The SUV (60%-40% fixed income / 40%-50% equity)

The SUV is useful and versatile. This is the type of vehicle that allows you to benefit from more stability on the road during storms while helping you to drive fast enough in beautifule weather. This asset allocation is usually qualified as a “balanced asset allocation”. You are basically looking to a half and half (fixed income / equity) structure.

- This is the most common type of investor according to investment guide: the balanced profile. While reaching 50% in both fixed income and equity, you have plenty of managed portfolios for your need. Select one that is well diversified in terms of geography and sectors of the economy (different industries) and that is low on MERs (management fees).

- If you are diligent in your research, you will be able to find package ETFs (exchange traded funds) that follow indices. Therefore, your stock portfolio won’t cost much in terms of Management fees and will track several indices (bonds, US market, Canadian market, International market and emerging markets for example).

- Mortgage funds, privileged shares’ funds or REITs can be added for the fixed income portion (I would avoid dividend funds as they are often sold as fixed income funds but they are still contain stocks for the most part).

The BMW M3 (30%-20% fixed income / 70%-80% equity)

If you have ever tried to race against a BMW M3, you probably realized that you need a pretty fast car to win! The M3 is very stable at high speeds and is not afraid to take a curve at 80 mph. However, if you push it too much, you can surely end-up in the ditch!

- Now, you are joining the most aggressive investors. Remember that growth portfolios reached almost -25% in 2008. If you think you can handle it, you can try managed portfolios. They offer a great investing opportunity as they rebalance your portfolio every 6 months to make sure that you keep the same asset allocation.

- However, I would lean more towards a combination of index funds, ETFs, money market funds (for liquidity) and bond funds.

- If you think you can handle the pressure, dividend funds or preferred shares funds could be a good alternative for your fixed income part. They will provide higher fluctuations than bonds or money market funds but they could provide a better return over the long run.

The Formula 1 (10%-0% fixed income / 90%-100% equity)

If you are in this category of investors, it means that you are married to the market (for better and for worse!). The formula 1 is the fastest car but don’t count on it to go through road blocks. High speed, but high fluctuations are part of the package as well!

- The only fixed income held in your investment portfolio should be money market funds for liquidity. This allows protecting your cash from inflation and you can withdraw this money at anytime to make your next investment move.

- If you have a systematic investment mindset, I suggest you purchase index funds with it. ETFs have a lower MERs (fees) but they cannot be bought on a monthly basis (without including the transaction fees). Be careful with index funds. Try to get general index (like index linked to S&P 500 or international markets) at first.

- If you prefer to trade directly, I suggest you open a brokerage account and get some trading courses (You can try these 10 trading lessons for free (no commitment or hidden subscription fees) from INO).

Author: Mike.

Image source:Jennifer Phoon, The Pug Father , A Geek Mom

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According to your investor profile, you might want to take a different route for investing. Forget what your neighbour or your brother-in-law told you about “the next big thing”. If they were that good, they would be calling you from their yacht in the Bahamas to give your stock tips… not over the fence while pushing their lawnmower  ;-)

In my last post about investing baby steps, I was talking about finding your investor profile. I think this step is omniimportant if you want to succeed as an investor. And succeeding doesn’t mean making millions, it does mean building a solid investment strategy that you will be able to follow that allows you to sleep well at night .

When I started to write this series, it was actually meant to be one post about a general way to approach your investment strategy. While writing it, I realized the quantity of information to consider prior to the start of your investment journey. That said, I will keep writing for this series and I won’t put all the posts in a row (imagine how boring this would be if you are already set?). So today, I am explaining investment strategies starting with beginners up to more experienced investors (in part 2).

The bulldozer (100% fixed income):

Steady as a rock, the bulldozer doesn’t go fast but it will get to destination regardless if the road is slippery or not. This is often the first type of investment you make as a beginner. If you look at 100% fixed income, you are probably withdrawing money from your investment account for retirement or planning a withdrawal though the home buyers’ or lifelong learning plan for the near future. One thing is for sure, you do not want to  risk this money regardless of the upside potential.

- Your first option is definitely looking toward high interest savings accounts (such as SmartyPig giving 2.01%). This money is available at any time and insured up to $250,000.

- Another great idea would be short term certificates of deposit if you plan on making a purchase even a bond  or CD ladder if you are about to retire or there already.

- Money market funds are another investment possibility. However you will need quite an amount (more than 100K) if you are looking for decent yields. As interest rates are at historically low levels, you are probably better off with online high interest savings accounts instead of money market funds.

The  trailer truck (80%-70% fixed income / 20%-30% equity)

Strong and steady, the tractor trailer can go long distances and go faster than the bulldozer. I like this asset allocation for investing beginners since most of your portfolio is secure, but you initiate yourself to the stock market. Therefore, you may experience market fluctuations without risking too much.

- There are already prepackaged mutual funds with bonds and stocks invested according to this allocation. This is a great start to begin your investing adventure as you don’t have to manage the portfolio yourself. However, those packaged investing solutions cost more in the form of higher management fees.

- Another solution would be to split your fixed income portion via a bond ladder and buy balanced funds (more aggressive funds) or Exchange Traded Funds (ETFs are for more experienced investors). Therefore, you would save on fees (bond and CD ladders don’t cost a thing to manage) and you will only pay management fees to a portfolio manager to trade the small stock portion. However, you must follow-up on the portfolio and rebalance it every six months to make sure you keep the same asset allocation.

So that’s it for today, next Thursday, we will explore investment suggestions for 3 other types of investors. The best stuff is yet to come !

Author: Mike.

Image source: hoyasmeg, 91RS

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Unfortunately, most parents don’t have much financial education (thx to the educational programs in  our schools!) to pass on their children. We are literally thrown out of the nest like baby birds  in the hopes that we learn how to fly before hitting the ground of a recession and get eaten by the Wall Street wolves waiting for us!

Managing a budget and paying off your debts is certainly very important. Yet, if you want to go forward financially, you should also supplement you revenues and build asset accounts by investing money. So once you have learned how to manage your budget and live within your means, it is time to start thinking about investing. This is why I am creating this investing baby steps series. Before you go read an investment guide and build a stock portfolio, you need to know who you are.

Investing Baby Steps #1: Know Who You Are

If you go meet a financial advisor, the very first thing he will talk about is your investor profile. They will give you a questionnaire (5 to 10 questions) and will determine which kind of investments is best for you according to your answers. The investor profile describes:

#1 Your Investment project:

Are you saving to buy a house?

Are you looking for a retirement plan?

Do you want to travel with this money?

Do you want to build a safety net for the darker days?

Depending on the project you chose, different investment strategies can be suggested. For example, if you think of buying a house in 3-5 years, you are better off investing most of your cash in fixed income such as bonds (70 to 80%) and the rest in the stock market. But, if you want to build a safety net and this amount needs to be accessible at all times, you are better off with money market funds or a high yield savings account such as Smartypig.

#2 Investment Horizon:

Do you plan to cash your investments in 1 to 2 years or in more than 10 years?

Knowing that market cycles (going from a valley to a peak and back to another drop in the market) last, on average, at least 5 years, investing your money in stocks with a time horizon of 3 years is like playing blackjack at the casino. You could almost double your money or lose 40% of it.

#3 Your risk tolerance:

Are you able to suffer a 10% market drop?

Do you panic when you start losing money on paper month after month?

Are you able to understand the difference between a short term fluctuation and your long term objective?

This is usually the last part of the questionnaire as the first 2 parts are pretty easy to determine and straight forward. However, determining your risk tolerance is a bit trickier. First, nobody likes to lose money. Second, everybody wants to take “risks” when the market goes up and wants to get out when the market goes down. Third, we are creatures often ruled by our emotions and our rationale disappears when we get our feelings hurt.

Since we often drive our investment decision based on fear, and fear is often driven by ignorance, I suggest you read more about personal  finance and the economy in general. This is how you will understand that market drops like the one we experienced in 2008 happens regularly. The only difference with 2008 is that we got hit harder than usual, but investors suffered during the tech bubble as well. If we go back in time, we have gone through several painful experiences as investor. But we always survived and so did our investment portfolio!

So the very first step before starting to invest is to determine your investor profile. I would suggest you meet a financial advisor so he can help you understand the questions and provide additional information regarding the market. But don’t sign any investing papers besides your investor profile during the first meeting (of course, he will tempt you to invest right away ). Take the time to fully understand what you want and what you are willing to go through in terms of market fluctuations before you start investing.

Next Thursday, we will look at different investment portfolios according to different investor profiles.

Author: Mike.

image source: polifemus

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We are approaching Christmas and most of us are now  shopping in “light speed mode”. Unfortunately, Santa won’t give us many gifts with regards to fixed income. Rates are currently at their lowest since the legend of Saint-Nicolas was first told and things probably are not going to be better in a few months. Can rates go lower? That is not the problem. In fact, I would be more worried if interest rates start rising. If you were bitten hard enough by the stock market in 2008 and decided to switch your investments towards bonds, you will see that your portfolio can suffer negative results as well. Why? Because bond values drop as interest rates goes up.

Why do Bond Prices Go Down When Interest Rates Rise?

This is an interesting concept and most people don’t realize the impact of rising  interest rates on bonds unless they have live through it: when interest rate goes up, the value of existing bonds goes down. Some people may be tempted to think that bond values would go up as more people would want to buy them due to a higher interest rate, but it doesn’t work like this:

Let’s say that you have paid $1,000 for a municipal bond giving 4% over the next five years. Once you have paid the amount of $1,000, you receive a transaction confirmation and you see the bond value in your investment portfolio.

During the next five years, you will receive the amount of $20 every six months ($40 per year, so 4% of $1,000) and at the end of the 5 years, you will get your $1,000 back. If interest rate haven’t changed, your bond value in your portfolio will stay at $1,000.

What if the interest rate goes down?

If interest rates go down, this means that the same municipality can offer bonds with a lower interest rate. Instead of paying investors 4%, they may be able to pay only 3% for 5 years. So they will continue to issue bonds at $1,000 but will offer 3% interest on them, so $15 every 6 months.

Even though your bond matures in 5 years, you always have the possibility to sell it on the market. This is why bond values fluctuate over time.

Therefore, if you have a bond paying 4% and the same bond is now offering 3%, do you think yours worth more? Yup, you are right. The value (originally set at $1,000) is now worth more money. In order to compensate for the fact that your bond is paying 4% and the others are paying 3%, your bond value will increase from $1,000 in order to compensate for the “extra” $5 you receive each semester.

So if rates go down 1 year after you have purchased your bond, you still have $160 to receive in interest before maturity while the new bonds will offer only $120 for the same period. While the calculation is a bit more complex as rates never change exactly on interest payout dates, your bonds value will more likely increase by $40 (so $1,040) to compensate the lower interest. So if you sell it on the secondary market, the investor won’t get more in his pocket compared to a new bond at 3% because he will purchase the bond at $1,040 and get $1,000 back in 4 years… while he will receive $160 in interest during this period.

This is why your bond values will temporarily increase. I wrote “temporarily” because if you keep your bond, you will still receive $1,000 at the end of the term.

What if the interest rate goes up?

We are currently living the lowest interest rate period of all time. Therefore, chances are that the interest rates will go up in the near term, right?

Based on the above mentioned example, if interest rates go up, bond values will go down to match the new interest rate. Therefore, your bond value of $1,000 will drop at $975 for example because your bond is not giving a high interest rate compared to what is being offered right now.

If you sell it at $975, the buyer will receive a lower interest rate but will receive $1,000 back at maturity. This is how the overall yield will be balanced.

How does bond value drop affect your portfolio?

If you have bonds in your investment portfolio, chances are that you will see their value going down during 2010 and 2011 (while the interest rate will go up). However, if you keep them until they mature, you will still get your money back. You just have to keep in mind that you will see negative returns during 1 to 2 years.

If you have bonds in your mutual funds, you will see the same variation. The only difference is that you don’t see which bonds you hold and what their value is since your money is pooled with others. Nonetheless, the result will be the same: you will suffer from 1 to 2 years of negative returns before your bond mutual funds bounce back upon bonds maturity.

Final Thought:

If you have bonds in your portfolio, be prepared to see their value tank once the interest rates start to rise. However, you don’t have to worry and keep the very same investing strategy. You will get your money back upon their maturities. In the end, you just have to be patient!

Author: Mike.

Image source: gilbertofilho

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Last week, I discussed why I really like index mutual funds. Some readers might prefer to trade ETFs (Exchange Traded Fund) directly, in order to replicate stock market indices with lower fees. However, there are 2 major inconveniences with ETFs when you are investing smaller amounts (i.e. less than $10,000):

#1 You are limited in your trades due to your small amount (you shouldn’t buy 5 or 6 ETFs with 10K)

#2 Transaction fees will eat up a lot of your yield (if you buy an ETF with $3,000 and you buying cost is $10 and your selling cost is $10, this represents close to 1% already).

This is why I prefer index mutual funds since they don’t carry transaction fees AND they allow for preauthorized systematic investments too.

Why Setting Up a preauthorized Investment plan?

If you have $10,000 or less to invest, this probably means that you are accumulating for retirement and that you have several years to prepare. Therefore, it is important to setup an automatic investment plan in order to participate in the stock market as soon as possible.

#1 Pay Yourself First

When it comes down to investing their savings, most people wait until a specific time of the year (the beginning or the end of the year in most cases) and drop a bigger amount into their retirement savings account. They prefer to do so since they think they can’t do much with $100 at a time. Yet they are wrong.

With any type of mutual fund, they can set an automatic preauthorized investment payment plan for as little as $25 per month (depending on the mutual fund). The most important advantage of this strategy is that it ensures that the amount you want to put aside for retirement is actually working for you.

Once it is taken from your account (or pay check) on a bi-weekly or monthly basis, you don’t have to think about putting money aside. You simply live with a different level of disposable income and your Roth IRA is growing without any pain.

Paying yourself first is definitely the best way to ensure a comfortable retirement. Look your Roth IRA contribution like a debt payment and you are your most important creditor (you owe it to yourself and your future!)  We have all heard how no one else is going to look after us financially.

#2 Dollar Cost Averaging

While this is not a major advantage, being able to enter in the market gradually as it goes up or as it goes down still averages a greater yield in your portfolio than attempts to time the markets.

Instead of trying to time the market and buy shares at their lowest, you continuously invest no matter what happens. Therefore, you are not always buying at the lowest price, but you are not always buying at the highest price either.

Therefore, you are averaging the cost of your shares. This will help smooth your investment statement balance from quarter to quarter. While the stock markets drop, you will keep buying more mutual fund shares at lower prices which will bring your overall balance higher. Remember the all important strategy to buy low!  This won’t make you make more money immediately, but you will have more shares in the markets when it goes up again. Therefore, you will be in a better position to recuperate your losses.

Final Thought

I think what I appreciate the most about systematic investment plans is the fact that you don’t feel it after the initial few months. You struggle a bit during the first pay checks since you were used to spending it all and there is less to spend now that you have decided to take care of your retirement.

However, after a few weeks, you get used to your “new” disposable income and you find a way to live with it. Next time you get a raise in salary, you just have to increase your investment contribution with the same percentage so you can benefit from a part of your raise and add more money to your retirement savings account.

Author: Mike.

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Last Tuesday, we looked at how to create a bond ladder with less than $10,000. While certificates of deposit are good to balance out your portfolio and provide peace of mind with security like a comfy blanket while sitting in front of a warm glowing fireplace, they will definitely not provide the growth to make your retirement savings account jump.

Some people won’t be able to endure the cruel market fluctuations and that is fine. This is why they should (even at an early age) setup their bond ladder and minimize their risk. However, if you understand that although your investments drop at times, over the long haul they have always gone back up (if you have a sane asset allocation…which will be explained in another post).

The problem is that if you have only $3,000 to invest, you don’t really feel like you should hop on the stock market roller coaster by buying a fraction of one or two companies. The transaction costs will be too significant and your risk due to the fact that you are concentrated only two stocks is too high. Therefore, you can already forget about stock trading with small amounts. Most people do it thinking they will hit a homerun but many end up like any other player facing the 5 time CY Young Winner, Randy Johnson…. 3 Strikes and out!

You are trying to build a safe retirement savings account here, not to impress your brother-in-law at the next Christmas party (I bet it would even be better if you can do both, right?).

Why I am a big fan of index mutual funds:

#1 Cheap cost

I don’t really like mutual funds because most of them charge an awful lot in management fees. For example, if you make an 8% return and the fund took 2% for management fees, you just has a 10% investment yield and the company took 20% of it off the top for their own pockets!

Index mutual funds, such as Vanguard, have very low management fees. They are not trying to beat the market, they are just trying to mimic it (considering that 70% of the professional portfolio managers on Wall Street can’t beat the S&P 500, you may want to try to match the index ).

You should be able to find index mutual funds around 0.50% fees (managemegement expense ratio) or even less. Therefore, when the markets are trending up, you are making money, and the mutual funds manager takes a fair cut!

#2 Diversification

The other thing that I really like about index mutual fund is their diversification. You can buy various index funds that follow different markets. The American stock market is pretty huge and well diversified. However, if the economy is not going anywhere during 3-4 years, your investment won’t do much either. This is why it is important to consider investing in Canada, European countries, Asia, the South American economy and/ or emerging markets.

The beauty of index mutual funds is that with very low capital (most of them start at $500), you can build a well diversified portfolio and invest in different countries. You may want to invest most of your savings in the American markets for several reasons, but investing elsewhere could make the difference.

#3 Low trading fees

If you start with a small amount of capital, the last thing you want are heavy trading fees. If it cost you $50 on a $1,000 transaction, that’s 5% gone from your investment even before starting!

Index mutual funds are part of the cheapest investment products you can trade on the market. Therefore, you keep the money in your retirement savings account and not in the hands of a broker

I still have a few investment strategies I want to talk about and then, we will discuss how we will build the portfolio.

Author: Mike.

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Insider trading is one of those things that we all hear about. Yet few know what it is and tend to think (incorrectly I might add) that only the big hedge fund managers should worry about trading on “inside information”. It always seems like investors think that they are above the law.

Now to be fair, yes the SEC generally pursues only higher profile cases. And so when an investors makes a $1,000 profit based on illegal information, there will usually be no action taken therefore no penalty. But is that really a chance you want to take? The consequences of insider trading can lead you directly to jail as it did for Martha Stewart when she got caught. And it seems like every once in a while, some high profile case is brought to the public’s attention, just to remind us all that these things are still being looked at by the SEC.

Before starting, I should further clarify because there are two types of insider trading:

1-Trading done by executives of a company. When the CEO or a high ranked officer of Microsoft does a trade on his stock, he must disclose the trade which becomes public information. This was done because investors usually want to know if company executives are selling their stock. It is may be that they expect the company’s stock to underperform in the short term.

2-The other type is the one that is illegal: When any investor does a trade based on material non-public information. Basically, any investor that has knowledge of facts that will have an impact on the stock is prohibited from trading on that stock. This can apply to anyone:

• You work at a company and hear from an accountant or exec that the results will be higher or lower than expected. In such a situation, you would not be allowed to trade on your company’s stock.

• Your neighbour tells you that his company is preparing to make an offer to buy a stock and that he is buying that stock because he is confident it will rise. In this case, your neighbour is violating federal laws as are you if you trade on one of those two companies.

It is tempting to do such trades, of course, because you will probably end up making a tidy profit. But before acting, just remember that it is a crime like any other. It is especially tempting since you know that the chances of being pursued and perhaps caught are very slim (these cases are rare and very difficult to prosecute) and also simply because of greed. If you own a stock that you find out will probably drop, you will feel very tempted to sell it before the drop actually occurs. But just take an extra minute to think about how much this could end up costing you….

author: Mike

image source: anonymous9000

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Are you among those who complained about the major banks’ excessive leverage?

Chances are that you or your neighbour is leveraged at least as much if not more. Think about it… If you own a house that is worth 400,000$ and you have a 360,000$ mortgage, you are leveraged 10 to 1! Many banks used that kind of leverage.

But for some reason, that has been ok and has become so accepted that it is almost surprising when someone buys a house with 30-35% cash down. Of course, that happened mainly because we have expected prices to rise continually. The worst that can happen is for my home’s value to stay the same for a few years right? So why not leverage myself, enjoy the good life and then sell my house 10-20% higher in 3-4 years? That is exactly what happened in the past couple of decades as owners’ bought more expensive houses and often even chose to own several houses simultaneously. Of course, when prices in many regions such as Florida, California and Las Vegas dropped by 30-40%, it created a very tough situation for many homeowners.

Imagine you have a 500K mortgage on a home that you paid 600K… and a few years later, your home lost 30% of its value… and so you now own a 400K house with a 500K mortgage, which is described as “negative equity”. Add a lost job and you have major trouble. The bank can take possession of the home at any point in time in such a situation and selling your house becomes a major insult as you “realize” your loss.

It’s always interesting to meet people who look at me as if I was from another planet when I suggest using leverage when investing in the stock market while hearing that they put little to no cash down when buying their half million dollar home. Sounds a bit ironic in my opinion. While you don’t see the definition of leveraging to buy a house in any investment guide, the point is that you are still borrowing a lot of money and taking a substantial risk in buying your principal residence.

Of course, most would say that they have no choice and that buying their home in cash is simply impossible. And in most cases, I agree. I don’t think there is anything wrong with that and as long as real estate prices do not experience a crash you are fine. Yet I still consider it very important to at least acknowledge that you are using a leverage strategy and that there is risk involved. If you are leveraged 10 to 1, there is risk. I’m not against leverage, far from it. But we should all be aware of how much we use leverage in our personal finance.

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-Collapse of the entire financial system: This one can no longer be dismissed easily since it was a distinct possibility during last year’s collapse of several US and foreign banks.

-Hyperinflation: With all of the money being pumped into circulation by the US government, many think inflation will pick up and could get out of control in the coming years

-Collapse of the US dollar: The US dollar, by almost any standard, has suffered major losses in recent months. There is a lot of speculation about the causes, the lack of the US government support to defend its currency, etc.

-US Government bankruptcy: With costs out of control, there is no end in sight for the deficits in the US and in fact they are becoming more critical year after year. Military, health care and pension issues are only a few of the reasons for the deficit. Will foreign governments decide to stop funding these deficits one day?

Apart from a few individuals, I think the vast majority would concede that these are remote possibilities that probably will not happen in our lifetime. However, an increasing percentage of the population is starting to prepare for worst case scenarios. How?

1-Cash is king: Having debt is bad enough but even having all of your money locked into investments means you could lose it all if things turn very bad. For this reason, many investors are keeping higher cash balances in their accounts and also at home, hidden in all kinds of places.

2-Metals: When a currency loses its value, one of the alternative assets over time has been precious metals such as gold and silver. For that reason, there is an increased interest in buying physical holdings that buyers can keep at home either in a safe or in a well hidden place. Metals have also been known to be one of the best ways to maintain purchasing power when inflation picks up significantly. These investors are often reluctant to buy gold in the form of ETFs for example because their worst case scenario also involves a complete collapse of the financial system which could render such assets worthless.

3-Diversification: Rich investors are looking at setting up foreign accounts where they can escape from exposure to the US dollar as well as the US financial system.

It does seem like a gross exaggeration doesn’t it? I’m not saying it’s not possible. Of course, it is difficult not to acknowledge the risk, especially after the near collapse we witnessed in late 2008… but personally, I’m not preparing for these scenarios in such a dramatic way for these reasons:

1-This type of crisis does not happen every year: Usually, all parties learn a great deal during such times which helps improve and stabilize the structure. Remember that major recessions usually happen once per couple of decades

2-The US government showed it was willing to do almost ANYTHING to save the system. Let’s not forget the magnitude of what was done last year. Major stimuli, injecting hundreds and thousands of billions of dollars, buying stakes in banks, etc. I personally believe that the only way a complete collapse of the economy would occur would be through a collapse of the US government… and if you believe in such a scenario, then I hope you have personal security guards to protect that gold.

3-It’s just too expensive. Do you know how much preparation  for this type of possibility will end up costing you in commissions, lost interest, etc? Over the course of a lifetime, it will end up being very costly. I just think it’s not worth it; I’ll take the gamble…

author: Mike

image source: scott3eth

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Just by writing this title, I already know that people won’t agree with this strategy. How can you tell people to get rid of their emergency fund while we are in one of the most important recessions ever? So please, keep reading until the end of the post, I promise to make sense

First things first, I am a big fan of the “pay yourself first” technique when it comes to personal finance. If you consider yourself as a priority creditor, you will put money aside for your personal finance and then, live off the rest. Many of my clients are asking the same question with regards to extra money: Should I pay down my debt or invest the difference?

Some people will build a 6 month emergency fund, others will invest the money in a stock portfolio and the rest will pay down their debt. But in many cases, the best investment would be to pay down their debt. And if you have an emergency fund, you should use it to pay off any existing debt such as your credit cards or create additional room on your home equity line of credit.

Savings accounts don’t offer much interest

When I advise my clients on what to do with their money, we find money market funds and saving accounts offering less than a 2% yield. So, here you are technically losing money if you put it aside in an emergency fund. How come? The answer comes in 2 words: taxes & inflation.

Historical inflation is over 2% and most economists expect it to keep an average pace of 2%. So, if you are marking 1.50% in your savings account and you pay 25% in taxes; you are left with a real return of 1.125%. Therefore, if the inflation is 2%, you will be lose almost 1% of your purchasing power per year. You don’t need to read an investment guide to understand that this is not the best way to increase your net worth, right?

On the other hand, credit card interest rates are much higher

Unless you were able to get a zero percent balance transfer credit card, you are probably paying around 10% on your credit card (if not higher). Therefore, you could use the money in your emergency fund (making 1.5%) and pay off debt at 10%. This method helps you  multiply your investment yield by more than 6 times when compared to a money market fund.

We’re in a recession, what happens if I lose my job and no longer have an emergency fund?

I guess this is the part I like the most about personal finance; there are no black and white answers! A few years ago, I would have answered back: take your whole emergency fund and pay off your debt. If you need money because you have lost your job, just use your line of credit for the time being.

However, since the recent credit crunch, we have seen financial institutions using the fine print to their advantage in order to cut credit limits to millions of upstanding individuals. The banks were so panicked that they simply looked to decrease their exposure to risk.

So I am not saying that everyone should cash in his entire emergency fund.

However, I think that if you have 3 months emergency funds (everybody should be looking to cover 3 to 6 months of income according to financial planning guidelines), you may use a few weeks’ or a month’s worth of income to pay off a few credit cards.

Once this is done, you can use the snowball effect to reimburse your emergency fund. Therefore, you will save a great deal of money in interest and you won’t be exposed to big risk.

Using the snowball (taking the money used to pay off one debt in full and add it to make a bigger payment on the following one) in order to reimburse your emergency fund will be a great way to make sure you replace your emergency fund to the level it was a few months earlier.

Author: Mike.

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