Sunday, October 13

Week 119 - $100/wk for a Rainy Day Fund

Situation: You'd like to sleep nights, so we suggest setting up a Rainy Day Fund, which we define as easily accessible money that doesn’t lose its value over time. That’s a hedging concept taken to the extreme, meaning that a perfect hedge will neither gain nor lose value in any market environment. In times past, we would have recommended using an FDIC-insured savings account for that purpose because it guaranteed your principal and paid enough interest to cover taxes and inflation. But currently we are reminded that the Federal Reserve has at times engaged in “financial repression” to prevent a 30s-style depression (see Week 76 and see Week 79). They did so after World War II, and again after the Lehman Panic. By “financial repression” we mean intervention by a central bank to drive down interest rates by "printing money" which allows investment to resume, preventing delation. The net result of this type of policy is that  savings accounts lose money to inflation and taxes but the National Debt grows at a slower pace. Your Rainy Day Fund has to make enough money to absorb those losses! That means you'll have to accept some degree of risk. Inflation-protected US savings bonds and 10-yr Treasury Notes have zero transaction costs and zero inflation risk but (because of financial repression) don’t always pay enough interest to cover Federal taxes (state and municipal taxes are not applicable). Now you see why your Rainy Day Fund will need to contain a few "hedge" stocks (see Week 117).

There is one way to avoid resorting to hedge stocks, which is to invest in a short-to-intermediate term, investment-grade bond index. The least expensive one requires a minimum initial investment of $3000: the Vanguard Intermediate-Term Bond Index (VBIIX in the Table). You can dollar-average small amounts into that fund each month without paying transaction costs, and it has a very low expense ratio of 0.2%. It will gain only half as much value in a credit crisis as a 10-yr Treasury Note (Column D in the Table) but going forward it will pay out enough extra interest that you’ll have a 95% chance of being able to cover costs from both inflation and taxes. There is, however, the ever-present problem found with holding any bond fund (even a short-term fund). If interest rates were to increase by more than 2-3%/yr and you were to need that money for early retirement, you might get back less than you’d originally invested. That is because, in a rising interest rate environment, the bonds previously purchased by the fund’s managers will lose value, i.e., those bonds no longer have a competitive interest rate. Whereas, if you hold US Treasury Notes or Savings Bonds you can count on getting back your original investment whenever you need it. So we’re back where we started: you’ll need to take the risk of holding a few hedge stocks to have a good chance of making enough money to cover transaction costs, inflation, and taxes.

Academic surveys show that for the average investor risk is related to poorly thought-out decisions, i.e., one-off portfolio tweaks that are made as a knee-jerk response to current market activity. In other words, we’re only human. We lose by not having a plan and sticking to it. The plan that we recommend is to dollar-average a fixed amount of money into a rarely changing list of stocks and bonds on a monthly or quarterly basis. I think of it as setting aside $100 a week (see my Rainy Day Fund at the top of the Table; data are current through 10/11/13). The main takeaway is in Column E of the Table, where you can see that long-term Finance Value for our Rainy Day Fund is much better than for the best-managed bond-heavy balanced fund (VWINX), 4.4% vs. -8.8%. This is consistent with the difference in 5-yr Betas seen in Column I (0.36 vs. 0.56). This is a remarkable testimony to hedge stocks, given that those compose 75% of the Rainy Day Fund. VWINX is less safe (Column D) even though it is composed 60% of bonds. Nonetheless, VWINX represents convenient, one-stop shopping. And, you’ll make more money in the long run since VWINX is a good hedge fund. How good? It has only lost money in 3 of the last 20 years (1994, 1999, and 2008 when it lost 9.62%) while returning almost as much to investors as the Vanguard 500 Index Fund (VFINX): 8%/yr vs. 8.7%/yr.

The type of Rainy Day Fund shown in the Table can be set up at low cost by using a dividend reinvestment plan (DRIP) for monthly additions to each stock (at computershare) and quarterly purchases of Savings Bonds or Treasury Notes (at treasurydirect). Either way, the money is electronically swept from your checking account, and this can be scheduled to occur automatically for DRIPs. For Treasury issues, you’ll have to go to the website each time.

What's the catch? Two possible problems arise: 1) You'll need to pick 4 or more hedge stocks because even the most stable companies with the greatest brands face challenges that take time to overcome. You can’t “game” these events, since company insiders are likely to be the only ones to know when a serious challenge is about to generate an article in the business press that will hammer the stock. They can’t benefit from having that insider knowledge: the SEC won’t let them sell their own stock at such times because that becomes public information and might cause a run on the stock. 2) Taxes on DRIP sales require documentation of “cost basis.” That means you’ll have to fill in 16 lines of a spreadsheet for each year you’ve owned a stock and reinvested quarterly dividends.

So how do DRIPs and inflation-protected Treasury Notes save me money? Academic studies show that 2-4% of the average investor’s money will go toward commissions, advisory fees, and other trading costs. My cost for the $5200 I invest each year comes to $58 or 1.12% (Column N in the Table). Relative to net asset value (NAV), those trading costs will fall as the years go by and my NAV grows through price appreciation, annual dividend increases, and compound interest (i.e., stocks pay dividends on dividends, and Savings Bonds pay interest on interest).

Bottom Line: If you follow my logic, you’ll see that it boils down to placing an aggregate investment on automatic pilot at low cost. The trick is to hold stock in companies with strong corporate cultures that have developed over many years of learning how to produce superior returns on a consistent basis. You and I only need to have enough patience and fortitude to keep benefitting from their accomplishments. Bull and bear markets won’t matter as long as we stay the course and don’t follow the crowd.

Risk Rating: 3

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