Sunday, May 25

Week 151 - “Lifeboat Stocks” for your Rainy Day Fund

Situation: Over time, you will spend a lot of the money that is stashed in your Rainy Day fund (see Week 33 and Week 119). Life has unique ways of generating unbudgeted capital expenses, which frequently require that you choose between two means of payment. Either use credit or use equity (i.e., your Rainy Day Fund). How can you cover those “pop-up” expenses and still avoid destroying your Rainy Day Fund? Remember, a key ingredient in a Rainy Day Fund is Inflation-protected US Savings Bonds (ISBs - see Week 33). Those actually grow 20-80% faster than inflation and offer several tax advantages. However, a quarter’s worth of interest is lost if you cash out an ISB before 5 years have passed. But, let’s face it: ISBs won’t allow you to spend much without depleting your Rainy Day Fund.

A remedy is to add what we like to call “Lifeboat Stocks” (see Week 8, Week 23, Week 50 and Week 106) to your Rainy Day Fund. Those stocks are issued by companies in “defensive” industries--utilities, healthcare, and consumer staples. The reason we make that recommendation is to get a higher total return while giving up only a little safety. That allows the effects of price appreciation and dividend reinvestment to replenish the Fund and keep it growing. The trick is deciding which companies to select for investment. There aren’t many companies that grow steadily and issue a stock that holds up well during downturns (bear markets and recessions) without becoming overpriced during upturns (like the current one). We can find only 12 companies that fit the bill, and 5 of those are electric utilities (see Table). Given that the stock issued by electric utility companies has many bond-like features, you might as well allocate the non-Savings Bond part of your Rainy Day Fund to a “balanced” mutual fund that has a lot of high-quality corporate and government bonds. We recommend the Vanguard Wellesley Income Fund (VWINX, Line 20 in the Table), which is 45% stocks and 55% bonds. Its annual expense ratio is only 0.25%/yr. But you’ll need to make an initial investment of $3,000 to get into the fund; then you can add as little as $100 at a time. So, a combination of 50% ISBs and 50% VWINX is a cheap and convenient way to have a continuously useful Rainy Day Fund.

But many of you want to invest in stocks because they’re interesting and offer a way to beat inflation and taxes, as long as you keep your transaction costs low and reinvest dividends. So, you’ll want to know how we picked the 12 stocks in the Table. Firstly, they had to have very good S&P credit ratings and be Dividend Achievers (S&P’s name for companies that have raised their dividends annually for 10 or more yrs). More importantly, they had to perform better than our benchmark (The Vanguard Balanced Index Fund, VBINX) over both the long term (10+ yrs) and short term (5 yrs) without losing as much as VBINX did during the 18-month Lehman Panic, which was 28%. But we bend those rules a little if there is outperformance in another area, like volatility (5-yr Beta) or valuation (P/E). Red highlights are used in the Table to denote underperformance relative to VBINX.

Bottom Line: A Rainy Day Fund won’t be of much use to you unless it includes stocks.

Risk Rating: 2.

Full Disclosure: For my Rainy Day Fund, I dollar-average into ISBs, WMT, JNJ, and NEE. It also contains shares of PEP and GIS, as well as standard US Savings Bonds--EESBs, which the US Treasury guarantee to at least double your money if you hold them for 20 yrs (total return = 3.5%/yr).

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