Sunday, July 19, 2009

Managing Surplus Money In The Short Term

If you have been saving since the start of this recession and are relatively debt free, I believe you should have hit the target of amassing an emergency fund of at least three months and with spare cash available for investment too.

While a three-months emergency fund is barely enough if the economic recession worsens, I know a lot of people are already getting antsy about having so much of their savings lying stagnant, especially with all the talk of green shoots and the spectacular stock market rally since March.

Managing Surplus Money In The Short Term
To be sure, risk appetite has increased and people want to earn more but somehow I still feel the stock market run-up looks pretty suspect.

For those who are hell-bent on higher yields, there are actually many ways to go about it. For quick gains, small-cap emerging market stocks have the potential to be multi-baggers and are extremely attractive.

The more adventurous can open a margin account whereby the brokerage usually lend double your principal amount for investment. Besides trading in stocks, you can also wade into more complex highly "leveraged" ETFs which can magnify by about 2-3 times the movement of the underlying index which they track on a daily basis.

Needless to say, the above approaches are volatile and speculative. It is exciting to make lots of money with leverage but equally heart-wrenching when the market moves in the other direction.

But that is not to say that 100% cash is good for our retirement portfolio. Inflation will eat away our wealth. Since the creation of the Federal Reserve, our purchasing power in US dollars has been whittled down by 96%. How is that for wealth building?

And with all the quantitative easing implemented by the Federal Reserve, inflation may yet go into overdrive and set us back further from our retirement goals.

As risks and rewards are correlated, we should take on prudent risk and seek higher returns by investing in bonds and equities, provided our emergency fund is not compromised. A minimum of 2-3 year time frame is appropriate for our investments so you must not touch the money for living expenses or emergencies.

It will not serve much purpose to turnover our stocks constantly as transaction costs will render the investment meangingless. Just look at Warren Buffett, he does not build his wealth from trading. Instead, he chooses his battles carefully, and let time compound his wealth.

Currently, the false sense of security in the stock market may lull us into placing more money into equities than we can aford, thus if and when the stock market falls by more than 50%, a lot of people will get into severe financial difficulties again.

I know it feels terrible to have our savings earning a paltry 1% to 2% in a money-market account or short-term CD while our friends make huge killings in the stock market, but on the flip side, ask yourself if you can accept that your savings is wiped out by 30-50% because you bought investments that could not hold their value over the long run.

I definitely don't encourage people to invest all their idle cash in this current economic climate. For me, I still prefer the traditional savings vehicles like money-market funds, savings accounts and CDs.

What do you guys think?