By George M. Hiller, JD, LLM, MBA, CFP®
Investing For Emergency Funds and Other “Don’t Risk the Principal” Accounts
Most people need an emergency fund of ready cash reserves quickly available in the event of financial emergencies, unexpected needs or opportunities. A general rule of thumb often employed by financial advisors is that individuals should plan for and set aside an emergency fund equivalent to three months to six months worth of living expenses. For example, consider the case of a family whose annual living expenses amount to $60,000 per year or $5,000 per month. Three to six months worth of living expenses would be $15,000 to $30,000. Based on these figures it would be reasonabe for that family to plan to have $15,000 to $30,000 set aside in an emergency fund. Then in the event of a financial emergency such as loss of job, disability, or unexpected medical bills, there exists a ready source of funds to meet the emergency. This emergency fund might also be used for unexpected needs or opportunities that arise from time to time.
An emergency fund should be readily convertible to cash. This means that the emergency fund should be invested in very liquid, very safe investments such as a money market fund, interest bearing checking or savings account or in some cases a short-term bond fund. The point is that the investment should be such that the cash is there when you need it and is either not subject to fluctuation of principal or such risk of loss is very small.
In addition to a relatively risk free emergency fund, many people want high levels of safety on part or all of their monies and investments. They may have a money temperament that is very risk averse, or they may not feel comfortable with the stock market or the state of the domestic or world economy, or their personal financial circumstances may dictate that they not assume significant risk of loss on their investments. You may be one of these people that requires safety and yet would still like to earn a better return consistent with your need for safety.
Most people need to assume some level of risk on their investment capital in order to be able to achieve their long-term financial goals. This means that the great majority of investors need to consider stocks, bonds, mutual funds, real estate and other areas of investment as part of their overall investment plan. There is a large body of academic evidence that suggests that it is wise to assume some level of risk on diversified long-term investment capital and reasonable to expect a higher level of long-term investment return than risk free investments can offer. Even so, many people may want at least a part of their investment capital in relatively risk free or very low risk investments.
There are no risk free investments. Something could go wrong with any type of investment and a loss of part or all of investment capital could occur. However, there are certain investments where the level of risk is so low that for practical purposes we call these investments risk free. Among such risk free investments are the following: most money market funds, Federal Deposit Insurance Corp. (FDIC) insured interest bearing checking and savings accounts and bank certificates of deposit, and certain U. S. Treasury securities backed by the full faith and credit of the U.S. Government.
Most money market funds and interest bearing checking and savings accounts currently pay less than 1 percent interest per year. For example, a typical money market fund might pay 0.30% interest on the balance in the account. However, at least one FDIC insured bank in the metro-Atlanta area offers 2.40% on balances of $25,000 or more on what it calls an investment checking account. This is 8 times or 800% more interest paid than available on a typical money market fund or interest bearing checking account. For those with less than $25,000 there are other banks including nationally known financial institutions offering rates in the area of 2% for your money. In general banks are required to be FDIC insured against loss up to $100,000 per account. Make sure you have this guaranty.
Another form of very low risk investment is bank certificates of deposit held to maturity. Average yields can be enhanced by building a laddered portfolio of bank certificates of deposit. For example, consider the following portfolio of bank certificates of deposit identified by Bank Rate Monitor as of April 21, 2004 on its web site www.bankrate.com.
Bank Certificates of Deposit Portfolio
|Description||APY (Annual Precent Yield)|
Assuming equal investments in each CD, the weighted average annual percentage yield on the above bank CD portfolio is 3.27%. The rates quoted above are for regular CDs (not jumbo CDs) and are not the highest rates quoted by Bank Rate Monitor.
Still another type of very low risk investment is short to intermediate term U. S. Treasury Securities held to maturity. Treasury securities will typically pay somewhat less than the top paying bank certificates of deposit for the same maturities, but Treasury securities are not subject to state income tax. In addition, Treasury securities are backed by the full faith and credit of the U. S. Government, so there is no default risk. Consider the following Treasury portfolio based upon current yields as of April 21, 2004 obtained from Bloomberg on its web site www.bloomberg.com.
U.S. Treasury Notes Portfolio
|2-Year Treasury Note||2.16%|
|3-Year Treasury Note||2.62%|
|5-Year Treasury Note||3.50%|
The weighted average yield on the above portfolio is 2.76%. These U. S. Treasury investments would arguably be safer than bank money market funds or bank certificates of deposit that are subject to FDIC guaranty limitations.
The next step would be to consider mixing U. S. Treasury notes with bank certificates of deposit (CDs). If you interleaved the Treasury portfolio with the CD portfolio so that increments matured every 6 to 12 months you would have a very safe portfolio that might look something like this:
Combined Portfolio of Treasury Notes and CDs
|$100,000||2-Year Treasury Note||2.16%|
|$100,000||3-Year Treasury Note||2.62%|
|$100,000||5-Year Treasury Note||3.50%|
The weighted average yield on this very safe portfolio of Treasury notes and CDs is 2.77%. Assuming that a portfolio of Treasury Notes and CDs increased yield on safe money from 0.30% in a typical money market fund to a new yield of 2.77% in a laddered treasury notes and CDs portfolio, then a $600,000 portfolio would have enhanced income of $16,620 per year (instead of $1,800 per year) or $74,100 in additional income over 5 years with very safe investments.
The concepts of enhanced investment returns on very safe investments discussed in this article are applicable to all but the smallest accounts. With a little bit of effort and research you can make your safe money work much harder for you while still being safe.
George M. Hiller, JD, LLM, MBA, CFP is the founder and president of the George M. Hiller Companies, LLC, a leading fee-only investment management, tax, estate and financial planning firm based in Atlanta, Georgia. Mr. Hiller is a member of the Christian Financial Professionals Network.