exchange-traded shares for four existing Vanguard® bond index funds: Total Bond Market Index Fund, Short-Term Bond Index Fund, Intermediate-Term Bond Index Fund, and Long-Term Bond Index Fund.

Pending SEC approval, the four new bond ETFs will provide broadly diversified exposure to the entire U.S. bond market as well as discrete segments of the market at an expected expense ratio of only 0.11%.

Vanguard ETFs™ are uniquely structured as separate share classes of existing Vanguard mutual funds. For example, Vanguard Total Bond Market ETF will be a separate share class of the $40 billion Total Bond Market Index Fund, the industry’s first bond index fund and one of the largest bond mutual funds in the country. Introduced in 1986, the fund seeks to track the performance of the market-weighted Lehman Brothers Aggregate Bond Index, and holds nearly 2,800 corporate, Treasury, agency, and mortgage securities.

The new ETFs will be managed by the Vanguard Fixed Income Group, which oversees $310 billion in fund assets, including $65 billion in bond index fund assets.