Investing Prerequisite #2: Expanded Emergency Fund

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This post is step 2 in our Investing Template.

Many people will debate the details and priority of this, but quite simply there is no reason to begin investing until you have enough liquid cash to survive for a reasonable period.  Unfortunately, this can mean different things to different people.

What Kind of Survival?

One pivotal question in figuring out how big this fund should be is how you would like to live during a financial emergency.  Suppose, for example, that you lose your job; are you comfortable cutting expenses severely so that you can keep more money in better investments?  The stress of finding a new job may be enough on its own without deprivation to boot.

Additionally, you need to really think about which expenses are necessary.  While you don’t want to keep too little in your fund, you don’t want to keep too much either.  This is an emergency fund, so you don’t necessarily have to keep every element of your current lifestyle during this emergency.  You can probably eat out less and see fewer movies, but would want to keep enough funds to pay for your kids’ private school.  Use a budget (you do have one, right?) to get a real idea of what you would need per month to survive and what you want that survival to look like.

What Is A Reasonable Period?

Once you know how much per month it takes you to live, the next question is how long you would reasonably need to live this way.  While some people advocate fairly small emergency funds, it is often desirable to put away enough money to live for a considerable amount of time.  If you lose your job, you don’t want to be forced into taking an inferior job, or cash out investments prematurely, simply because your money is running out.  You may have a realistic idea of how long it would take you to find a job, but I say be very pessimistic when enacting your emergency fund.  I believe 3 months living expenses is a minimum. This is only my personal opinion, but I think giving up potential investment returns is well worth the security this extra time buys.

What is Liquid?

Liquidity is a measure of how quickly you can get the cash.  The most liquid accounts are savings accounts or money market accounts.  Accounts where you can either write a check against it, or get the money into a checking account within hours, not days.  Generally however, liquidity comes with a price.  The more liquid an asset, the worse the returns typically are.  Certificates of Deposit (CDs) for example, offer better returns generally, but require you to leave the money on deposit.  This may sound like a deal breaker, however an ideal solution can involve CDs.

CD Ladder

For those who wish to have a large emergency fund, but don’t want to earn terrible returns on the money, a CD ladder may be an ideal solution.  A CD ladder is a series of CDs that mature often enough that you can use them as your emergency fund.  For example, you might go every month and open a 6 month CD with enough to live on for one month.  If you did this every month for 6 months you would now have a CD ladder.  Every month a CD will mature with enough for you to live on for that month.  If you need that money, retrieve it and don’t allow the CD to renew. If you don’t need the money, leave it there and allow it to compound.  There are many tricks and optimizations for starting a CD ladder, but it can be an optimal way to build your emergency fund.

Now that you’ve eliminated your debts and created your emergency fund you are ready to start making more intricate decisions for your investment strategy.

Investing Prerequisite #1: How To Deal With Debt

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This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.

Basic Investment Template

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My next several posts will be attempting to define a basic investment template.  Basically I’d like to develop a checklist to help anyone figure out where and how their money should be invested.  Most investment advice I read is very vague.  While most contain good advice it is usually in a vacuum.  You’d have to read hundreds of these articles to develop a coherent strategy and you still might miss a key point.  I will update this post as I create each installment and may reorder and edit them based on your input and questions.  I will also be posting much more frequently until the template starts to take shape.  Please feel free to start putting any questions below and I will attempt to answer them as I go.

Investing Prerequisites

• Step 1: Dealing With Debt
• Step 2: Your Expanded Emergency Fund
• Step 3: Goals and Time Horizon

Tax-Deferred Accounts

• Step 4: Tax-Advantaged Overview
• Step 5: Retirement Accounts
• Step 6: College Saving Accounts
• Step 7: Homeownership Accounts
• Step 8: Health Spending Accounts

Implementation

• Step 9: Allocation
• Step 10: Techniques

 

Is It Too Late For An Investing Strategy?

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As the savings rate dipped to historic lows, people argued that this was not a cause of concern due to the appreciating value of stocks and real estate.1 People we’re leveraging themselves, but it was considered justified because their houses and stocks were worth more. This of course has proven to be far from guaranteed. People watched as those assets, which were often serving as collateral, spiraled lower and lower in price.

As the markets have plummeted, many people have adopted a “wait and see” strategy. They are “waiting to see the markets recover” before they put any more money into their retirement funds. This begs the question: Why were you investing in the first place?

If these investors thought the Dow Jones was a buy at 14,000, why are they reticent to buy it now at a fraction of that price. Ultimately, the problem is these investors never had a strategy. They’ve only stopped to think about what makes sense investment-wise now that they’ve already experienced large losses.

Is It Too Late?

The simple answer is it’s never too late to have a strategy. However, the strategy you may develop may not paint a rosy picture. Many of us should take this opportunity to do what we should have done before the economic crisis: decide what actions really make sense for us. If you’re hoping to retire in the next few years, should your money be in stocks? Many hopeful retirees’ answer to that question is: I have to leave my money in stocks so I can make back what I’ve lost. My one piece of advice to those who are looking to recover losses in their 401Ks is:

Do not try to “get your money back.”

Until you’ve sold your stock, you haven’t “earned” any of that money. You had an asset that was worth more than when you bought it, and now it’s worth less. That’s the nature of assets. Just because you were up at one point at the casino, that doesn’t mean you get to take home the most you were ever worth while you were there. Ultimately if you had no strategy up until now, there’s no time like the present.

Don’t let the fact that you didn’t develop a strategy earlier keep you from developing one now. Spend some time thinking about 1.) how much money you can expose to risk, and 2.) how soon you’re going to need your money. The right strategy varies from person to person and family to family, and there are countless paths to take. If you want to play “market speculator” and wait for the market to recover, feel free; but understand the risks of this approach. If you want to ignore the stock market that burned you, this may be a valid strategy; but make sure you’re picking the strategy for the right reasons.

Make your strategy now! The next time something like this happens, you’ll be ahead of the game.

1. Wall Street Journal: Don’t Dismiss Our Dismal Savings Rate [↩]