Uncommon Cents

Some people discover their risk tolerance is rather low, or lower than they thought, in stock market times such as these. If that is indeed the case, what options do these people have?

The principle of risk/return does not disappear just because someone can’t deal with somewhat higher risk; rather, it becomes very clearly in effect. If someone wants to take absolutely no chances with their money (or just shy of no chance), they can certainly do that, but the returns their money will gain will be quite low–but they will exist. This is unless it’s someone who would rather bury money in coffee cans in their back yard or stuff it in their mattress, of course–but that’s not investing.

Realistically, everyone needs a safe place to put at least some of the dollars they have. An emergency fund needs to be kept away from stock market risk, because emergencies don’t come on a schedule (some would say the market currently is in a state of emergency!). So “chicken money” is something everyone has at least some of–money we’re too chicken to put at any risk at all.

Savings or Share Accounts: These are your typical accounts at a bank or credit union. Right now the rates of interest on them are anemic–in the case of my mother’s bank account, one fourth of one percent of interest! That’s definitely not keeping up with inflation. However, since the account is FDIC insured and she’s well within the limits of the insurance, it’s as safe as the federal government’s word. If you’re going to use one of these, make sure you have insurance by the FDIC or the NCUA (in the case of a credit union). You won’t make much, but your money will be safe, and it’s really high in liquidity, meaning you can get at your money pretty much anytime (provided the bank’s business hours work for you).

High Yield or Money Market Accounts: These tend to be a lot like savings or share accounts but with a somewhat higher rate of interest and possibly more limits on accessing your money. For instance, I have a Capital One Direct high yield savings account that pays me 3.55% interest and allows check writing and ATM access–but limits how many checks I can write per month. Fortunately, it also allows electronic access, which is a bit more liberal. This is a nice place to stash an emergency fund, since it’s almost as liquid as a savings or share account.

Certificates of Deposit: CDs tend to have rates about the same if not a little higher than high yield or money market accounts. In return for offering a little more interest, you lose liquidity. Still, CDs you may be appropriate for an emergency fund with a little planning (having a CD mature every month with 5/6 of an emergency fund means at most you’d be one month away from access, and having that remaining 1/6 in something like a high yield account could do it) but for simplicity’s sake, you may not want to use these for that purpose. Make sure you are wary of the FDIC limits (which apparently will be increasing, at least for awhile) on how much they’ll insure if you really are concerned about safety!

Treasury Bonds or Notes: In many ways considered the safest of investments, there are lots of different bonds and notes you can get; some may offer tax advantages. I have a bit of my portfolio in I series bonds, for instance. There are also government issued bonds or notes from local or state governments that may be worth looking into as well. Again, the rates are not fantastic, but combined with possible tax advantages as well as safety, this could be a viable option.

Money Market Funds: Not quite the same as the money market accounts, these are mutual funds that invest in short term instruments. They are not backed by FDIC or NCUA insurance as they are mutual funds, although they recently had some temporary insurance offered to them with unusual circumstances that led to a “run” on them as a consequence of the Lehman Brothers bankruptcy. Money Market funds nearly always have a stable net asset value of $1 per share and pay a return based on how their investments do. Of course, since it’s a mutual fund, your initial investment will likely need to be more than you can put into a savings account, money market account, or CD, and you may have commissions to deal with.

Bond Funds: In bond funds, you have a ton of choice just as you do with stock funds. If you’re looking for safety, consider the quality of the bonds in the fund; “junk bonds” may offer higher yields, but more risk. Funds that are based on Government National Mortgage Association bonds–Ginnie Mae funds–tend to be both very safe and pay very nice returns. A fund like the Vanguard Total Bond Market Index has offered similar performance and safety to the Ginnie Mae funds over time. Again, these are funds, but unlike the money market funds which almost never move off the $1 per share net asset value mark, these do fluctuate a bit, but historically, nothing like stock funds.

There are some alternatives–from about as safe as you can get to pretty safe with some amount of risk–to consider for your chicken money, whether that’s just your emergency fund or your whole portfolio. Good luck in selecting one that might meet your needs!

Risk tolerance is a subject that’s discussed a lot in investing. It means how much you can live with in terms of taking a chance with your money, typically meaning that in order to have more potential gain, you have to live with more potential loss, and if you only want to avoid losses, you can, but sacrifice the potential for larger gains. Some people have virtually no risk tolerance in investing–those are folks who need to be in investments like Certificates of Deposit and government issued notes, bills, and bonds or to bury their money in coffee cans welded shut in the back yard. On the other hand some will take huge risks by investing in a single stock with everything they have. If that stock is the next Google, they’ll be incredibly rich! If it becomes the next Pets.com, they’ll lose everything.

The vast majority of people would say their risk tolerance is somewhere in the middle. Where on that continuum you are is easy to overstate when the market is doing well; lots of folks say they’re very comfortable with stock market risk when the market is having the kind of run it did in 2003-2007, with positive returns every year. However, when a year like 2008 happens–with virtually the entire market in a tailspin–those who really have the risk tolerance they state to stay in the market actually do that: stay in the market. Those who don’t start heading for the exits.

You can tell the low tolerance group easily: they’re the ones who are saying that if you stay in, you’re a fool, and proudly declare how they moved everything into cash. They said they have risk tolerance, but they really didn’t. Of course, history shows that cashing out and moving to cash after a market dump tends to be exactly the opposite of the best decisions, but that doesn’t stop them.

Times like this say a lot about how much risk you’re willing to stomach.

As for me? I haven’t sold anything since my usual bit of changes in April of this year. How about you?

While this is being listed under “Basics”, it may surprise some that the argument between which to do first: save for goals (retirement, a home purchase, college education, or other long term goals) or pay off debt.

The answer I have for this argument is a bit complicated, and includes a little of both, but the short version is: both are important.

When you’re at the point of dealing with this saving vs. debt reduction argument, it’s pretty much a necessity you’ve examined your baseline budget and gotten a handle on your cash flow. If you’ve not done these, do so first! Once you’ve got your cash flow positive from month to month, let’s go ahead and work on what to do with those positive dollars.

First off, start with an emergency fund. Consider a money market or high yield savings account (possibly with ATM card and check writing, like at Capital One Direct) for this money. How large of an emergency fund? We’ve discussed this before, but if you’re considering this choice, I’d suggest having at least $1,000 in there (if, however, you’re at the point that you’ve paid off all of your unsecured debt–basically everything but a mortgage–you’ll want to bump up that emergency fund to something between three and six months of your earnings). So the first part of this answer is, “save–for a $1,000 emergency fund”.

Second, consider your time horizon: if you are less than five years away from retirement, you will want to make saving a priority over debt reduction; however, if you’re on the opposite end of that timeline, debt reduction–and hopefully debt elimination–is certainly a priority.

Third, you are likely to want to do a bit of both at the same time, the question is how much of each you do. If you’ve decided debt reduction is your priority, make a plan and stick to it. Put the majority of your positive cash flow into paying down–and paying off–that debt. Consider the Debt Snowball or some of the other options we’ve written about previously. If you’ve chosen to concentrate on savings, put the majority of your positive cash flow into that (we will discuss some thoughts on how to put your savings dollars to best use at a later date). No matter which you’ve chosen, though, make sure you pay at least the minimums on your debt promptly–late charges and possible hikes in interest fees for paying late or insufficient amounts will make it even harder to overcome these debts.

Finally, keep at it! Persistence and perseverance are the keys to your eventual financial success. There will be many difficult moments along the way, but the sooner you start–and the more diligently you follow your plan–the quicker this will all happen. A journey of 1,000 miles begins with one step–so take the step of figuring out which to work on as your first priority: debt reduction or savings.

I received the following email from a reader:

“Any suggestions on what to do with money that I’d like to have earning at least a little interest but need to be able to access quickly? I’m thinking perhaps a money market, but I’m not sure where to find a good one.”

This kind of money, which commonly is an emergency fund, is what is called “chicken money”, a term I credit to Terry Savage of the Chicago Sun-Times. Chicken money is money that you cannot afford to expose to the risk of the stock market (or any other kind of similar fluctuation).

Chicken money is commonly in either money market (or similar high yield) accounts or certificates of deposit. The issue with using CDs is exactly what our reader cites–the need to be able to access it quickly. While you certainly can get money out of a CD, you pay a penalty if you do it when the certificate hasn’t matured.

That mostly leaves a money market or similar account. Local banks here have been paying pathetic rates; credit unions are a bit better, Internet only banks tend to be even better (to check out current rates as well as any special promotions, consult with Bankrate and Bankdeals). Internet only banks have their advantages, but due to their lack of physical branches that can make access difficult. Having a debit or ATM card associated with the account is beneficial (although there tends to be limits on how much you can withdraw during a day and the network of no charge ATMs might be limited), and check writing would give about as close to “full” access of an Internet bank’s account as possible.

Two options I have personal experience with are ING Direct and Capital One Direct. ING Direct’s Orange and Electric Orange accounts tend to have decent rates (and if you would like, I have bonus referrals available that will give you a few more dollars, contact me for details) and provides a debit/ATM MasterCard; they also have a network of “no fee” ATMs. The good news for me is that there’s such an ATM within two miles of home; the bad news is that there might not be such a situation for you. They do not, however, give you a checkbook (for my Electric Orange account I can have checks issued by them; they mail them out, which takes a few days). Like most online banks, they prefer to deal with money transfers online, which is instantaneous between accounts at ING Direct, but takes a few days to other institutions.

For accessibility, Capital One Direct adds a checkbook to its ATM card (which, unlike ING’s, is not a debit card). This is helpful for me, as I often make deposits from that account into a local bank. However, their ATM network seems very limited compared with ING’s–I cannot find a single no charge one within 75 miles of me, which is basically the entire island, and likely the entire state. The checkbook in many ways makes the money more accessible than the ATM card and does not subject the user to the typical $500 (or so) per day limit on ATM withdrawals. I was offered a special interest rate when I opened my Capital One Direct account as a Costco member but I was not able to find such an offer perusing Costco.com.

So there are two options for chicken money; both are quite safe, pretty liquid, and pay about as high a rate of interest as can currently be found. Capital One Direct has a checkbook which can be quite useful in terms of liquidity; both have ATM cards; ING Direct’s ATM card doubles as a debit card and they appear to have a larger network of no charge ATMs. Take a look at these (and other) options if you have a need to stash away these kinds of dollars.

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

Many investors worry about stock market risk when dealing with their money, and admittedly, very few investments are without risk. The risk in the stock market tends to be around the market declining and the volatility the market often displays. These factors many times scare investors out of the market and into “safer” investments, like money market accounts, government issued bonds, and FDIC insured certificates of deposit.

While there certainly is a place in any investment account for bonds and cash, these investments only isolate you from certain types of risk. They have their own risks, as well, the biggest one being that your investments will not keep up with inflation.

With the current low interest rate environment, many investors (or just people with an emergency fund) are seeing evidence of just this. If headline inflation is 4% right now and your “high yield” account pays 3.5% (which is a pretty decent rate these days), your money not keeping pace.

This does not mean to pump every dollar you have into stocks; quite frankly, there are good reasons to have other types of investments (see our articles on asset allocation). What it does mean, however, is to be aware that what are considered “safer” investments are not totally safe; there are still risks involved, and in some ways, the risks are more dangerous than those in the stock market. Consider other ways (like diversification, asset allocation, and tax advantaged means of investing) to reduce your risk and help your dollars do better than the rate of inflation–hopefully far better!

For fixed income investors who don’t think much of bonds, finding decent returns has become more and more challenging. Money market and high yield savings accounts have rates that have plunged in recent months, and certificates of deposit have not done much better. It’s become a real challenge to find decent returns, but since this question came up yet again this week, I thought I would go through some possibilities; some of these are similar to what we’ve discussed before, but some are new, or at least a new slant:

Check Credit Unions

Credit unions tend to have better rates than banks; sometimes you qualify to be a member through your employment, membership in an organization, or just where you happen to live, work, or worship. While I wouldn’t expect stunning rates, you certainly won’t harm anything by looking.

Go Online

Online banks (ING Direct, Virtual Bank, Capital One Direct, and others) may offer better rates than you have available locally (and don’t forget I still have bonus referrals for ING and Virtual Bank, contact me for details!). You can also check Bank Deals and Bankrate to see what might be available for you locally and on the Web.

Don’t Tie Your Money Up For a Long Period of Time

Conventional wisdom holds true–if you go with a longer term, you get a higher rate as far as a CD goes. However, given that a “higher rate” isn’t all that high, you’re taking a big risk by tying up your money when rates may increase before the term of the CD is done. Chasing rates in this way doesn’t appear to be wise; you may be better off staying in a high yield or money market account to keep things liquid.

Consider Other Options

If you have debt, consider paying it off or at least paying it down. Remember, if your debt is at 5% and you pay it off, what you’ve done is like earning 5% on that money. This might be one of the best things to do with money that you would otherwise have parked.

Yes, there is a need for even the most aggressive of investors to have at least some cash around, and finding somewhere secure and high yielding to plant it and watch it grow is a smart idea. In these challenging interest rate times, however, you may need to take a harder look around than ever to figure out just where you want to have your money sit.

Net asset value refers to the current price per share of a mutual fund or exchange traded fund. The net asset value is calculated by taking the total value of all the securities in the fund’s portfolio, subtracting any liabilities, and dividing that result by the number of shares outstanding.

Mutual funds compute their net asset value once daily. It does this using the closing prices of the securities in the fund’s portfolio. Every order, either buying or selling, involving the mutual fund is processed at the net asset value determined on the date of the trade, but the actual trade price is not determined until after the close of the trading day.

ETFs trade like stocks, meaning that while their value will be quite close to the actual NAV of the ETF, it’s possible that it will be trading at a premium or discount depending on market demand.

The concept of net asset value may be helpful in viewing a bond fund’s value versus owning an actual bond. If you buy a bond at face value and hold it to maturity, you get the money you paid for the bond back plus interest payments along the way. If you buy a share of a bond fund, while you hold the bond, you also get interest payments, but instead of dealing with the original face value of a bond and getting that money back at maturity, you buy the share at a certain net asset value and when you sell it, you get it at what may be a very different net asset value. Along the way, depending on how the fund performs, the net asset value is likely to fluctuate. If you have difficulty tolerating fluctuation in the net asset value of a bond fund (which tends to be considerably less volatile than in a stock fund), perhaps you would feel more comfortable with an actual bond or, for those who have virtually no tolerance for fluctuation, a FDIC insured certificate of deposit where you are assured of getting the amount of money put into it back–not a penny more, not a penny less.

Understanding the concept of net asset value can help you to understand changes in prices of various funds and how much volatility you are comfortable with.

A Certificate of Deposit, also known as a CD, is a savings certificate which entitles the bearer to receive interest. A CD is time limited in that it is issued with a specific time frame, typically somewhere between one month and five years. When a CD is issued, the interest rate that is paid is locked in until the CD matures; in return, the bearer agrees not to withdraw the principal without paying a penalty. CDs are typically insured by the Federal Deposit Insurance Corporation (FDIC) for American banks or the National Credit Union Administration for American credit unions (hint: if your bank or credit union is offering uninsured CDs, don’t take them up on it!).

CDs are considered among the safest of deposits and subsequently the interest paid on a CD tends to be relatively low. CDs along with money market accounts, government bonds and notes, and commercial bonds are all considered fixed income securities–they are less volatile than the stock market and typically pay a lower rate of return than you may expect with a stock but with less risk. Unfortunately, as they lack liquidity, CDs are not really appropriate for an entire emergency fund, although they could be part of an emergency fund–keep one month’s savings in a money market account and the rest in a one month CD that renews. This approach is a bit more complicated, but may yield a bit more interest.

CDs have a role in the preservation of capital; if you can afford the lack of liquidity and want to make sure you aren’t going to lose your money, get an insured CD at your local bank or credit union. You may not make a lot in interest, but you won’t lose anything either!

After a few weeks of waiting, a package from the Pennsylvania mutual fund giant showed up in my mailbox. In it was a pamphlet on the brokerage option that I mentioned previously (and which I already had) and a few pieces of paper explaining some of the details.

I don’t say this often about Vanguard, but I was immediately disappointed. While I can invest in both Vanguard funds not currently offered in my plan as well as (through their FundAccess service) thousands of funds from other mutual fund families (apparently 300 of them), I found that I cannot invest in ETFs or REITs. Now, there are a lot of other investment vehicles that are not allowed in the VBO, including futures, precious metals, currencies, CDs… but the two I would be most interested in would be ETFs and REITs. That said, I can live without them.

The paperwork that came with the pamphlet is pretty scarce. Aside from the pamphlet and the paper outlining what investments I cannot make with the VBO, a few other sheets which provided identifying information with my account number, a commission schedule, and a few other things.

However, there’s absolutely no information in the packet about how to use the Vanguard Brokerage Option except by calling or going to Vanguard.com. However, when I go to Vanguard.com, there’s nothing that screams out “brokerage option!”, and the little I can find using Vanguard.com’s help search tells me to call.

Oh well.

This will get worked on in the next off stretch I have.