Category Archives for Invest & Retire

Early Retirement Risks – And How to Prepare for Them

The following is a post by MPFJ staff writer, Kevin Mercadante, who is a professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.

Millions of people hope to enjoy the benefits of early retirement.

It’s opportunity to change the course of your life, from a career focus to one is based on taking on new challenges while kicking back a bit. But, early retirement is not a risk-free proposition. Below are some of the risks you could face in early retirement, plus some strategies to help you deal with them.

A major stock market decline

Since 2000, we’ve had two major stock market declines, so this is more than just a remote possibility. If you retire sometime in your 50’s, the likelihood of a major decline or even a crash is even higher since your retirement portfolio will need to cover more years.

Diversify your investments. The best protection against a major decline in stock prices is to have at least some of your money invested outside the market. This will become even more important as you get older. If 50% of your money is in stocks, and the other 50% is in fixed income investments, and the market sustains a 50% drop, your portfolio will only lose 25% of its value (50% of the half is invested in stocks).

Keep some non-retirement investments. What can really hurt retirees in a major stock market decline are the twin siphons of falling equity values, and withdrawing money from your portfolio for living expenses. You should have some investments held outside of your primary retirement portfolio that you can tap during a major market decline. Not only will that keep you from drawing down on a declining portfolio, but it will also prevent you from having to sell off positions at the bottom of the market.

Have backup job or business skills to fall back on. At the extreme, you may need to spend some time earning a living in order to offset the losses you have taken in your portfolio, particularly if they have been severe. And you can also use employment income to help you avoid taking withdrawals from your retirement plan during the market decline.

Inflation

Inflation is a major threat to retirement, particularly for an early retiree. We all know what inflation has done over the past 30 years, now imagine that you retire at 55 and will need to provide for yourself for the next 30 years. It can get messy.

The “seek withdrawal rate”. Loose theories have shown that if you withdraw no more than 4% per year of a portfolio that is invested largely in the stock market, then you’ll never run out of money. This is because the average annual rate of return on stocks has been in the 8% range for the past 100 years.

Continue investing in stocks. Since inflation will always be a threat to your portfolio, you will not have the luxury of moving all or even most of your money into fixed income investments. Even as you move into your 60’s and 70’s, you’ll need to have a substantial amount of your portfolio invested in stocks. Long-term, growth is the best remedy for inflation.

Look to inflation sensitive investments. There are certain investment classes that tend to thrive in periods of high inflation. Stocks related to energy and precious metals are the historic front-runners. These will merit consideration in the event inflation begins to heat up.

Health insurance before you’re old enough for Medicare

If you retire prior to age 65, health insurance will be an issue. You’ll become eligible for Medicare when you turn 65, but you’ll need to provide for your own health insurance if you retire at an earlier age.

The Affordable Care Act is taking effect right now, and though the details are unclear, there is some evidence that the bill will go a long way toward helping people over 50 obtain more affordable health insurance. There is even an alleged breaking point at age 57 – that is the age at which you get the price benefit that will be paid by younger contributors to the system.

But, since we don’t know yet how the Affordable Care Act will play out, you have to consider other options.

Take a catastrophic health plan. This will keep your monthly premiums to a minimum. You might take a deductible of say $10,000, which you can offset by having an equal amount of liquid assets. The important thing is that you will have coverage for medical disasters that might threaten your financial position.

Take a part-time job with health insurance coverage. There are companies (Starbucks and Target among them) that offer health insurance for part-time employees. But another benefit of the Affordable Care Act is that under the law, employers will have to provide health insurance coverage for any employee who works a minimum of 30 hours per week. This is not a perfect solution to the health insurance dilemma, but it can be an option if maintaining a private plan will be too expensive.

How about you all? If you are planning for early retirement, have you considered any of the above risks? If so, what are you doing to address them?

Share your experiences by commenting below! 

***Photo courtesy of http://www.flickr.com/photos/76657755@N04/7027606047/

Mid-Year 2013 Blogging and Personal Goal Setting Check-In and Progress Update

Back in January of this year, I laid out some personal goals for my life in general and blogging goals for My Personal Finance Journey for the 2013 year.

As I experienced in 2012, (click the following link to view my 2012 blogging goals and year-end progress updates) by tracking these goals periodically, it provides me with more accountability and visibility to what I am doing and where I want to go with this community/blog and in my life. As such, the purpose of this post is to review how I’ve been doing so far in 2013 in reaching the aims I set up for myself.

As far as life goes from a personal and blogging perspective, the first half of 2013 has been very successful in my opinion. As usual, graduate school has taken quite a bit of time/effort, and as such I wasn’t able to spend quite as much time on my blog (and we’ll most likely see this reflected by a good number of Not on track status updates below). But, such is life I suppose, so I’m not too disappointed about it all!

I’ve really been glad during the times that I’ve gotten busy with graduate school to have a solid group of staff writers to continue producing top-notch content. However, in the madness of it all, I have had some time to do around 5-10 back-test/historical pricing analyses to analyze the various asset allocation components that I employ.

So, here goes! An update on my progress so far in 2013 for my blogging and personal goals, with updates highlighted in bold text below. This should be fun!   

The blogging goals for 2013 were as follows:

• Get to bed at midnight or earlier.
  • On track. Been doing very well at this! I don’t seem to have the energy to stay up until 2am every night anymore! haha
• Take 1 day off per week (Saturday or Sunday) completely from doing work on my blog or from my graduate research job to keep my mind feeling more “fresh.”
  • More or less on track.
  • Instead of taking an entire day off each weekend, I’ve been focusing on getting out and doing a big bike ride once per weekend. Afterwards, I generally am pretty tired, so even though I might answer a few blogging emails or do a few things, I don’t work all that much. 
• Become better at following the Getting Things Done email/work flow management system to focus my time and energy on high value projects first and avoid distractions.
  • On track. 
• Hike or bike ride 1 time per week with a group.
  • On track. I’ve been doing quite a few 4-5+ hour rides recently on the weekend! 
• Do a bike race if my Achilles starts to feel better.
  • My Achilles has been feeling better, but I haven’t felt the need to do a real bike race yet. I’ve just been enjoying doing it recreationally on the weekend. 
• Hike more with the Charlottesville Hiking Group.
  • I have not been doing this very much since I’ve been biking a lot.
• Read one personal finance book per month.
  • On track. 
• Go backpacking one time per month in warmer months.
  • Now that it’s summer, I’ve started to think about doing this soon! 
• Take a trip out-of-town 1 time per month. Visit sister’s new home in Raleigh. Visit one of the beaches in Virginia.
  • Not on track. As usual with the biological/cell-based nature of my experiments in graduate school, it’s been hard to get totally out of town during the weekends.
• Learn how to build a group speaking business.
  • Have not done. 

How about you all? How have you been progressing on your personal/professional goals you set for yourself in 2013? 

The Size of Your Emergency Fund Should Be In Inverse Proportion to the Stability of Your Income

There are all kinds of methods that are used to determine what the proper size of an emergency fund should be.

Perhaps in an attempt to simplify the process, the most common recommendations are for either a flat amount – say $1,000 – or a certain number of months living expenses, which typically ranges anywhere from one to six months.

In reality however, determining the right size for your emergency fund may not be all that simple. A flat amount or so many months living expenses will work only in the most general sense. Your method also needs to account for the variables of life. And one of the biggest variables is the stability of your income.

It isn’t possible to have the right-sized emergency fund unless you adequately adjust for qualitative factors, one of which is income stability. How should income stability affect the size of your emergency fund?

Types of income that should affect the size of your emergency fund

Evaluating the stability of income is mostly a matter of considering the source. A salaried position with full employee benefits would represent the most stable source of income. This will be especially true if the job is in a professional position, such as nursing, accounting or teaching. Government jobs tend to be even more stable, since layoffs from such positions are infrequent.

At the opposite end of the spectrum, are employment situations in which all – or at least a substantial amount – of your income is derived from non-salaried sources. Some examples might include:

• Self-employment
• Commission sales jobs (100%)
• Salaried jobs in which a substantial amount of compensation is derived from bonuses, commissions, or overtime
• Contract employment
• Hourly positions with variable schedules (includes most part-time positions)
• Seasonal jobs

Another type of employment with unstable income includes jobs with a high frequency of layoffs. An example of this would be many positions in the building trades. Since the construction industry in general tends to run with the boom and bust cycles of the real estate business, building tradesmen qualify as having less stable income sources.

Now that we’ve set some definitions for what constitutes income stability, and which income types they apply to, let’s get back to the question of how much to have in an emergency fund.

Greater income stability requires a smaller emergency fund

If you are on the high end of income stability – let’s say that you have a full-time, fully benefited job with the government, and you even have some tenure. If that is your situation, then you can be on the lower end of the emergency fund scale. Given that financial planners usually advise having something like 3 to 6 months of living expenses in your emergency fund, the stability of your income would allow you to keep your fund at the lower end of the range. You would likely be perfectly safe with just three months reserves, and you may even be able get away with a little bit less. For most people, the biggest emergency situation is the loss of a job or the potential for a serious reduction in earnings. But if your job and income situations are extremely stable, then that potential emergency will not be a reasonably likely scenario, and your emergency fund doesn‘t need to be as large.

Less income stability requires a larger emergency fund

It’s easy enough to see how a very stable income situation would require a smaller emergency fund. But the situation gets a bit more complicated when you’re talking about less stable income sources, such as the ones listed earlier.

If you are in a situation that is generally unstable income-wise – or at least has the reasonable potential to be so – you will want to be at the higher end of emergency fund recommendations, at the very least. In just about any of these income situations you should have at least six months of living expenses in your emergency fund.

If you’re income situation is at the high end of unstable – such as self-employment or 100% commission – you may want to increase your fund to cover as much is 12 months of living expenses. The larger emergency fund is necessary not only to compensate for potential loss of income, but just as important, to give you some peace of mind during periods of wide income fluctuation. If you have enough money saved to cover your living expenses for a year, you should be able to keep calm and to do whatever is necessary to turn your income situation around.

Still another benefit of the larger fund – from my own personal experience – is the tendency for other emergencies to develop when you’re dealing with an income crisis. Blindside disasters just seem to be more frequent when income is low. There’s nothing really scientific about how much money to have in your emergency fund. And there are different ways to calculate how much you’ll need. But whatever method you take, you should seriously consider your income stability as a major part of the criteria.

How about you all? What factors form the basis for the selected size of your emergency fund?  

Share your experiences by commenting below!

***Photo courtesy of http://www.flickr.com/photos/44313045@N08/6290270129/sizes/s/in/photostream/

What Asset Allocation Level Should You Use for Treasury Inflation-Protected Securities (TIPS)?

Over the past couple months, we’ve been discussing several interesting aspects of asset allocation and portfolio design. Thus far, we’ve explored how gold/precious metals, international equities, REITs, short-term bonds, and intermediate-term bonds perform as asset classes and if/how they should be weaved in to your asset allocation.

Continuing this investigation on portfolio construction, I wanted today to look in to the question of “what level, if any, of your portfolio should be allocated to Treasury Inflation-Protected Securities (more commonly referred to as TIPS)?”

Let’s get started!

WHY BOTHER CONSIDERING THE ADDITION OF TIPS AT ALL?

To begin, the first question that I suppose we should address is why it’s even worth considering adding TIPS to your portfolio in the first place.

As is the case with many elements of Modern Portfolio Theory and portfolio construction in general, TIPS theoretically should provide a favorable diversification benefit when incorporated with other components of your portfolio.

More specifically, this diversification benefit comes from the fact that the average return statistics of TIPS are not perfectly correlated with other commonly-included asset classes of a portfolio. In mathematical terminology, we can say that the diversification benefit is obtained because the correlation coefficients of TIPS with the other asset classes are not 1.

To demonstrate this in tabular form, I ran a correlation coefficient analysis of the annual returns of the Total US Stock Market, TIPS, and Short-Term Treasuries between the ~40 year period between 1972-2011 (using data from the Bogleheads.org Simba backtesting spreadsheet).

The correlation coefficient results can be seen in the table below. As you can see (green highlighted cells), the correlation coefficients between TIPS and the Total US Stock Market / Short-Term Treasuries are quite favorable at 0.20 and 0.03, respectively. What this means in English is that the returns of TIPS move in sync with the stock market in general only 1/5 of the time and with Short-Term Treasuries almost none of the time.

According to Modern Portfolio Theory principles, adding a poorly correlated asset class in to a portfolio can often decrease volatility while possibly, increasing returns. Thus, this is the motivation for looking at including TIPS in a portfolio/asset allocation.

In addition to a potential diversification benefit, TIPS provide a “pure hedge” against US inflation. In other words, unlike some other indirect hedges against inflation that may or may not be guaranteed, TIPS offer investors a guaranteed real rate of return, no matter what happens to inflation in the future. This also indicates that the real returns of TIPS have less variance than that of nominal bonds. Lastly, being Treasury securities, they have 0 default risk.

WHAT DO THE EXPERTS SAY ABOUT ADDING TIPS TO YOUR PORTFOLIO?

Before getting too far in to my own asset allocation analysis, I generally like to quickly review and summarize the thoughts that people much more qualified than I am have on a subject.

As such, listed below is a summary of what has been recommended in the books of several well-respected asset allocation authors regarding the incorporation of TIPS in to a portfolio:

• Larry Swedroe (probably my favorite investing author I have found to date)
  • In Larry’s two books, The Only Guide to a Winning Investment Strategy You’ll Ever Need and The Only Guide to Alternative Investments You’ll Ever Need, Swedroe provides the most complete, definitive position that I could find in the literature of what allocation investors should consider giving to TIPS.
  • Essentially, he states that numerous academic studies have been conducted, and all come to the similar conclusion that TIPS should “dominate” the fixed income allocation for investors, especially in tax-sheltered accounts.
  • For example, he shared the results from 3 studies that concluded the optimal portfolio position based on risk-adjusted returns for the overall portfolio was between 50-100% of the fixed income allocation.
• Burton Malkiel
  • In his famous and amazing book (2003 edition), A Random Walk Down Wall Street, Malkiel provides example asset allocations with 5% of the total portfolio allocated to TIPS (~25% of the fixed income allocation).
  • Unfortunately, it is never explained exactly how this 5% level is derived. The book only mentions that TIPS are a wise component to add to a portfolio.
• William Bernstein (my 2nd favorite investing author I have found to date)
  • In his 2002 book, The Four Pillars of Investing, Bernstein displays sample portfolios/asset allocations with TIPS representing 4-20% of the total portfolio, depending on the investment horizon. 10% seemed to be a common allocation used within this range.
  • Generally, this equated to ~1/3 of the fixed income allocation. 
  • As was the case with Malkiel’s book, Bernstein doesn’t really get in to exactly how the allocation to TIPS was derived, but simply mentions that it is beneficial to have some exposure to the asset class.
• Alexander Green
  • In his book, The Gone Fishin’ Portfolio, Green recommends a 10% allocation to TIPS (equates to 33% of the fixed income allocation).
• Although not a book (but simply a group of people with a lot of collective knowledge), on the Bogleheads Forum, the most popular fixed income allocation is a 50/50 split between nominal and TIPS bonds.

Conclusion from Literature – So, after looking through all of the books that have helped me build my portfolio over the years, there doesn’t seem to be a clear consensus among the various authors. On one hand, we have several that recommend committing about 1/3 of fixed income assets to TIPS, while on the other hand, Swedroe is recommending anywhere from 50-100% fixed income allocation to TIPS. Of course, this number will change as your life cycle allocation adjusts during different life stages.

HOW HAVE TIPS PERFORMED IN THE PAST COMPARED TO OTHER PORTFOLIO COMPONENTS?

In this case especially, the literature seemed to be rather inconclusive about what is exactly the correct amount an investor should allocate to TIPS.

The first thing that is interesting to examine when seeing how TIPS have performed compared to other common asset classes is to see how an investment made a long time ago (~40 years in this case) would have grown.

As such, shown below is the hypothetical growth of a $10k starting investment in Short-Term Treasures (red line), the Total US Stock Market (blue line), and TIPS (green line) between the years of 1972-2011.

As you can see, the investment in TIPS provided approximately (at least from the graph) the same return as that of Short-Term Treasuries. As would be expected, the equity asset class returned much higher than the fixed income investments.

The actual return data that produced the graph above is shown in the table below. First, as we would expect given that TIPS have a MUCH LONGER average maturity (~9 years) than the Short-Term Treasuries (~2 years), TIPS have higher volatility than the Short-Term Treasuries.

However, it is somewhat surprising to me that investors were not really compensated that much more at all for shouldering the increased risk of TIPS. For example, an investor only obtains an ~10% increase in average returns for TIPS in exchange for taking on an ~50% increase in volatility (standard deviation).

Essentially, what this data shows is that with TIPS, even though they have some attractive potential benefits, they don’t seem to have been very efficient compared to Short-Term Treasuries over the past 40 years.

TIPS ALLOCATIONS IN A 3-COMPONENT PORTFOLIO DESIGN

More important to us as portfolio design “engineers” is how an asset class will behave and/or benefit us when incorporated in a realistic portfolio/asset allocation.

To assess this for the TIPS asset class, I re-ran the portfolio analysis during the 1972-2011 period using a portfolio consisting 30% of fixed income (split between varying levels of Short-Term Treasuries and TIPS) and then a 70% allocation to the Total US Stock Market.

Shown below is the average annual return vs. risk graph that resulted from the analysis. Going from left to right, each plot point on the curve represents increasing allocations to TIPS, as described on the below table.

And, shown below is the exact data that was used to construct the return / risk curve above.

If we examine this data a little more closely, we see that numerically, the most efficient allocation to TIPS in terms of the highest return/risk ratio occurs at 1% TIPS, so very little at all (3% of fixed income allocation). However, in the grand scheme of things, the return numbers don’t change all that much as TIPS are incorporated, meaning there is not that significant of an effect.

Intriguingly, if a 60/40 equity/fixed income asset allocation split is used as opposed to the 70/30 employed above, the optimal level of TIPS becomes ~5% (12.5% of fixed income allocation). Furthermore, if a 50/50 split is used, the optimal TIPS level is found to be 8% (16% of fixed income allocation).

Overall, my 3-component TIPS analysis leaves me with the following question –

Why does my analysis predict much lower optimal levels of TIPS (3-16% of fixed income allocation) when the books I reviewed above recommended 25-100% of fixed income allocation?

I can think of several possible causes for the discrepancy. First, the data I’m using could be wrong (hopefully not). Second (and more likely), is the possibility that I am not comparing apples to apples, which in this case, means inflation-adjusted returns to inflation-adjusted returns.

To investigate the disparity in findings, I obtained the inflation data for the years being analyzed, subtracted it from the annual returns of the various asset classes, and generated the table below showing the summary of my findings.

When adjusting the returns for inflation (4.39% annual average inflation during the time period analyzed), the case for incorporating TIPS in to a portfolio becomes more significant, with the most efficient level being at a 7.4% TIPS allocation (of the total portfolio, or ~25% of the fixed income allocation) for the 70/30 equity/fixed income portfolio. If we use a 60/40 or 50/50 equity/fixed income overall asset allocation, the optimal allocation to TIPS becomes ~23% of the fixed income allocation.

You can view the complete set of numbers/calculations for my analysis by accessing the Google Docs Spreadsheet here.

CONCLUSIONS ABOUT TIPS ASSET ALLOCATION AND MY PERSONAL PATH FORWARD

So, after sifting through all this analysis, what’s the overall verdict on what asset allocation should be committed to the TIPS asset class?

Listed below are my key takeaways from this investigation:

• TIPS provide the potential for a very significant diversification benefit due to their low correlation with both equities and nominal bonds.
• In addition, since TIPS provide a solid hedge against inflation (something which is almost guaranteed to happen) by providing “real returns,” they are truly a hard asset class to ignore.
• The literature recommends that between 25-100% of an individual’s fixed income allocation be committed to TIPS because of these benefits. It is often stated that TIPS should be the dominant holding in one’s fixed income allocation (meaning >50%).
• In my own analysis of the ~40 year period between 1972-2011 using a 3-component portfolio of US equity, Short-Term Treasuries, and TIPS, I found that:
  • The return values HAVE to be adjusted for inflation in order for TIPS to have a significant case to be included in the portfolio.
  • After adjusting returns for inflation, the most efficient level for TIPS in a portfolio is ~25% of the fixed income position. 
  • I hypothesize that the TIPS allocation for maximal portfolio efficiency would have been higher if I used intermediate or long-term maturity bonds in my portfolio construction. However, since I like to use short-term bonds (which provide an indirect hedge against inflation since short-term rates are able to adjust fairly quickly as inflation changes), dominant levels of TIPS were not required to increase efficiency.

My Personal Path Forward – I want to lastly share how this analysis affects me personally. I currently use a 70/30 equity-fixed income asset allocation. 5% of my total portfolio (or ~17% of my fixed income position) is allocated to TIPS. Thus, I’m a little bit below both the optimal level found in my own analysis above and also what is suggested by most authors in the literature/Bogleheads.org. Because inflation is almost a certainty to occur in the future and the fact that TIPS provide a guaranteed real rate of return, I think it is prudent for me to increase my TIPS allocation.

Regarding the question of WHAT TIPS allocation I will use going forward, I believe I will stick to the lower end of the recommended spectrum, shooting for a ~25% fixed income allocation to TIPS, or 8% of my total portfolio. I don’t necessarily want to increase much higher than that due to the longer maturity that the Vanguard TIPS mutual fund I will use has (9 years). To keep my overall fixed income / equity allocation levels the same, I’ll exchange my short-term bond index fund allocation over to TIPS to make the required change.

A good question going forward perhaps is whether it is better to use the new Short-Term TIPS Fund or the regular TIPS Fund that Vanguard offers. I’ll put that on my list of things to analyze soon!

How about you all? Do you have any exposure to TIPS (or another inflation hedge) in your investing portfolio?

If so, what % of your portfolio does it constitute?

Share your experiences by commenting below!

Emergency Fund Considerations – Where Should the Account Be Located and What Should It Be Invested In?

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By now, you all probably have read about the importance of having an emergency fund (with enough money to live off of if the need arises) invested in a very stable account. In fact, in my account hierarchy / financial prioritization order, this type of cash account ranks right near the top.

However, several aspects of emergency funds that there exist substantial differences in opinions include 1) where this money should be held and 2) what the money should be invested in. As such, today’s post will be dedicated to seeking position on these two considerations around emergency funds.

Let’s get started!

Emergency Fund Location – Where Should the Money Be Invested?

When it comes to the location of your emergency fund savings, the key is access. 

We need to have access to this money within 1-2 days or so at the most if something unexpected pops up. More specifically, we need to have this easy, quick access to our money also without incurring any penalties, fees, or additional debt (like a credit card – which is the whole reason why credit cards are NOT emergency funds).

If we limit our selection to account locations with this criteria, nearly all traditional retirement accounts are eliminated, and we are left with the options below:

• Contributions (but NOT earnings) to a Roth IRA.
• Normal, taxable accounts.

While both of these account types are viable options for an emergency fund, analyzing your personal finances can provide some insight in to which is likely the better emergency fund location option for you.

Let’s start out by stating the obvious – if your income is high enough that you are not allowed to contribute to a Roth IRA, then your only option is to use a taxable account for your emergency fund. If this is the case for you, you can likely skip the next few paragraphs.

For the remaining people who ARE ELIGIBLE to make Roth IRA contributions each year, they likely to fall in to one of two categories:

• Category 1 – Folks who are fully funding their Roth IRA each year, and
• Category 2 – Folks who are NOT fully funding (or not funding at all) their Roth IRA each year.

However, as you’re likely well aware, we cannot simply fund a Roth IRA with however much we want each year. There is a set yearly (and vis-a-vis, lifetime) limit that the IRS imposes each year ($5.5k in 2013, for example). Because of these limits, it is in your best interest to begin funding a Roth IRA as soon as possible (i.e. not waiting until you build up an emergency fund in a regular taxable account to start your Roth IRA contributions). 

Specifically, this applies to the location of emergency fund savings in the following way:

• Category 1 – Folks who are fully funding their Roth IRA each year. 
• If you’re already maxing out your Roth IRA each year, then you’re better off having your emergency in a regular, taxable account, so you can save your “tax-free” Leg of the Three-Legged Stool for retirement, when you need it more, and have more growth.
• Category 2 – Folks who are NOT fully funding (or not funding at all) their Roth IRA each year.
• If you’re not funding (or not fully funding) a Roth IRA each year, then you’re better off opening up a Roth IRA as soon as possible and beginning to use your contributions as an emergency fund.
• This will get you started accumulating capital to take advantage of the set lifetime limits imposed by the IRS on Roth IRA contributions.

If you’re interested in reading more about this decision process, I’d recommend the two great articles below:

• MyDollarPlan.com – Roth IRA Emergency Fund Explained
• BogleHeads Case Study – When Using a Roth IRA As An Emergency Fund Makes Sense

Emergency Fund Vehicle – What Should the Money Be Invested In?

In other words, we want to invest in some vehicle that has close to 0% chance of decreasing in value, that does not lock up our money for a set period of time and incur fees/penalties for early withdrawals (like a CD), and gives us a competitive yield based on the stability profile.

If we impose these criteria, we are left with the following obvious options:

• Money Market Mutual Funds and Money Market Savings Accounts.
• This is what I currently utilize for my emergency fund savings.
• Bank Savings Accounts (not available in a normal brokerage Roth IRA, but may be available through Bank IRAs, like ING Direct/CapitalOne360).
• Bank Interesting-Bearing Checking Accounts (probably not available in a Roth IRA).

However, here recently in reading Oblivious Investor and some of the BogleHeads Forums, I’ve discovered that folks are using (in whole or in part) Short-Term Bonds/Short-Term Bond Mutual Funds as vehicles for their emergency fund savings.

Most likely, the reason for this is because they are trying to obtain more competitive interest rates on their savings, given the abysmally-low rates offered by money market accounts these days. For example, as of this writing, the CapitalOne 360 money market savings account is offering 0.75% APY, while the Vanguard Short-Term Bond Mutual Fund has delivered a return of 1.5% over the past year, so about 2x what the money markets are getting.

Having established that Short-Term Bonds meet the competitive yield criteria, we then need to determine if they are liquid and very stable. As far as liquidity goes, if you use one of Vanguard’s Short-Term Bond funds, they are likely to have $6-30 billion or more in total assets, meaning that you drawing out even $20,000 in emergency fund money in one day will likely not be a problem at all. So, I think Short-Term Bond Funds are fine from a liquidity perspective. 

Thus, the only thing left to analyze is the stability of Short-Term Bond Funds. In a post I wrote in April 2013, I analyzed the ~20 year performance data of 5 of Vanguard’s Short-Term Bond Mutual Funds. The results are shown in the table below:

As you can see in the table above, all of these short-term bond funds are VERY stable.

• In fact, during the period from 1996-2013 (even with experiencing two financial crises in 2000-2001 and 2008-2009), the minimum return over a year-long period was close to +1%. 
• Furthermore, the worst loss experienced in any one month period was only -2.46%. 

Thus, I would conclude that Short-Term Bonds are indeed a suitable place for a part of your emergency fund, and maybe even ALL of your emergency fund if your total assets are fairly large.

For me personally, since my total assets are not extremely large yet, I like the idea of holding my emergency fund in a very secure, FDIC-insured, money market savings account that cannot decrease in value. This makes me feel better about taking risks in other places in the equity portion of my portfolio. However, I wouldn’t be opposed to shifting my emergency fund to short-term bonds in the future as my asset base grows.

How about you all? Do you hold your emergency fund in a Roth IRA or in a normal, taxable account?

What do you invest in with your emergency fund savings to keep it secure?

Share your experiences by commenting below!

***Photo courtesy of http://farm7.staticflickr.com/6131/5930041360_c98831f232_o.jpg

Is There Really Such a Thing as Good Debt?

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The following is a post by MPFJ staff writer, Kevin Mercadante, who is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.

We live in a world that’s awash in debt.

Complicating this fact is that debt has become so common in the average person’s life that we may not even perceive the threat that a truly is. That can cause us to take on debt that we would be far better off avoiding. At a minimum, we should develop a hierarchy as it applies to debt. We may decide that there are certain times that we should go into debt – and others when we just need to walk away from it.

This is  the essence of the good debt versus bad debt debate. We know that certain debts are just plain bad. Credit cards and other types of consumer debt are in this category. Then, there other debts that we might think of as good debts – and sometimes they are, but not always. But is there really such a thing as good debt?

This is hardly scientific, but I think that before we decide that a debt is a good debt – that is, one worth taking – we should ask a few important questions to help us decide:

• Is what is being purchased with the debt life-altering in a positive way?
• Is there a decided absence of reasonable alternatives to taking on the debt?
• Will the debt put me in a hole that I’ll never get out of?

If the answer to any of these three questions is “no”, then what we are looking to purchase will not result in anything like good debt. If we use such questions as a litmus test of the debt, we will come up with a very short list of good debts – and even then there will be limitations.

A home mortgage – within limits

There can be times when taking a mortgage to buy a home is something close to a necessity – in many cases it really isn’t. Shelter is an absolute necessity, but owning the shelter that you live in isn’t always. But if you have a growing family, you may eventually need to own a home. Or if you have a business with certain physical assets that cannot be stored in an apartment or rental home, you’ll need to own.

On the flip side, if your purpose for buying a home is to trade up to McMansion, the home mortgage-as-good-debt argument turns into a leaky boat. Assuming that your purchase is a necessity, it’s obvious that you will be unable to pay cash for the house. If you need to buy, there’ll be no alternative to taking on a mortgage. Right there, the home mortgage will improve your life in a positive way, and there really aren’t any reasonable alternatives to borrowing in this case.

So far, it looks like a good debt situation! Where home mortgages get sticky is in that last test question – will the debt put me in a hole that I’ll never get out of? The answer to this question essentially separates good debt from bad when it comes to mortgages. If you’re buying a home that fits well within your budget, you’re making a large (more than the minimum) down payment, and taking a loan will be paid off in a reasonable amount time (certainly nothing longer than 30 years), the mortgage qualifies as good debt. If on the other hand, you are buying a home is at the upper reaches of your ability to afford, putting little or nothing down, and might even need to take a 40 year mortgage, you’re probably stepping into the bad debt zone. You’ll have a mortgage that can in fact put you into a deep hole that you’ll never get out of. A debt isn’t suddenly good just because it’s called a mortgage. It’s your ability to reasonably afford it, as well as the necessity of the purchase that make the difference.

Student loans – within even tighter limits

One of the biggest problems with student loans today is that it is effectively debt without parameters. You need to qualify for just about any loan you take based on your financial position. But student loans are the exception. You can get the loans without any income, assets, or credit history, and that’s what has made so many students take on more than their share of debt.

Like housing, a college education has the potential to improve your life, and for many students there really are no viable alternatives. This would seem to make student loans good debt by default. But the problem with student loan debt is its potential to put you in a deep hole – much in the same way as over buying a house with an out sized mortgage will. Once you have these loans, they are nearly impossible to get out of. You’ll have no asset to sell to payoff the loan, and generally cannot discharge them in bankruptcy. That’s a deep hole – especially if the debt is large.

If the debt is beyond your ability to repay in a reasonable fashion, than it is not good debt no matter what else it will do for you. Even though “the system” doesn’t impose limits on how much student loan debt you can take, you need to do this yourself. Decide how much debt you think that you’ll reasonably be able to handle with or without a college degree. (Many people take student loans but don’t graduate; they still owe the debt.) If you are borrowing anything beyond this limit, you’re voluntarily accepting a bad debt arrangement.

Medical debt usually is good debt, even if we don’t think of it that way

We don’t often think of medical debt in connection with debt, good or bad. But, the incidence of medical debt is on the rise, owing to higher deductibles and greater reluctance by insurance companies to pay for medical expenses.

Unless you are borrowing to pay for elective surgery, debt that is incurred to cover medical expenses almost always has a positive impact on your life, and lacks in any reasonable alternatives. This is an expense category where you often have to take on debt even if it will put you in a deep hole. If it’s a choice between saving your life or that of a loved one, and avoiding debt, you’ll naturally choose to save the life. Does this make medical debt good debt? I think so – even if it doesn’t feel like good debt. Medical debt is virtually a category all its own. Let’s call it necessary debt.

What about car loans?

I don’t think of we can reasonably say that car loans come under the good debt label in any way. Sure, it’s close to impossible to buy a brand-new car without going into debt.

But, unlike the categories above, there’s always an alternative here. You may want a new car, but it’s unlikely that you absolutely need one. You can always buy either a less expensive new car, or a used one. With cars, it’s very possible to buy a vehicle that you can afford without going into debt at all. In fact, borrowing money to purchase a car is usually motivated by a lack of willingness to wait until we are able to afford the kind of car that we want to buy. That makes the good debt argument here very weak at best.

How about you all? How do you define good debt versus bad debt?

Share your experiences by commenting below!

***Photo courtesy of http://www.flickr.com/photos/90994597@N05/8268391582/sizes/n/in/photolist-dADEKy-acpH9H-9

Should You Include Emergency Fund and Specifically-Earmarked Savings in Your Overall Asset Allocation?

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On New Year’s Eve before the official start of 2013, I posted an article mentioning that I was updating my target asset allocation to a 70% equity / 30% fixed income split, up 5% from the 75% equity / 25% fixed income split I had been using since I started this blog in 2010. Using the 25/75% split in overall asset allocation, it boiled down to having 5% of my overall assets held in cash. 

The reason that I changed my asset allocation targets to 30/70% stemmed from the fact that during the past year with the accumulation of specifically-earmarked vacation savings, dream and life values savings, and my emergency fund, I have tended to carry around 10% of my overall assets in cash-equivalent accounts. Since I like having this amount of cash on hand being saved for specific purposes, I figured it was about time for me to accept the fact that I need to change my target asset allocation percentages to account for this preference – hence the change.

When I made the change mentioned above, it seemed to make a lot of sense, and I didn’t think much of it at all. However, several days ago, a reader brought up the question below, which made me think about reconsidering my strategy:

Should savings that are earmarked for specific short/intermediate-term needs (vacations, buying a car, home down payment, college savings, doggie emergency fund, buying a new $3,000 bike, saving for a pool, saving for a rental real estate investment) and one’s emergency fund be included in your long-term asset allocation percentages? Or, should it be considered as a completely separate basket(s)?

Let’s explore an answer to this question, shall we?

Reasons FOR Including These Savings in Your Long-Term Asset Allocation 

In the process of learning about personal finance through reading many of my favorite books throughout the past 7 years or so, there is one consistent message in the majority of them when they talk about investing – that money held in different baskets (Roth IRA, IRA, 401k, taxable investing account, etc) should be counted together as one common portfolio / asset allocation.

Because of this common theme around considering your investments (generally, the authors either explicitly or implicitly are describing retirement / long-term investing) as ONE portfolio instead of many, I imagine that many folks out there (like me!) carry this same strategy through to how they treat their cash savings earmarked for specific purposes and their emergency fund – they simply count these funds as part of their long-term asset allocation / overall portfolio.

However, does this same advice actually still apply for one’s tactical cash savings?

On one hand, I suppose the argument could be made for including earmarked savings in your long-term asset allocation on the basis that…

• Doing so will provide you with a more accurate, global view of your overall finances (it is YOUR cash after all, so why wouldn’t you count it in YOUR asset allocation?) 
• Doing so gives you a more accurate feel for the level of secure holdings you are carrying.
• If you’re like me, these earmarked and emergency fund savings were taken in to consideration when I calculated my fixed income asset allocation. 
• Even though you’re investing for the long-run, if a financial emergency pops up, you’re going to use whatever money you have access to in your ENTIRE asset allocation, so why not treat it all as the same pile of money?

However, if we look in to the issue in a little more depth, do these reasons still hold true?

Reasons for NOT Including These Savings in Your Long-Term Asset Allocation 

Even though I do include my emergency fund and other intermediate-term cash savings in my retirement asset allocation, one thing that I do NOT include is the savings that I accumulate each year for paying estimated income tax from un-taxed self employment and graduate fellowship income. The reason for this exclusion is because the money comes in and out of my portfolio so quickly (1 year or less) that the only thing it would do is skew my asset allocation percentages to make me think I am holding more cash than I am. In addition, these estimated tax savings were not taken in to consideration when I calculated my fixed income asset allocation.

Reason # 1 – Including the Savings Makes You Think Your Holdings are More Conservative Than They Really Are

When I really started thinking about it, I realized that it could be argued that including tactical savings in your asset allocation is wrong because it makes your investments seem more conservative than they really are.

An example illustrates this very nicely, in my opinion.

Let’s consider that someone has an overall net worth of $100,000. She uses a 40% fixed income / 60% equity overall asset allocation split. The fixed income allocation includes a $10,000 emergency fund (10% of the total allocation), which the investor has determined based on her specific monthly expenses to be enough to sustain her and her family for 6 months of life should she get fired from her job.

Let’s assume that the unthinkable happens. Her job gets downsized, and her salary all of the sudden vanishes. Fast-forward 6 months. Her emergency fund cash savings of $10,000 are now gone. If all else stayed the same, her asset allocation would now be 70% equity / 30% fixed income. If she had developed her asset allocation with her emergency fund in mind, then this might be all right. However, if not, she might be a little too much exposed to risk.

Reason # 2 – Earmarked Savings Cannot Be Rebalanced to Maintain Your Target Asset Allocation

At first glance, a compelling reason against including earmarked savings in your asset allocation is that similar to your home, it really doesn’t make sense / is not easily possible to rebalance when it comes to your emergency fund or earmarked savings, since these amounts are specifically chosen for certain needs/values/wants.

However, if we examine how these cash savings fit within an overall portfolio, I feel this potential problem becomes a lesser issue. For example, in my portfolio, my emergency fund and earmarked savings fit in to the 10% cash allocation, which along with 5% TIPS and 15% short-term bond funds, makes up my 30% fixed income asset allocation. If the equity markets were to decrease significantly, I would find myself needing to sell these various fixed income asset classes to maintain the proper risk exposure. Naturally, I wouldn’t be able to sell my emergency fund savings, etc, but I would be able to sell my other cash accounts and bond mutual funds in order to maintain the right allocation. Thus, I think everything would work itself out fine.

Conclusion

Having investigated all of these considerations, what’s the verdict? Should your emergency fund and other short/intermediate cash savings be included in your asset allocation, or not?

As with many things in personal finance, I think the answer to this is that it depends. More specifically, it depends on how your fixed income asset allocation targets were calculated in the first place (but that either way is probably just fine).

• If they were calculated solely taking in to consideration qualitatively how much variation in your portfolio you can handle whilst still being able to sleep at night, then I would recommend NOT including your emergency fund, etc in your asset allocation totals.
• If on the other hand, your fixed income asset allocation target was calculated (as I did mine) more conservatively by considering both how much variation you can tolerate from a qualitative perspective and listing out your specific cash needs, then including your emergency fund, etc in your asset allocation calculations is fine!

How about you all? Do you include your emergency fund and short/intermediate-term cash savings in your overall asset allocation, or treat them as their own separate “pools?”

Share your experiences by commenting below!

***Photo courtesy of http://farm4.staticflickr.com/3133/2695338561_b762408b97_o.jpg

The Plaintiff’s Options When Receiving a Structured Settlement Annuity

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The following is a guest post. Enjoy! 

A Purchased Annuity

What to Consider

Provided Security

Selling the Annuity

How about you all? Have you all ever received any settlements from a court case? If so, how was the settlement paid out?

Share your experiences by commenting below!

Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.

• When deciding whether to receive a court settlement as a lump sum vs. an annuity, the thing that I would look at are the fees/expenses involved and also the rates of returns offers.
• In many cases, annuities can involve higher fees and not be worth it in the long run than simply taking the lump sum and investing it yourself. Of course, there are pluses and minuses on both sides!

***Photo courtesy of http://upload.wikimedia.org/wikipedia/commons/d/dc/My_Trusty_Gavel.jpg

Tips for Riding Out Stock Market Downturns

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The following post is by MPFJ staff writer, Greg Johnson. Greg is a proud husband, father, and debt crusader who is in the process of becoming debt free. Along with his wife, Greg co-founded the personal finance blog, Club Thrifty, where they encourage readers to “Stop Spending. Start Living.”

Unless you’ve been living under a rock, you have probably heard the news that the markets have been on a pretty sweet rally recently. At the time this was written, the Dow Jones Industrial Average was over 15,300, and the S&P 500 sat at almost 1,670 – both record highs.

Stock market rallies like these can make your financial year in only 6 months. Better yet, they build our confidence as investors. Heck, everybody feels like they are the next Warren Buffet when the market is going gangbusters. Yet, the smart investors realize that the market works in cycles.

Unfortunately, honeymoons don’t last forever. Whenever there is an extended period of rampant growth and excitement, there is almost always a little trouble lurking right around the corner. Being prepared for the downturn can help you from giving back your gains and losing your sanity.

Here are a few tips to help you ride out the next short-term market storm.

1) Invest for the Long-Term

Long-term investing is one way to help stave off the fear of down markets.

When you are investing, time is almost always your best asset. Why? Because time allows you to wait out the short-term fluctuations of the market. Even with the abysmal performance of the stock market over the previous 5-10 years, the stock market’s average annual rate of return over its history is still near 10%. Since we can not guarantee future performance, the best way to predict it is to look at past performance. Thus, if you invest over the long-term, past performance would indicate that it is likely that you will receive a near 10% return on your investment.

Investing with a short-term mindset makes you much more vulnerable to the short-term swings of the market. So, when it comes to purchasing a security, make a decision and stick with it. Fight your fear, and ride out the wave of discontent. While the belief that high markets will eventually come down usually is correct, remember that the inverse (markets that are down will usually go up) is also typical.

2) Don’t Try to Time the Market

This goes hand in hand with investing for the long-term. You’ve heard the saying, “Buy low, sell high?” In my opinion, trying to time the swings of the market will only get you into trouble. Guessing what the markets are going to do will only cause you headaches and cost you money.

Essentially, trying to time the market is gambling. Luck plays a major part in the success of somebody with this investing mindset. What most of us should be doing is trying to eliminate luck from the equation as much as we possibly can. Unless you are a very experienced day trader, the fact is that you should probably be investing your money for the long-term. The “everyman” would be wise to only purchase securities that he plans to hold onto for at least 5 years, preferably 10. If you assume that attitude, you are bound to make money in the good times and ride out the valleys that the market will eventually throw at you.

3) Stick to Your Plan and Don’t Panic

When the stock market is riding the tidal wave up, it is easy to get excited and want to invest all you have in stocks. Of course, the opposite is true as the wave crests and the market begins to come crashing downward. Terror can easily set in as you realize all of the gains you worked so hard for are slowly, or quickly, washing away. However, sticking to your plan in both the good times and the bad can help you to avoid those gut wrenching feelings of sheer panic.

By creating and maintaining a set asset allocation, you can rest easy knowing that your overall financial plan is suited to help you make money in the good times and minimize losses during the bad. Furthermore, keeping to a relatively strict asset allocation plan will help you to diversify your wealth so that you are not too heavily invested in only one type of investment – like stocks or real estate. You should meet with a financial professional to help you determine your specific plan based on your investment horizon (the length of time you plan on investing) and your personal risk tolerance. Once you have your plan, stick with it. Keeping with a well thought out program will protect you from getting greedy during the upturns and self-defeatist during the rough times.

How about you all? What are your tips for staying sane through the ups and downs of the market? How do you protect your assets from market fluctuations?

Share your experiences by commenting below!

***Photo courtesy of http://commons.wikimedia.org/wiki/File:MICEX_Index_graph.png

City Living: The Perfect Lifestyle for the Retired?

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Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
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Click here to enter my free $65.84 giveaway for a chance to win 5% of My Personal Finance Journey blog income and give another 5% to charity! Deadline to enter is May 31st, 2013.

The following post is by MPFJ staff writer, Melissa Batai. Melissa is a freelance writer who covers topics ranging from personal finance to business to organics to food. She blogs at Mom’s Plans where she shares her family’s journey to healthier living and paying down debt.

Share your experiences by commenting below!

***Photo courtesy of http://www.flickr.com/photos/16179216@N07/8230568960/