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!

One of the things that we all need is a safe place that earns some interest in which we can park some money; this is typically “chicken money”, money we need in case of emergencies and cannot put at any stock market risk. For these, a high yield savings or money market account are likely the best choices. Sometimes these accounts allow check writing and have automatic teller machine (ATM) cards for easy access; they also often require minimums but pay comparatively high yields.

Where to find these accounts? Here are some ideas:

Your local bank: the obvious place to look would be your local bank, assuming you have one. Unfortunately, this may also be the worst place to look. While not its money market account, my local bank pays–get this–0.25% on its regular savings account. Yes, that’s right, one fourth of one percent. I can’t imagine its money market rates will be thrilling. The one big advantage a local bank has is that they are, well, local–meaning you can walk in and get your money when you need it.

Your local credit union: Credit unions for decades have been alternatives to traditional banks that tend to pay higher interest rates. They also are local to you, and many have liberalized their rules as far as membership goes–for instance, the Hawaiian Tel FCU here lets anyone on island join. The question is whether or not they’re higher enough versus some of the other alternatives.

Your memberships: Perhaps you’re a Costco member or belong to an auto club or professional organization; it’s worth checking to see if you can get any kind of special rates. Costco, for instance, has an arrangement with Capital One Direct. Even your employer may qualify you for something.

Online: Bankrate.com provides easy comparison of interest rates. You may also want to consider an online bank; Virtual Bank, ING Direct, iGoBanking, Capital One Direct, and many others are offering higher rates of interest than you would typically find in a local bank or credit union, often with no or low minimum initial deposits.

Consider all of these options when looking for a home for your chicken money. We all need a safe place to put some of our money; we may as well try to get the best interest rate we can in the process. For what it’s worth, if you’re interested in opening an account at either ING Direct or Virtual Bank, I still have some referrals which will get the two of us a bonus when you open a new account! Contact me if you’re interested.

CNNMoney has a story on a family who lost their home in the mortgage crisis. A grandmother who bought her first house and was getting rent money from her two daughters who “unexpectedly” saw her mortgage payments shoot up hundreds of dollars a month.

No more house.

Yes, I feel horrible that someone who had bought a home–their first home–might lose it to foreclosure. Especially someone who at least had saved a sizable amount–$20,000–as a down payment

But read the story more closely: the house she bought cost $489,000. Her yearly income is $25,000.

Time out!

There’s lots of responsibility to go around on this one. Borrowing $489,000 on a salary of $25,000 a year is totally out of line with reality. And loaning someone with a $25,000 a year salary $489,000 is incredibly irresponsible. There’s no way someone with that kind of salary to reasonably have a mortgage of that size, meaning that not only did the borrower need to know beforehand she couldn’t afford it, the lender needed to let the borrower know that–and there’s no way a lender couldn’t have known that it wasn’t a workable loan. This was doomed from the start, a marriage of a borrower who didn’t know what they were getting into and a lender who wanted to make a loan–and some dollars–in a bad way.

All of that said, while I feel horrible for this lady and her family, I just can’t support a taxpayer bailout of folks who have gotten themselves in deep with mortgages they can’t pay. These are the biggest investments almost all of us will ever make in our lives and we owe it to ourselves–and each other–to do our homework and not get ourselves into situations where we’re in over our heads. We’re not talking about a situation where someone lost their job or had a catastrophic illness or accident; we’re talking about a situation that was 100% preventable beforehand. Yes, I feel horrible, but no, I can’t say bailing them out is the best use of taxpayer dollars.

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.

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!

Welcome to your Link Payday for May 20, 2008. After a really rough 10 day stretch of work, I now have a few days off to try to get ahead on the blog. Let’s take a quick look around and see what the best of the Internet has to offer us in the way of personal finance:

While not from a personal finance blog, RankingsAndReviews.com discussed hybrid payoff time–how long someone needs to own a hybrid car vs. an equivalent gasoline only car before the increase in gas milage outweighs the increased cost. Obviously, this is highly dependent on the cost of gas.

Do clotheslines make people think poverty? Given that my family has used clotheslines forever (and about never uses the dryer), that thought has never crossed my mind, but Trent over at The Simple Dollar teaches us how frugality may give the impression of poverty and the social pressures that may prevent the choice of the frugal option.

JD over at Get Rich Slowly features a reader email that asks the readers what to do when I’m doing well financially but my family is not. This is a fascinating piece that makes readers consider their personal values around money and family as well as what it really means to help people.

Be careful when buying something that says, “no interest for twelve months,” wisely warns My Two Dollars, because No Interest For 12 Months Does Not Mean No Interest At All. The best way to buy something like this is to have the cash available when you want to buy it, then put it in an insured certificate of deposit until it’s time to pay it off!

Moolanomy explains what an annuity is. I am not a fan of them, but this is a much more impartial view of this financial vehicle (and I’m still not a fan!).

And there’s your link payday for May 20, 2008!

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!

The term subprime refers to borrowers who have issues with their credit history. The credit rating and history of the borrower is what is subprime (meaning poor or non-existent), rather than the interest rate of the loans given to subprime borrowers, which are higher than typical. Subprime loans also carry more risk for both the borrower and the lender. The lender is lending money to a borrower who has not demonstrated through a healthy, verified credit history the ability and willingness to repay the loan, justifying the higher interest rates–just as a higher return is expected in investing for taking more risk, a higher rate on the loan is expected for the lender taking more risk. The borrower takes a higher risk of defaulting as the payments are higher and they have not demonstrated a history of being a good credit risk. While subprime lenders offer loans to those who would otherwise not be able to borrow enough money to, for example, purchase a house, the unfortunate downside of subprime is that many borrowers are unable to repay the loans.

In regards to the current subprime mortgage crisis, a subprime borrower would often take on an adjustable rate mortgage that usually starts with a low “teaser” interest rate for a few years then resets; combine this with a rise in interest rates over the past few years (prior to the last six months) and the subprime mortgage borrower often ended up unable to pay their mortgage, leading to defaults and foreclosures.

The subprime crisis is not yet over–it led to the fall of Bear Sterns last week and it is not yet known what effect it will have going forward. The lesson to learn from subprime is this: in terms of dealing with bonds, buy quality; build a healthy credit history so you do not have to engage in a subprime loan; and only borrow what you can afford. The next few months will tell us just how extensive the damage due to subprime has been.