Tuesday, June 19, 2007

The emergency fund

I've been reading a lot of personal finance blogs over the past few weeks and one of the most common recommendations is to establish an emergency fund. I don't have an emergency fund so I've been getting a little worried about it since I've seen how important it is to others.

On the other hand, I don't fully understand them yet. Most people seem to keep their emergency fund in a savings account, which is one of those "lessons from dad's generation" that I want to avoid. Savings accounts exist to make banks richer after all. If you get one of those high-interest saving accounts, things are a bit better... but still, your money is making more for the banks than for you.

I was thinking today on my drive home from work about what to do. One thought was to keep my emergency fund in the form of bonds in my stock account. Not even bonds, but a bond ETF like AGG or SHY. These funds invest in bonds so they're very very stable. If you look at AGG's chart, you'll see it's varied only a few percent in the last 5 years. In the meantime, it returns a 4.78% dividend, divided into monthly payments. This is better than most savings accounts, except the high-interest ones that can have 5% or even 5.05% (the highest I've seen). So why not do that? Well, the biggest advantage of having it in your stock trading account is equity. It's like a big chunk of gold sitting in your account giving it weight. One day you'll say, gee I want to buy a few shares of XYZ and hold onto them for a few days -- but I have no money! No problem, you can use margin to buy them, and the margin will be secured by your bonds.

An even better strategy is to say, ok I have $2000 in my bonds, so I'll get about $100 interest this year. Therefore I'll buy $100 of options in XYZ! Downside: you make nothing in interest (about the same as keeping your emergency fund in a major bank... I'm looking at you Wachovia!). Upside: you'll make more than 5% overall, maybe significantly more. That's why options are cool, if you use them responsibly. They let you limit your downside (you can only lose your small investment) while having an unlimited upside. Because of the massively high leverage that options provide, combining them with a backbone of bond funds for guaranteed income means that your account will basically never *lose* money but will generally do much better than 5%.

I've been reading about options for a while but have never actually bought or sold them. I am very excited about using that strategy, however.

If an emergency comes up (which should be very rare) you can get out of the bond fund pretty quickly since it's traded on the stock exchange (yay ETFs). From there, a lot of brokerages let you write checks against your account; some even have debit cards. To me, it's no more trouble than going to the bank in person to withdraw, or transferring your emergency fund from the savings account to your checking account online.

I don't think it's the accessibility that defines the emergency fund, but rather the guarantee of availability, which I think this strategy provides adequately.


JonathanRaleigh said...

For my "emergency fund" I use my sharebuilder money market account. When the time comes that I HAVE to have the money I can just easily transfer it. it earns about 4.48%

The thing about putting it in a bonds fund is that you'll have to pay a commission to buy and sell. Right? Thats what I'm thinking, but I'm not sure because I've never tried it, but I just figure since its and traded fund you would.

If you had $1k in your bond fund and need it to pay for repairs on your care and had to get it all you would pay between 3-4 months interest for commissions (assuming commission is $16)

Just my opinion.

Jon said...

Sharebuilder has a great interest rate. You're right about commissions, too, at least with ETFs. I've never bought bonds directly either so I'm not sure how that would work.

Maybe it's not such a good idea with a small fund... although on the blogs I've read, the suggested amount ranges from $1k like you said to "a full year's salary"! One pretty common suggestion is 2 to 3 months' expenses, or even 2 to 3 months' income. I don't have nearly enough money to dedicate that much to an emergency fund right now but for people who do, the commissions wouldn't be as big of a bite.

Also, how often do you plan on using the fund? If it's a yearly event with a small fund, then I think you're right, but if it's a few years then you'd have to weight the benefits carefully.

Another thing to consider, if you have a margin account, is that you don't necessarily need to sell your bonds to get the money. If your margin rate is 10.5% (pretty common for small accounts... big accounts can get even less), and your bonds earn 5%, then borrowing against your bonds is like a 5.5% loan, which isn't too bad. So if you need quick cash and you're able to pay it back within a few months, that could be a good option.

JonathanRaleigh said...

I like the idea of having the option to borrow on margin. :D