What Would I Do With $50,000?
Recently, Joe over at Retireby40.org discussed his options for a $50,000 emergency fund, and I must confess that I thought they were rather poor. Not that Joe is making poor decisions, but his options for investing this money are pathetic. A 5 year CD paying 2.25%? That is a guaranteed loss of purchasing power because you know that after taxes and inflation are taken into consideration, the value will be down!
Now Joe has certain requirements, and I am not trying to change his mind regarding them. But he did ask the question posed in the title and since my answer was going to be longer than could be held in a comment, I thought I would write a post about it.
How I Would Manage $50,000
I have to assume that Joe is debt free (with the possible exception of a mortgage) so I would make sure that I am debt free as well. I also have to assume that there is some savings in Joe’s budget so that he might be adding to this fund at a rate of $500-$1000 per month. You don’t want to be quitting a job with a budget that is tight.
I also have to assume that the likelihood of needing all $50,000 within one month is incredibly slim. What emergency costs that much? You should have other insurance to cover major medical or disabilities or liabilities so needing the whole sum at one time would be unexpected. So having access to half the money rather quickly seems reasonable to me.
Invest in Stocks
So, I would invest in stocks. Now I know it doesn’t meet Joe’s requirements but hear me out. Investing in a margin account would allow you to access half of the equity rather quickly (within one week). The interest rate on that at ETrade is 8.44% which is likely better than a credit card. Again, how much will be needed at one time?
But there is the concern about loss of principal. Now I am just as concerned about loss of money as much as the next guy and possibly even more so as I get older. This is why I use protective puts. I would look for large company stocks that pay dividends but might be slightly volatile so that they pay a good premium on covered calls. Then I would buy some puts, sell some calls, and collect the dividend. I would probably split the money in two portions and invest in one energy and one tech stock.
For example, I might choose to purchase 1000 shares Intel stock (INTC) at $26.38 and purchase the January 2013 $22.50 strike put option at $1.47 per share. I am choosing the longer term put because the cost per month of protection is relatively low. Thus my total cost is $27.85 plus commissions or $27,850.
I would then sell the April 2012 $28 strike calls for 42 cents per share lowering my basis to $27.43. Now if the stock heads above that price by April and stays there so it gets called out, then I have made 57 cents in profit plus the 21 cents quarterly dividend or $0.78 on my $27.43 investment. The yield is 2.8% over 3 months which is much better than a five year CD. But let’s not forget that the put option has an additional 9 months of time value left which can be sold for additional profit.
Rising Tides Are Easy
So it is easy to make money when your stock increases in price, but the real problem is the risk involved. What if the stock drops like a rock? The most money that is at risk is the difference between the basis of $27.43 and the put strike price of $22.50. That is $4.93 which represents an almost 18% loss of capital! That sounds too risky. But we will collect 84 cents in dividends over the next year so we would only lose 15% instead. But still losing 15% of an emergency fund is not fun.
However, this is where it is important to be able to add to the fund. If you are adding $1000 to the fund each month, then an additional 100 shares could be purchased in 2.5 months. If purchased at a lower price, then the basis will decline and additional calls could be sold after April. Eleven contracts could be sold at that point. The strike may end up being the $27 strike so this may help cushion the loss. Additional shares also means additional dividends which can be reinvested.
Now if the stock ends up $15 in January 2013, that is OK. The puts will be exercised at $22.50 giving the investor $22,500 which can then be used to purchase 1500 shares. If this is all that happened between now and then our original basis in the stock is $27.43 minus the 84 cents in dividends. The new purchase drops the basis even farther to $17.73 which would make selling a $17.50 call option a possibility.
The bigger risk is a slow grind down to $22.51 where the investor has difficulty managing the covered calls from April to the following January. That is where some experience helps as well as being able to purchase additional shares during the year to bring the overall cost of the position downward as the stock declines.
The bottom line is that I would be putting 15% of my capital at risk in order to earn about 5% over 3 months. To me, that is reasonable which is why personal finance is personal. You would never catch me investing in a CD in a negative real interest rate environmental. Again, a personal decision. But, since the question was asked, I answered it.
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With having been in South Carolina on a golf trip over the past week, I hadn’t really done any round up or link posts, but I do want to highlight those carnivals CFM has been in these past two weeks. Be sure to check them out. A big thank you to all the sponsors.