Category Archives: Investing

Is An All Cash Emergency Fund Stupid? Academics Say Yes!

 Cash Emergency FundSeptember’s Journal of Financial Planning has a controversial article about emergency cash funds.  Titled “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” the paper argues that a 6-month cash emergency fund comes with an “exorbitant opportunity cost” resulting in lower levels of wealth at retirement.

It’s become a sort of dictum that you should save at least 3-6 months of monthly expenses in case of emergencies. It’s the kind of advice people instinctively agree with and follow. The authors tear down this cornerstone of financial prudence and provide an impressive argument for a change in thinking.

First Things First

The authors begin their argument by invoking utility theory, which simply states investors should seek to maximize returns while minimizing volatility. Too often investors use “mental accounting” and see their wealth in buckets when they should be focused on the total portfolio. If for example they complete a risk tolerance quiz and they are shown to have a high-risk tolerance then they should apply a similar level of risk to their emergency fund.

The authors do add some important caveats. A more aggressive emergency fund should only apply to people in the “accumulation phase” of wealth building rather than those in retirement.

Secondly, it should apply to “more affluent” clients of financial advisors rather than the average Joe. I accept the first caveat but I feel the second is a little strict. Their analysis and insight can apply to people further down the income scale.

Before jumping into the reasons why an all cash emergency fund might be sub-optimal it’s necessary to state its purpose. The authors see emergency funds as having two main goals. Protect against “income shocks” (unemployment) and savings for future consumption. It is with this definition that they question what has become commonplace financial planning.

1. Insurance – The authors point to the myriad of insurance products that can protect people from income shocks. We have income protection insurance, incapacity insurance, mortgage protection insurance and many others that would soften the blow of any unemployment period. The risk of loosing a job and being unable to survive is slim given the range of products that exist.

2. Diversification – For those who want to invest their emergency fund in more volatile assets they can diversify some of their risk and see greatly improved returns. People tend to invest emergency funds in cash because it’s safe however, that does not mean investing in stocks for example is unsafe. The risk can be reduced.

3. Human Capital – The authors suggest that investors neglect to evaluate their human capital when making investment decisions. For example a college professor is likely to have a high degree of job security and could probably afford to take more risk with their emergency fund than a stockbroker. Certain jobs are safer and certain people are highly employable. If you fit into one of these categories then a more aggressive emergency fund could be appropriate to maximize utility.

4. MAIN ARGUMENT – Opportunity Cost – To conclude their argument the authors created a model to calculate how much wealth a person would loose by not investing their emergency funds into stocks and bonds. They took an example of someone working from age 25 to 65 assuming average levels of unemployment. Stock and bond data ran from 1926 to 2011.

The results were staggering.  If an individual invested their 6-month emergency fund in a 60/40 portfolio instead of cash they could expect to have up to 20% extra in retirement savings. This clearly calls into question the requirement for a 6-month emergency cash fund given the assumption you want to maximize returns. The question investors need to ask themselves is whether the peace of mind of having cash in the bank, is worth loosing up to 20% of potential retirement savings.

Emergency Cash

Concluding Thoughts

The authors make a compelling argument against the 6-month emergency cash fund. However, beyond a client’s risk tolerance and the possible use of a risk tolerance questionnaire they didn’t look at other risks. Notably, counter party risk (getting access to your insurance or investment from a provider).

Utility theory might tell us what is optimal but it fails to account for the behavioral psychology aspect of the human mind when it comes to investing. Regardless, the authors have made a compelling argument and if they can’t get investors to entirely drop the 6-month emergency cash fund I am sure more than a few would consider switching to three months.

3 Step Checklist – Should my clients invest in Bitcoin?

BitcoinAs the hype around Bitcoin recedes and the price finds a base at $108 from highs of $234 it’s time to take a measured look at the crypto-currency. Bitcoin exists as a reaction to the problems surrounding government issued currencies. Namely, that central banks can seemingly print money ad infinitum, debasing the value of our money.

It also exists to challenge the power of banks. The original source code for Bitcoin had a reference to a Times article titled “Chancellor Alistair Darling on brink of second bailout for banks.” Enough it seemed was enough. For a comprehensive background on Bitcoin’s origins and how it works I suggest you read a brilliant introductory article at Priceonomics blog.

Today I want to tackle whether Bitcoin could be a good investment opportunity for your clients. [FULL DISCLOSURE – I am long Bitcoin and have invested in the digital currency].

Step 1 – Your Client’s Risk Profile

At Pocket Risk we are constantly looking at the topic of risk tolerance, capacity for loss and need to invest. Fundamentally, you need to ask yourself whether your client’s risk profile matches with this kind of asset.

Statistically speaking the volatility of Bitcoin is comparable to a 50/50 stock and bond portfolio when you look at the daily closing prices going back to July 2010 (Source Bitcoincharts.com). That being said there are important caveats, such as the fact Bitcoin has only existed since January 2009 and remains to be tested in throughout different economic cycles.

Furthermore, just like there were no laws to govern the Internet in the early 90’s there are no laws that truly govern Bitcoin today. That means you and your clients have very little legal protection. There is no FSCS (Financial Services Compensation Scheme) for Bitcoin and cases of online theft do arise with no obvious recourse.

That being said Bitcoin is still considered an opportunity. Simply because we know from past experience that some of the greatest economic developments have come from places that started off as speculative wild wests (i.e. wildcatting in the oil rich American mid-west, China, the Internet and others).

Does your client need to take this kind of risk? Unlikely, but if they have a portfolio in place that is likely to take care of their future needs it could be worth using any surplus to invest in Bitcoin.

Bitcoin-ChartBitcoin Chart – June 2012-June-2013

Step 2 – Your Client’s Philosophy

There are two types of investors in Bitcoin at the moment, those driven by the ideals and those driven by greed. I could never suggest someone invest out of greed, so look to discover whether your client agrees with the Bitcoin philosophy. If anything, it might make the blow a little softer during price falls. Here are three questions to help you discover whether your client is sympathetic to Bitcoin.

A)   Are you concerned about inflation and currency devaluation?

B)   Are you concerned about the amount of control banks have over your money?

C)   Does the idea of a decentralized network of anonymous individuals working together to build an online currency intrigue you or scare you?

Step 3 – The Practicalities

If your client is comfortable with Bitcoin’s volatility, admires the ideals and is prepared for the fact that they could loose all their money overnight the next step is work out the practicalities.

Buying Bitcoins has become increasingly easy over the last few months. It wasn’t long ago that you could only store the currency on your hard drive. If your hard drive crashed, you lost all your money. Backups were essential.

You can now purchase Bitcoins without too much difficulty on online exchanges/pseudo-banks. The two most popular are MT. Gox and Coinbase. There are no fees for holding Bitcoin, only a transaction fee for purchase (typically 1%). I am not aware of any method of managing Bitcoins through a wrap platform so a client would likely need to sign up for themselves. This is not practical but expected given Bitcoin it is a recent invention.

Finally, the tax implications for Bitcoin are yet to be established. The working assumption is that Bitcoin is a store of value similar to gold or other commodities and will be taxed as capital gains.

Concluding Thoughts

Investing in Bitcoin is a high-risk strategy. I would only invest if your clients are prepared to loose all of their investment over night. If they are not prepared for this kind of risk, then I would avoid this opportunity and move on to the next.