Since the inception of Thoughts On Money, the objective has been the same – to help translate the complex world of personal finance into something more palatable and to address common questions that investors have. If you’ve been a long time reader of TOM, you know that most investment questions don’t have a one-size-fits-all answer; this is why I commonly encourage readers to address these particular issues we discuss with their advisor. The goal of financial planning is always to tailor a solution that fits each investor’s unique situation.
Focus on the Process
The problem with often concluding, “best to discuss with your advisor,” is that you, the reader, don’t get the opportunity to peek behind the curtain and see how an advisor would think through one of these financial solutions.
Today I am going to invite you to one of those problem-solving exercises. We are going to address a common financial issue/question, and I really want you to focus your attention on the process of how one would go about deriving a solution. These financial problem-solving skills are the key takeaway or learning opportunity, not the actual conclusion.
This lesson should not be too dissimilar to a high school math course that you’ve taken in the past. The textbook provides most of the answers in the back of the book because the teacher is less worried about you getting the right answer as much as your ability to structure the steps needed to come to that answer.
Just as the proverb goes, “Give a man a fish, and you feed him for a day; teach a man to fish, and you feed him for a lifetime.” Today I will teach you to fish.
So, let’s get started.
Absolutely No Interest
Last week here on TOM, we discussed the importance of always needing to adapt and acclimate to the ever-changing economic environment around us. We focused on what a low-interest-rate environment means for investors and how they should adjust the way they approach risk, cash management, and managing their balance sheet.
Over the last week, I’ve been approached with questions asking me to elaborate on how one would evolve how they manage their cash allocations in a low/no interest rate environment. Let’s use this question specifically to walk through those financial problem-solving skills.
STEP ONE: DEFINE THE PROBLEM
The process all starts with identifying the problem. So here it is, since the dawn of time, people have always liked to keep a certain amount of “rainy day” money in their bank account. If an emergency arose, this would provide an easy-to-access source of funds. Traditionally, one could just resource a money market fund or high yield savings account from their local bank or even build out a CD portfolio to earn a bit more interest on their money. As interest rates have continued to shrink on an annual basis, many savers had begun looking outside of their familiar banking relationships and scouring the online banking community for more attractive interest rate opportunities. Now, as interest rates sit near zero, many of these online promotional rates have expired, and again the saver is left with an unattractive low yielding savings account.
So, there’s the problem; cash savings pay little to no interest. This low interest means that if each year, everything you plan on purchasing gets a bit more expensive (inflation), then the buying power of these funds are deteriorating over time.
STEP TWO: IDENTIFY THE OBJECTIVES
Before we begin discussing potential solutions, we first need to identify our objectives. To do this, we need to look back at why we have an allocation to cash in the first place. This is an important part of the process because it allows us to go beyond a mindset of “I do this because this is the way I’ve always done it” to a place where we look at each specific part of our financial plan and reaffirm that there is a reason/purpose for each component.
Financial planning 101 tells us that the reason for our cash allocation is so that if an emergency arises – a medical bill, taxes, car issues, etc. – we have ample coverage to fund one of these potential issues. Because cash is (1) easily accessible, and (2) the value doesn’t fluctuate, it makes it an obvious solution for meeting emergency needs.
Imagine if you had all your money in stocks, and in March of this year, an emergency expenditure came up. At one point in March, your stock portfolio might have been down 35% from its peak value, so you might be forced to sell your stocks at a depressed value to meet this surprise expense. Not to mention that your stocks’ sale may take a couple of days to settle, which means you would not have immediate access to your cash. As you can see, a stock portfolio would not fulfill those key objectives; we identified (1) easy to access and (2) stable value, which are the key tenants of why the emergency fund is needed in one’s financial plan.
STEP THREE: POTENTIAL SOLUTION
The best potential solution would need to maintain these key features of access (liquidity) and stability (volatility) while also introducing an additional benefit of providing interest (yield) to help combat inflation and retain buying power.
Now, I’m going to begin crafting what a potential solution might look like. As I mentioned, I typically shy away from this on TOM because each solution ultimately needs to be customized to the individual. Remember, today’s primary takeaway is not the solution, but rather the process for getting there. With that said, we will walk through what a hypothetical solution might look like.
Alright, I know my shopping list, I need a financial instrument that will provide easy access to cash, maintain a stable value, and pay interest. There is no such thing as a free lunch in economics, so as I explore potential cash substitutes, I know there will be key differences and potential risk factors that need to be considered.
The primary reason we are exploring an alternative to cash is that interest rates are low. So, let’s try to solve this issue first and then address the other two objectives. In investing, this risk/reward relationship exists, which means if we want to increase the incremental reward, then we’d have to increase the incremental risk.
Let’s assume that cash sits on one end of the risk spectrum, and stocks sit on the other end of the risk spectrum. Under this assumption, one incremental notch up the risk scale could likely move us from cash to high-quality bonds.
Let’s assume our saver is a high-income earner, so it’d make sense to use municipal bonds because of the associated tax benefit. So, our saver is considering replacing their legacy cash allocation with a high-quality municipal bond portfolio.
Now, these funds will be earning interest, which means one objective is solved. The saver now accepts that this change in risk will introduce some level of price fluctuation (both positive and negative). Additionally, this high-quality municipal bond portfolio will not maintain the same liquidity profile as cash. We described liquidity as the ease of accessing funds. They’d have to seek a buyer of their bond and await this transaction’s settlement to access these funds as a now, municipal bond investor.
So, we need to introduce an additional component to help provide a complete solution. This accepted change in risk is where a portfolio line of credit could be useful. A portfolio line of credit uses your investment portfolio as collateral and provides a credit line that can be resourced if a need arises. By coupling this credit line with one’s portfolio, you’ve now created an easy-to-access funding source. When the need or emergency presents itself, one can make a withdrawal immediately, just as one would with a typical checking or savings account. Having the flexibility that if an emergency arose in a month like March 2020, they could resource the line of credit and then decide at a later date which investment to sell – stocks, bonds, etc. – for paying back that line of credit. This flexibility around timing the sale of assets is a valuable benefit.
So, we did it. We came up with a combo solution that increases the expected interest, minimally alters the expected price stability, and created an alternative source for liquidity/withdrawal needs.
STEP FOUR: WEIGH THE BENEFITS
Ok, up to this point, everything has been a brainstorming exercise. Still, as you approach potentially executing a solution like this, you need first to review all the pros and cons of your proposed alteration. Are the potential benefits worth making the change? The answer will be absolutely yes for some solutions, and for others, it just might not make sense.
For an investor that (1) typically likes to hold a meaningful percentage of their balance sheet in cash and (2) the potential interest accrued on this substitute allocation would be significant concerning their living expenses, then this could make a lot of sense. If those things aren’t true, then it might be a whole lot of work with minimal impact.
Think about how you would do this exercise if you were considering refinancing your mortgage. If you’ve been through the refinance process before, you know the hassle of collecting documents, filling out paperwork, and how long it takes to close out the process. If it meant saving $5 a month on your mortgage, then I’d say it probably isn’t worth it. Part of the process is mentally deciphering the “grief-to-benefit” ratio associated with making any change.
Another factor you will want to weigh is that our investor is transitioning from a high yield savings account that paid interest that was treated as taxable income to a municipal bond portfolio that pays tax-free income. It would be optimal if you compared the net of tax income of each to make an appropriate comparison. I often see investors forget to factor in tax implications when thinking through their proposed financial solutions. Taxes matter; it’s a real cost, so make sure to account for this variable.
STEP FIVE: SECOND OPINION
Ok, now you’ve muscled through the challenging part of the process. In science, one always starts with a hypothesis and then tests one’s theory before one comes to a conclusion. Now it’s your turn to take your potential solution and present it to wise counsel for feedback. This could be your financial advisor or another trusted source. It would be best if you were asking knowledgeable people to beat up your idea, poke holes in your plan, and challenge your thinking.
I do this all of the time. I’m blessed to work with many knowledgeable individuals, continually presenting them with my ideas. I have this insatiable desire to improve on how we serve clients and the financial solutions we execute. So, I’m always brainstorming.
Here’s what might surprise you. I have a HUGE “idea graveyard.” Not every idea or potential solution will find its way to the financial plan, and that’s ok. Again, going through the process is the important part, and ultimately siphoning out the overly complex or non-impactful solutions is essential to finding those ideas that should be implemented.
A Broken Record
With the risk of sounding like a broken record, I want to remind you that today’s discussion had nothing to do with cash management and everything to do with teaching you how to think. You’ve learned the steps for crafting a financial solution and establishing an applicable process across any financial planning obstacle you come up against.
I’m sure today’s discussion probably sparked some questions, so please don’t hesitate to contact me. You can reach me at firstname.lastname@example.org.
And that’s a wrap for this week. We will be back next week with more of my Thoughts On Money.
This is TOM signing off…