Planning for the Proverbial Rainy Day
The economic downturn has brought finances and the need for planning into the headlines. As people consider the reality of job loss, the concept of having a rainy day fund evolves from proverb to reality. Having some easily accessible savings to cover an emergency is generally a good idea but it may not be easy to decide how much to set aside. One of the main reasons this is true is because saving money is always accompanied by an opportunity cost. That is, if people are building up their savings, they are not doing something else with their money. For example, if they’re not funding their retirement account, they may be trading one problem for another.
Since prudent planning generally includes having emergency funds available, we must decide how much is enough. I have often heard “six months spending” suggested as a target but I have found that to be a frustrating goal for many. When a target amount seems too imposing, some people will see no way to reach it and simply quit trying. Before he retired from the Wall Street Journal, Jonathan Clements once wrote that people with equity in their homes didn’t need such a fund as they could always borrow via a second mortgage. I believe he later retracted that statement but I think it might be a concept worth considering. Even though home equity was sometimes poorly used leading-up to the recent market meltdown, I think planning on utilizing a second mortgage remains a sensible option for many.
Such available equity allows the necessary savings to be smaller, so the correct amount might be the answer to the question: “How much do you want to be able to tap without having to borrow?” When I work with individual clients, I often suggest a range of things, not dollars. I.e., do you want to be able to have your car’s transmission repaired or buy a refrigerator or re-roof the house? I think people are often better at answering thing questions because not everyone still thinks in terms of costs these days. Over the years, many have gotten more used to payments instead.
This approach usually allows us to arrive at an appropriate size for the fund, bringing us back to the question of the best way to build it. If we choose to do so over time, some sustainable amount must be named. Rather than offer a suggestion like reducing your latte intake by 2 per week and using that $10 to fund the account, I think a more useful approach is to consider Nike’s slogan: Just Do It. The target balance can be divided by 52 to yield the amount to be saved weekly. If you pay yourself first, you will adjust your budget around those extra savings. When time doesn’t appear to be an issue, it may be easier to start with something like half of the next raise or a lump sum like a portion of a tax refund.
Once the funding is completed, of course, a decision must be made about what to do with that extra money. As planners, we are likely to suggest that the saving be continued and added to college or retirement savings.
With as many different situations as clients, no one answer is ever going to suffice for all. We work with each client trying to guide the process, usually starting with a short test aimed at learning about each one’s tolerance for risk. Depending on the situation, we might also employ additional tests which help us discover the role money plays in a person’s life. These tools allow us to learn enough to make appropriate suggestions for each question. Once a “rainy day fund” is established, it has been our experience that saving very often becomes a self-fulfilling prophecy: when people see the account growing, it’s reinforcing. They become more wedded to the idea, eventually ensuring their saving success.
Warren Ward Associates does not have the answers to all financial questions, although we almost always have suggestions for our clients to consider. Whether related to developing an emergency fund or deciding how to meet a long-term goal, we are always willing to listen and offer advice.
Who is Charles Ponzi and Why Are People Saying Such Terrible Things About Him?
Our Securities and Exchange Commission (SEC) defines a Ponzi scheme as “a type of illegal pyramid scheme named after Charles Ponzi”. This, of course, begs the questions of who Ponzi was and how he came to the attention of the SEC. Back in the 1920s, Ponzi defrauded thousands of New England residents by helping them speculate in postage. He promised investors at least a 40% return every 90 days by taking advantage of the differences in value between U.S. and foreign currencies used to purchase international mail coupons. Again, the SEC: “Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period—and this was 1921!” Although he paid off the earliest investors to make the scheme look legitimate, subsequent investigations found that he had only purchased about $30 worth of coupons.
Ponzi was probably not the first to pull off such a trick but, 90 years later, we still use his name to describe schemes which use money from later investors to pay off earlier ones. These early investors inadvertently bring new investors into the fold by sharing stories of their success. At least “until the whole scheme collapses” (quoting the SEC one final time).
This past year has brought a spate of similar scams to light. Withdrawals are not a problem for the perpetrator as long markets are doing well. During bull markets, people are comfortable letting their investments (apparently) continue to grow along with the markets. However, when markets decline, people often decide to lock in some of those profits, leading to requests for withdrawals and the sort of implosions we have seen. The June 12th The Washington Post reported that the FBI had nearly 500 Ponzi scheme investigations underway.
These frauds sometimes feature recurring themes, such as an affinity group, to attract investors. Ponzi was an immigrant and played on his Italian heritage to bring in trusting investors. Bernie Madoff used his Jewish connections to do the same. In other ways they are different: Ponzi targeted uneducated investors, describing himself as a populist. Madoff famously catered only to the elite. Being a Madoff client carried considerable caché, at least until last fall when investors requested $7 billion and only about $200 million was available.
Ponzi offered to let people get rich quick, while Madoff promised consistent returns regardless of market conditions. Ponzi perpetrated his fraud before the existence of the SEC while Madoff basically ignored it. Both of them duped thousands of investors, neither actually invested the money they raised and both built unsustainable pyramids which ultimately collapsed.
Ponzi pleaded guilty to a federal charge and spent about 14 years in prison before being deported. Madoff pleaded guilty last winter to 11 felony counts of orchestrating a fraud. Apparently he told his sons that it would amount to $80 billion, although that probably includes fictitious profits in addition to the money originally invested. According to the records I’ve seen, very few of his clients were Indiana residents. This might be basic Midwestern conservatism at work or simply that his sales machine had not yet begun to focus on the heartland by the time he confessed.
Regular readers of my articles have heard these words before but in light of recent abuses, they bear repeating. If you encounter an investment which seems too good to be true, it almost certainly is.
At Warren Ward Associates, we begin the process of investing on behalf of our clients by asking two questions. First, who will buy this investment when it’s time to sell? And, second, if the safest investment in the world is paying a given percentage, what additional risks will our client have to take to earn some multiple of that? Our investment process generates wealth by reducing losses, not providing extraordinary gains. Our approach is strategic and evolves with the markets. It does not offer a way to “get rich quick” but then neither do most other investment opportunities, as Ponzi, Madoff and others so ably demonstrate.
