How Big Should Your Tranquility Fund Be?

 

There are no emergencies, only stupid people who ask questions.

There are no emergencies, only stupid people who ask questions.

 

The word “emergency” doesn’t have a polar antonym, but “tranquility” and “calm” were the best candidates we could find.

Go pick a personal finance website at random. You can start with any of the jetsam on this list. Sooner or later, the purveyor of the site you selected will mention how important it is to have an “emergency fund.” You know, for emergencies. We’ve already explained how that’s among the laziest, least original, most derivative ways of telling people what they should be doing with their money. You don’t need an emergency fund for a million reasons, the most prominent of which are:

  • By definition, emergencies happen infrequently enough that if you earmark funds for them, those funds aren’t helping you and growing for you like they could be.
  • Almost any emergency you can think of, you can insure against.

Need cash in a hurry? Like, within the hour? That’s what your checking and savings accounts are for. More importantly, why do you need that much that fast? Now, whatever you answered for the previous question, answer this more fundamental question: “Do I need that much money that badly because I did something stupid months or years ago, either once or chronically, and now it’s catching up to me?” Did your engine seize and require a $2500 rebuild because you were too lazy to visit Manny, Moe & Jack and pay $20 for an oil change? Do you need to spend 50 large drying out at Betty Ford because of your continued failure to ever buy a $3 Diet Coke? True emergencies that can’t be insured are unbelievably rare, and focusing on their unlikely occurrence to the exclusion of more pressing and important matters is Reason #1 why most personal finance advice puts the “awful” in godawful.

Pressing and important? What’s more pressing and important than an emergency? 

Everyday life, Jim. Hence the idea of a tranquility fund. Modifying the definition of an emergency fund given at our other creative outlet, Investopedia, a tranquility fund is an account created for the purpose of setting aside money to be used during the unremarkable times that constitute the bulk of one’s life.

If that sounds vague, use your imagination. Personal finance, at its root, is as painfully simple a pursuit as there is. Collect $x. Spend $y. Then determine what you’re going to do with $x-y, and you can start by ensuring that that quantity is as large as possible. That requires nothing more than making x large and y small, but if we had a nickel for every personal finance site that fixated on nothing but minimizing y, we’d have more x than we could spend.

Your tranquility fund is $x-y. In other words, everything past necessary expenses. The money has to go somewhere. One of the starkest realizations any university economics student makes in intermediate study is yet another obvious one that’s been hiding in plain sight: every dollar has to be either spent or saved. And “saved” is just a synonym for “spending deferred.” You can have a little now, or a lot later. Delayed gratification is the carrot that makes the Charlie Mungers of the world. The evil cousin of delayed gratification, immediate gratification, has its devotees too. People like Len Bias and Vodka Samm. There are thousands of examples in the former category, billions in the latter. Faceless gamblers, both the casino/dog track kind and the “Take this side street, where no cops will breathalyze us” kind.

Incessantly pressing on the “necessity” (really a luxury) of an emergency fund would be like never shutting up about how important it is to have a smoke alarm in your house. You should test the smoke alarm every month, even if that means schlepping a ladder inside and inevitably banging it against a doorway and creating some cosmetic damage. Oh, and be sure to replace the batteries regularly. Again, that’ll require a ladder. You might want to invest in a battery tester, too. Don’t forget to have an exit plan and memorize which is the safest way to leave your house in the event of a fire. Also, be sure the smoke alarm has the label of a recognized testing laboratory. A smoke alarm with a strobe light is also handy if you have deaf or hard-of-hearing people in the house. Make sure you read the owner’s manual that came with the alarm, and store it in a safe place, but you should still get a professional to install the alarm. Also, remember to temporarily suspend the alarm’s sensitivity if it’s susceptible to cooking fumes. You’ll want to get an ionization alarm for flaming fires, but a photoelectric one for smoldering fires. For the best protection, get both and SWEET CHRIST ENOUGH ALREADY. THANKS FOR YOUR CONCERN BUT THE EXTREME IMPROBABILITY OF MY HOUSE CATCHING FIRE ISN’T WORTH THE AGONY OF SPENDING MY VALUABLE TIME HAVING TO LISTEN TO THIS ENDLESS SPIEL ABOUT SMOKE ALARMS. JUST INSTALL IT AND LET’S GO.

How is that any different than obsessing over emergencies and the funds that are supposed to fund them? There’s what, a 10,000-to-1 chance you’ll actually need a smoke alarm, or an emergency fund? Then you should spend .01% of your time thinking about it. Or one minute a week, and even that sounds like too much. Spend the remaining 99.99% of your time doing something valuable – creating and building wealth, rather than hoping your car gets hit by a meteor (with no “catastrophic astronomical event” coverage in your policy), just so you can withdraw the entire $493.67 from your sporadically stocked emergency fund and be able to tell people like us, “See? I told you so!”

 

Part II of Our Exhilarating Series About Risk

You’re not going to understand this unless you read Part I, and you probably won’t understand it even then. That’s a criticism of our ability to explain things, not your ability to absorb them.

Last week we tried to figure out what those measures of risk under a mutual fund’s chart mean. Here’s the chart for the Dodge & Cox stock fund, updated from last week. The numbers for the fund itself haven’t changed, as Yahoo! hasn’t recalculated them since September 29 (and we can’t be bothered to do it ourselves), but the numbers for the fund category itself have changed:

Dodge & Cox II

α and β we handled last time out. What about Mean Annual Return, R², standard deviation, and Sharpe and Treynor ratios? Let’s see if we can do this and still retain your interest.

Mean Annual Return. “Mean” means average, right? Yes, but there are different kinds of averages. Note the time period listed in boldface on the chart. This isn’t the standard (arithmetic) average, calculated by adding up the values of a bunch of items and then dividing by the number of items. This is geometric average. Replace “adding” with “multiplying” and “dividing by” with “taking the nᵗʰ root, where n is” in the previous sentence and you’ve got it.

Here’s the difference. For instance, what’s the average of 5, 6 and 7?

Screen Shot 2013-10-15 at 3.08.50 PM

That’s the arithmetic average. (Ignore the vertical line down from and to the left of the 3, it’s just a typo.) Here’s the geometric average:

Screen Shot 2013-10-15 at 3.09.16 PM

Not quite the same. Geometric average is necessary when calculating returns over a period of years. If you use arithmetic average it’s confusing and paints an inaccurate picture. Anyhow, by measuring the individual annual increases (or decreases) and calculating their geometric mean, we know that over the past 3 years the Dodge & Cox Stock fund has averaged a 1.46% gain, which beats the category.

 

Now onto. It’s a measure of spread, which is contingent on mean (which, for our purposes, means mean annual return.) R² is supposed to separate how much of that return is attributable to the fund itself from how much is attributable to the underlying benchmark – here, the standard index. If DODGX is just riding the market’s coattails, we want to know about it. The lower R² is, the more the fund’s performance is its own doing, for better or worse. You calculate R² by graphing the performance of both entities, the fund and the index, over time. They won’t be identical, of course. You measure the difference between the fund and the index at different points, square the differences, and in this case discover that DODGX’s movements are explained almost entirely by the index. 96.5 on a scale from 0 to 100. Some if not most people prefer funds with high R², the argument being that a rising index lifts the boats that are most in sync with it.

Generally, R² of over 90 is considered high. R² of under 70 is considered low.

 

What about standard deviation? Like R², this is a general statistical term that applies to all sorts of sciences, not just finance. If you didn’t learn it in high school or college, here it is in its simplest form. Take 5, 6, and 7, the data points that served us so well in the previous example. Their (arithmetic) mean is 6, we know that. Just like the mean of -40, 27 and 31 is also 6. But obviously, the first set of values is a lot tighter than the second. In other words, their standard deviation is lower. You calculate standard deviation by

  • Subtracting each term from the average.
  • Squaring each of those differences. 
  • Adding them all together.
  • Dividing by the number of items.
  • Taking the square root of that. 

Again, we don’t expect you to calculate this yourself. But we’re not just going to throw an unfamiliar term at you and explain it without going into details. We’re writing this in such a fashion that if you want to, you can reproduce the results yourself. Otherwise we’re not really explaining anything, we’re just listening to ourselves type.

Using the 5-step process above, the standard deviation of 5, 6 and 7 is .816. The standard deviation of -40, 27 and 31 is 32.568.

But how does this help us and what does it mean? What are the quantities, the data points we’re dealing with here?

Answer: Monthly total returns. Keep in mind that the table above shows results for only the last 3 years. So we take DODGX’s return in October of 2010, its return in November of 2010, etc., until we have all 36 monthly total returns. (Well, that’s not entirely true. We then annualize them, which is to say, we take each monthly total return to the 12ᵗʰ power.) DODGX’s standard deviation is 14.67, slightly higher than that for its category of funds. That number is a percentage, by the way. It means that assuming a normal distribution – a bell curve – DODGX’s returns will be within 1467 basis points of its average return 68% of the time. It’ll be within 2934 basis points – two standard deviations – of its average return 95% of the time. And it’ll be within 4401 basis points, or three standard deviations, 99.7% of the time. The 68%, 95% and 99.7% aren’t arbitrary, either. They’re natural constants. Well, they aren’t really, but they’re close enough that we can say they are without turning this into an introductory-level probability course.

Alright, it looks like we’re going to have to stretch this out to 3 parts. Friday, we’ll do Sharpe ratio, Treynor ratio, and give you our synopsis of what the point of all this is.

Another 3 Bite the Dust

 

That is one eye-catching logo

That is one eye-catching logo

 

The Dow. Or, in metonymic fashion, simply “the market”. The single quantity most identified with the strength or potency of the economy, particularly its investing arm. We’ve discussed before what exactly the Dow Jones Industrial Average is and how to calculate it, but that was 4 years ago and it’s time for a freshening.

In one sentence, if you’re too lazy or burned out to read the linked article above: Add the stock prices of 30 particular large companies, multiply the sum by a constant, and there’s your Dow index. Mindlessly simple, and either in spite or because of that it’s managed to burrow itself into the collective consciousness. The companies have changed throughout the years, U.S. Leather having less impact on the economy today than it did in 1899, but here are the 27 oldest constituents of the Dow:

3MAmerican ExpressAT&T
BoeingCaterpillarChevron
CiscoCoca-ColaDuPont
ExxonMobilGeneral ElectricWalmart
Home DepotIntelIBM
Johnson & JohnsonJPMorgan ChaseMcDonald’s
MerckMicrosoftDisney
PfizerProcter & GambleTravelers
UnitedHealth GroupUnited TechnologiesVerizon

 

Earlier this month, the 3 remaining slots were occupied by Bank of America, Alcoa, and Hewlett-Packard. Last year the Dow traded out one of its components for another, and this is the first time in 9 years that it’s traded out 3 simultaneously. We’ll get to the newcomers in a minute.

Bank of America, as you may remember from our haranguing of a couple years back, received a direct $45 billion in taxpayer cash, and $5 billion more via equally culpable straw purchaser intermediary American International Group to avoid what 2 presidential administrations feared would be the collapse of the economy. We weren’t close to having that happen, and the bailout did thousands of times more harm than good, but Bank of America has a more effective public relations department than we do. 6 weeks after the cash infusion, B of A stock hit a nadir of $3.14. Within a year the stock price had sextupled, leading B of A management to issue pronouncements; of perfunctory thanks to the helpless taxpayers, and of the promise of happy days ahead to investors and borrowers. Long story short, by the end of the next year the stock had again lost 2/3 of its value. A consistent non-performer drags the value of the index down, so Dow Jones & Company said “enough” and went looking for suitable replacements.

Same deal, to a lesser extent, for Alcoa and Hewlett-Packard. The former is profitable but dwindlingly so, and revenue is down year-to-year for the first time in a long time. Alcoa is an acronym for Aluminum Corporation of America, and aluminum prices have been dropping steadily for the last 2 years. Alcoa isn’t diversified enough to make up for the commodity price drop, and so it did do the Dow adieu.

Did do the Dow adieu. Did do the Dow adieu. In other news, the 6th sick sheik’s 6th sheep’s sick.

Finally, the titan-cum-laughingstock Hewlett-Packard. For those of you either too young to know or too well-balanced in your daily lives to care about this stuff, Bill Hewlett and David Packard were the original Jobs & Woz. H & P started their company in a garage in Palo Alto, the Steves in a garage in Los Altos, 8 miles away.

But a lot has changed since 1939. By the 2010s, Hewlett-Packard was making mistakes almost for the fun of it. The company spent $1.2 billion to buy Palm, and basically wrote the purchase off a year later. They hired an overmatched CEO who didn’t even last a year. He authorized the purchase of Autonomy, and if you think the Palm purchase was stupid at least Palm didn’t publicly overstate its value by $9 billion. Yeah, that was another writeoff. Hewlett-Packard stock free-fell last fall, bounced back this year (doubled, in fact), but that wasn’t enough to keep it in the Dow.

The replacement stocks fit the index as well as any, given the Dow’s implied goals of reflecting the diversity and breadth of the economy. The committee traded out a tech company, a mining company and a bank and replaced them with…a shoe company and 2 more banks.

Notice something about the list of 27? Relatively few of them are full-on consumer companies, selling something you can buy in a store. Thus Nike joined the mix. Not coincidentally, Nike stock is at an all-time zenith. Revenue is growing – arithmetically rather than geometrically, but Nike has been around for a few decades. Add healthy profit margins and a price/earnings ratio with room for growth, and Nike was an easy choice.

Goldman Sachs, profiteers of the 2008 mortgage crisis and beneficiaries of the infamous Troubled Asset Relief Program, replaced Bank of America. An exchange of scoundrels? Perhaps, but the former’s financial statements are far more attractive than the latter’s. Goldman Sachs’s earnings per share is at a record high. Also, it’s the most juiced company in America. Its CEO seems to spend more nights at the White House than Michelle Obama does, and the list of recent Treasury Department upper-level hires reads like the 2002 Goldman Sachs internal phone directory.

That leaves Visa which, curiously, began to trade publicly only in the spring of 2008. (Prior to that Visa was more an agglomeration of companies, more of a “membership association” than a standard stock issuer.) At its initial public offering the stock traded at $44. It’s now within a gallon of gas of $200, and the company enjoys a market capitalization of $125 billion. (Fun Fact: Visa cards debuted in 1958, under the name BankAmericard. A service of…Bank of America. B of A licensed the card to other banks, and by 1970 had effectively ceded control to the entity that would become Visa.)

How does this affect you, the ordinary investor (assuming you’re an ordinary investor)? Minimally, unless your investments’ value derives from the value of the Dow. Or, of course, if you’re long into any of these 6 companies. If your mutual funds are tied to an index, chances are pretty good that it’s the 17-times-broader S&P 500, whose makeup remains unchanged.