Financial Pyramids

“I've got all the money I'll ever need; if I die by four O'clock” - Henry Youngman

During yesterday’s blog I was tempted to talk more about our emergency fund but didn’t want to get too far off track from CD ladders. So this blog will be dedicated to my family’s theory for investing. With the recent Madoff ponzi-scheme fraud you hear of people who put their entire savings into one Hedge fund and lost everything. This violates the second law of investing:

2. NEVER put all your money in one basket

No matter if it were your mattress, a bank, a CD, a great stock or a hedge fund, DO NOT put all your money in one place. Smart thieves will check for money in your mattress; your bank might fail; your hedge might be a fraud. But unless you are the world’s most unlucky person, it is unlikely that all these will happen together to wipe out everything. Diversify so a loss in one place is buffered by money kept elsewhere.

Side note: while mutual funds are a great way to diversify amongst stocks, you are still invested in the stock market itself and when it tanks (like now) nearly all stocks go down. It is safer to spread money across multiple markets like bonds and foreign stocks as well as domestic stocks. It is also important to keep in mind that your mutual funds may be less diversified than you think. You can buy 20 different funds but discover that they all invest in the same “top” 20 stocks. Or you may discover that your mutual funds are heavily tilted toward some favored sector. My funds were “bank heavy”, i.e. overly invested in the stocks of banks when the bank crisis hit and wiped out value; e.g. Citibank has fallen from $50 per share to $1. To find out how diversified you are, check out Vanguard.com. You fill out an online form with your mutual fund accounts and their Portfolio X-Ray will look inside the funds to tell you what stocks and market sectors you are weighted in.

So if Diversify is Rule #2, what is the First Law of Investing? It is:

1. NEVER invest what you can NOT afford to lose

The mathematical “laws” of the marketplace reward higher rates for higher risk. When you chase high rates you are “accepting” a greater risk of a total wipe out. We are in the current financial crisis because banks and investors thought they had found an exception to the rule, Collateralized Mortgage Obligations (CMOs). The high paying CMO “tranches” bundled together the mortgage payments of high default-risk homes. The risk of mortgage default was waved away in two ways:

• With many homes bundled together it was unlikely that the majority of them would all default at the same time. (This proved false when the housing bubble burst).
  
• The mortgage payments were insured by AIG. If homes defaulted, AIG would bail out the CMO funds. (The default crisis proved so big that AIG ran out of money. They lost $64 BILLION (with a B) last quarter and the US government has given them over $150 Billion to keep AIG out of bankruptcy.)

There is no magical investment. High rate = high risk.

BOTTOM LINE

So are high rates always bad? No.
No one will ever get wealthy with rates paid by banks and CDs. In times of high inflation your money actually loses value in the bank if the interest rate is below the inflation rate.

So what do I do? I diversify and build a financial security net before investing. Keep in mind that I am not a financial planner and that this is just my family policy. We establish investment tiers, a financial pyramid with a firm (but low rate) foundation to a high and risky (but great rates) peak.

• First we keep enough money in our checking account to pay the month’s bills. Any money in excess of this goes to our emergency fund savings account, which pays some interest (but not much).
• The emergency fund is capped at a value that would keep us afloat for about 3-6 months. When this grows too big we move the money to CDs or investment funds.
• The CDs are our buffer to last us for a few years of bill paying. The rates are OK and the money is safe. The size of the buffer should vary based upon circumstances. Since I’m employed in a good job and retirement is far way, our buffer is about 5 years. When retirement gets near, I will start moving money out of risky investments and into safe CDs or equivalents.
• Lastly, after we’ve filled out the immediate, short-term, and long-term tiers, anything left over is invested in the markets for a long-term return. This is the tier that has taken a huge hit this past year. Our near-term security is safe but I’ll have to rethink dreams of early retirement.