AskDong

MoneyMonk posted the other day about how boring personal finances can become. I know exactly what she’s talking about. I’m sure after reading about Leona Helmsley’s dog, David Bach is penning “Smart Pets Finish Rich.”

I like reading personal finance magazines such as Kiplingers, Money, and SmartMoney. I like reading personal finance books. However, most of time reading them gives me a sense of deja vu. So what do you do when you still want to know more about personal finance but the typical article bores you to tears? The problem isn’t that there isn’t more to learn, but that most personal finance books and articles are often written for a broader and new audience.

I believe that for many people personal finance knowledge grows in pattern that might follow something like this:

If you’re bored with personal finance magazines, you’re most likely at the “What’s Next?” stage. I think I’m there myself. This doesn’t imply I’m out of the rate race. I’m not. It just means I have a plan, and generally know what I need to do, and want make sure I execute as effectively as possible.  I get the most of my 401K plan.  I contribute to my IRA account.  I save and invest outside retirment accounts.  Getting out of the rat race doesn’t even imply that you hate your job, but rather that you truly want to work for the work itself. A job should not be a tether. As you can see from the diagram above, underlying all these steps is the the notion of valuing and maximizing time. I firmly believe personal finance is more about time than it is about money. I also know I still have a lot to learn about both money and time.

So what is next? I think it really depends on the individual. Since my educational background is in Economics, I probably lean toward economic and investment topics, but for other people it could be driven more by environmental concerns. Some people approach personal finance from desire for self sufficiency. This desire can manifest itself gardening, or car and home repair. Last but certainly not least is the desire to give back. When you know how to have plenty, there should ideally be strong impules to want to share the wealth so to speak.

So if you’re bored with the generics of personal finance, here are some related subjects off the top of my head I would suggest looking into.

• Economics
• Stock Investing - Learn how to value companies, Understanding Derivatives
• Real Estate Investing - Landlording, Home Repair
• Green Technology
• Charities - Learn about local non-profit organization and how to get involved

A few weeks ago, I detailed how I was moving most of savings into Treasury Bills. The last couple weeks a have been an excellent lesson on the risks and potential benefits of a more active cash management strategy. But before I get into what’s happened with my monies, I want give a very simple overview of interest rates and how the interest rates for different savings instruments such as money market fund, CDs, etc are affected by what’s happening in the debt market.

Any fixed income type of investment such as a CD or Bond or even savings and money market account are tied to the debt markets. The debt market is where the government and corporations go to borrow. Bond investments are directly tied to these markets as bonds prices are set by what people are willing to buy and sell these obligations at. The lower the price, the higher the effective interest rate. For example if a bond that sells for $1000 pays $100 annually in interest, it’s basically paying 10% interest. Let’s say for whatever reason people are only willing to buy that bond now for $800. The effective interest is now 100/800 or 12.5%. While we might not think of CD investments, savings accounts, and money markets as part of this market - they are. Banks invest in bonds and other debt obligations, take a cut from the top, and pay interest to our deposit accounts.

So what affects the interest rate on any particular piece of debt? The overall economy, and credit risk. Borrowers who are more likely to default pay higher rates to offset the higher chance of default. The other piece, the economy, is more complicated. One piece is the expectation on inflation. If inflation is higher interest rates need to be higher not only get over the inflation hurdle but people expect the Federal Reserve will raise interest rates to combat inflation. For the same reason when economy is stagnant the market will anticipate lower interest rates from the Fed even before the Fed lowers them. The Fed can effectively set short term interest rates by fiat, and most of the time longer term rates will follow. Of course in truth, it’s all much more complicated, and entire books can be devoted to the subject.

So what happened to my treasury investments? I actually got pretty lucky. As you can see on the graph above the interest rate for the 4 week treasury T-Bill peaked on August 2nd. As an individual investor when I participate in the treasury auction, I have no say in what price I buy, and receive whatever rate the auction clears at. Luckily, I decided to buy on August 2nd and August 9th, the recent peak. The credit market preceded to melt down later in the month. The spread between good borrowers and bad borrowers increased dramatically. It became much harder to borrow money. The Fed responded to problem by 1) injecting more money into the system by buying illiquid debt backed by subprime mortgages 2) subsequently lowering the discount rate from 6.25% to 5.75% (this is the rate that Fed lends money to banks overnight). The actions by the Fed, and fear in the market has effectively lowered the interest rate that secure instruments such as 4 week t-bills pay.

While I was lucky in my timing, one of the risks in investing in T-Bills is that the interest rate on them can move quickly. I could’ve easily thought I would be getting 5% and only end up 4.5%. The interest rates in deposits at the ING and HSBC tend to be a little more stable given that they track the Fed Fund rate (another interest rate that the Fed sets) which changes but is less subject to short term fluctuations. One way to avoid short term volatility is investing in longer term treasury bills such as 26 week bills, but then money is locked up for a longer time. Also another way to take advantage of sudden movements is to lock in CD rates. The day the Fed lowered the discount rate, I locked in a 12 month CD at ING at 5.35%. Given that rates offered CDs will track prevailing interest rates, ING has since lowered the rate offered to 5.15% as would be expected.

Recently there have been spate of articles on personal finance blogs dealing how to deal with the volatility in the market. Trent at The Simple Dollar had a lively debate on his hands when he suggested that someone should not invest in something (stocks) in it makes them uncomfortable. Nickel makes a solid argument to ignore the market volatility and stay invested.

While I am fairly risk adverse and generally support a passive index fund approach toward investing, I tend to advocate what is commonly thought of as more risk than the average personal finance blogger. There are plenty of blogs in the personal finance space dedicated toward investing such as Moomin Valley. However most blogs that really focus on personal finance, and almost all the really quality personal finance blogs preach a passive index investing style. Do I disagree with this style? Hardly. I think most people should listen to the cantankerous curmudgeon who is John Bogle, and adopt the Bogle approach. That said, I believe many of us can afford more risk, and not only that but proper deviation from the all index fund, dollar cost averaging approach towards investing is inherently not more risky. Do I think most people are qualified or have the time to actively invest? No. I remain wholly unconvinced if I have the aptitude or the time myself.

If you ever hear what John Bogle has to say about investing, his whole mantra is about reducing transaction costs. The man knows what he’s talking about, and that is truly the only advantage index funds have versus individual stocks and actively managed funds. I completely buy into that, and think it’s a great reason to adopt a basic index fund strategy. The problem is often times when people argue for passive index fund investing, the arguments imply that somehow picking individual stocks and or trying to time the market is more risky. A poorly diversified portfolio of individual stocks is more risky - that is true. However even with 30 stock holdings it’s possible to construct a fairly well diversified portfolio that should have volatility similar to an index such as the S&P 500. Hell, the Dow Jones Industrial Average is only 30 stocks, but then again it’s really not much of an index for the modern era.

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Opportunity cost, and sunk cost are two terms from economics that have become an accepted part of the mainstream vocabulary. Generally speaking, most people understand what each means, but what the economic underpinning of both terms? Understaning both of these of costs and how they should or should not apply to our decision making leads to better financial decisions.

Opportunity Cost
The concept of opportunity cost underpins much of what is considered microeconomics. It’s one of the most important concepts there is. Opportunity cost is the cost incurred by doing something because it removes the option of doing something else. The best example and simplest understood example of opportunity cost is how it applies to education. For instance if I were to choose to attend graduate school for y dollars, the cost is not only y dollars, but also x dollars in forgone salary. Opportunity costs apply to any situation in which there is any kind of choice. The cost may be monetary, or it could be just as likely time or experiential. When we pick entree from a menu we experience both accounting and opportunity cost acutely. The accounting cost is the price of the entree, and the opportunity cost is not having being able to eat the next best dish (assuming that we can only eat one entree). The opportunity cost is not opportunity of eating all the items on the menu, only the best alternative. An economically minded person understands that the true economic cost of deciding upon one specific entree is both the price of the entree and foregone experience of eating the other dish. Thinking about opportunity costs leads to better decision making.

Sunk Cost
Sunk concept is in some ways the mental flip side of opportunity cost. Whereas we often forget or ignore opportunity cost to our detriment, we don’t ignore sunk costs when we should. Sunk costs are the cost already incurred that cannot be recouped. Sunk costs do not represent any value, they purely represent the money, time and effort already put into a cause. Keeping sunk costs in mind generally leads to good money being thrown after bad. Another example of sunk costs can be seen in the commercials supporting the war in Iraq. While I personally don’t agree with the current war, I believe it’s perfectly rational to disagree with me on that point. However, my inner economist cringes at the one commercial I’ve seen which features a brave veteran who lost his legs in Iraq. The commercial ends by saying something like, “don’t let my sacrifice be made in vain.” Any reasonable economist understands rational decisions going forward should not be based on costs incurred in the past, sunk costs. These commercials are effectively pitching the consideration of sunk cost. The pitch to economist must be made on the benefits outweighing the cost going forward. If an economist were directing the commercial, the pitch would identify the opportunity cost of staying Iraq vs leaving which are innumerable - stability in the middle east, lower terrorism, increase American credibility, etc. Regardless of where one stands on the issue, arguments should at least be made on sound and rational thinking. Consideration of sunk costs is irrational.

The more common (and much less political) example of sunk cost is the cost of a movie ticket. Once the the ticket has been paid for it’s a sunk cost, and should not be heeded in the decision to actually watch a movie. So if you’re watching a movie, and it’s bad there’s little reason for you to stay. The price of the ticket is sunk, and staying and watching the movie has an opportunity cost of watching another movie or doing something else. If watching the movie is not producing value, the cost of watching (the opportunity cost) should be the only consideration and not the fact that one’s already paid $10 for a ticket. Yet, how many of us will continue watching a bad movie? Or even worse, stay in a investment because of what we’ve already paid?

This is not a post about why anyone should be running from the equity (or debt) markets. I’m firm a believer that most individuals should be as close to fully invested in the markets at all times. Market timing is awfully hard to accomplish. Nor do I believe that anyone needs more than 3 months in emergency fund assuming there are other sources to be tapped like equity lines of credit, maturing CDs, etc. Yet contrary to all those beliefs above, I believe many individuals would greatly benefit from having a cash stash.

There’s nothing else like cash. Not just cold hard cash in the form of bills and coins, but cash in a savings accounts, money market funds, checking accounts - basically what is defined as the M2 money supply less CDs. Unlike other investments which can be both illiquid and are generally invested with a time frame in mind, cash is definitionally liquid, and has no time constraints upon it.

However, the virtue of holding cash is not just having cash itself, but the opportunities that having cash begets. How many times have any of us said, “If I only had the money, I would’ve made fortune in X.’ X might be great real estate purchase. X could be an incredible stock idea. X could have been put into helping a friend start up a business. I don’t believe in get rich quick schemes, but I also believe that many successful individuals take calculated risk with the right business opportunities. In order to take those financial risk you either need to have the cash or borrow it. Unlike corporations, individuals cannot easily go out into the debt market and borrow money. The best option we have is to borrow via home equity. Personal loans generally have onerous terms that make them unpalatable for the purpose taking risks. Even if I did have good access to funds via a home equity line, I would not want to be 100% leveraged in a risk taking venture. I would be more comfortable putting cash to work and then using some leverage.

The question is how much cash is appropriate? Warren Buffet holds over 50 billion in cash at Berkshire Hathaway for potential investments. This is nearly 1/4 of the company’s market capitalization. 25 percent would be very large percentage of someones’ networth to be held in cash. I believe for most people the percentage held in cash should be much lower, and generally slides up as someones’ networth increases. Cash in some ways is the investment you make after you’ve made all your other investments. I can’t imagine most people would want to target more than 25% in cash holdings, but many people would be well served by being 10-20% cash. However, the most important part of being in cash is understanding that you are the type of person who wants and plans on taking risk with that cash.