Meanwhile, back on Earth...What to do with cash.

I enjoyed writing the previous post, and I think it is great to get folks thinking about risk and long term investing, but I suspect many of my readers have a shorter term focus. I indicated that nearly everyone should have a minimum of 3-6 months expenses in cash or short term investments. For retirees without other sources of income, the amount should be considerably larger, perhaps on the order of 3-5 years. This is critical because failure to be prepared for inevitable setbacks leads to the type of debilitating debt we've discussed in previous posts. And for retirees, the larger stack of cash helps prevent having to sell stocks or other assets in a down market.

Unfortunately, there are several problems with having large amounts of cash.

• Readily available cash can burn a hole in your pocket. If readily available cash tempts you to spend, put it somewhere it is a bit less available. This is one of the reasons to keep a minimum amount in your checking account.
• Risk averse, short term investments generally have low returns. This is particularly true of the checking account, another reason to minimize the balance in your checking account. I generally keep a small balance in my checking account, charge nearly everything to my credit cards and transfer the needed funds to pay the credit card each month just in time to pay the bill. This allows me to keep maximum balances in higher yielding accounts. There are a couple of caveats to this method: 1. If the use of credit cards increases your spending, don't use this method. 2. Do not maintain balances so low that you incurr overdraft and other expenses. These expenses can easily eat up the increased returns. On the other hand, getting maximum return from every dollar is a key to making forward financial progress.

Fortunately, improved competition and availability make it easier than ever to improve returns on your short term investments. Here are some vehicles I have used recently for this purpose:

• Internet banks such as Ing Direct and Countrywide have made it possible to easily access the best possible rates. These accounts can be easily set up in a few minutes on the internet and make it easy with a few keystrokes to move money to a better return or to your checking account when needed. These banks offer FDIC, so they are some of the safest investments around.
• Money market accounts through a brokerage, mutual fund company or Paypal are also easily available via the internet. Although not FDIC insured, these are generally safe investments. The return changes on a daily basis, but right now they have some of the best rates for immediately available cash. This is particularly true of Paypal, where I have much of my cash right now, although you'll want to check regularly to see what rates are available. The best rates seem to rotate between various companies. If you are considering either opening an account at either an internet bank or a money market account ask your friends whether they have an account. They often have bonuses for referring new customers that can improve overall returns for moving your money.
• Because of the increased competition, local banks are also forced to increase their returns to attract deposits. Frequently, I see high teaser rates from local banks. Just keep in mind that they offer the teaser rates to bring in customers, hoping to lower the rate later, so if you go this route make sure you keep on top of the rates and terms being offered. These banks are also less convenient for me, but if you are willing to spend the time to shop and patronize the local banks you may be able to improve your return.
• If you can get by with less availability for some of your funds and are worried about inflation you may want to consider the US Government, in the form of I Savings Bonds. These offer a combined rate made up of inflation plus an incremental rate, meaning you'll always earn a return above inflation, which is not always possible in other short term investments. They require a minimum term and you will lose 3 months interest if redeemed within 5 years, but again, they are easily accessible via the internet. These are obligations of the US government and are therefore about as safe as you can get. Taxation of interest is deferred until withdrawal as well, which makes them ideal for those in high tax brackets nearing retirement.

The list could go on and on, but you get the idea. To ease the pain of keeping a significant amount of cash available, use all your resources and keep watch. Remember, each dollar your investments earn is a dollar you don't have to earn somewhere else and then it begins to compound.

Effect of diversity on risk

Jon, thanks for your comments (see comments on previous post). I certainly understand and agree with your premise that diversification greatly reduces risk, but I could not have made the case in as concise and detailed an argument. It may be time for you to write a guest article. If interested, just send it in an email and I'll post it.

Your example uses just two stocks vs one, so imagine how significant the decrease in risk if you consider thousands of stocks from different industries with different market caps and from different international economies. And, this extreme diversity is easy and cheap with todays index funds. This is why I indicated I'm comfortable with a higher percentage stocks in my portfolio than conventional wisdom allows.

I'm struggling with one point you make, which is that your average return is only slightly decreased. From what I know, I think there is no decline in average return unless you can predict which stocks will have higher average returns in the future. With the efficiency of markets today, I'm not sure that is possible to do consistently.

I'll point out another thing to worry about, though. Your example talks about two negatively correlated stocks, and the case is clear for that example. Unfortunately, I have found that most stocks worldwide have a significant degree of correlation, which is the basis for my trading in international stocks. I've discussed this with many readers, although I have yet to post a blog on this topic. And, the real trick to understanding the decrease in risk is predicting the amount of correlation of your assets. The big worry is underestimating the risk by underestimating the correlation.

Good news for long term investors! The market is down!?

For a retiree like myself, with no income but my investments, a market like the one over the last couple of weeks can easily cause a bit of panic. If you extrapolate this trend, I could be working at Mickey D's within a few years. Consequently there arises in your gut the desire to sell. It is this instinct, and an inverse one in the booming market, that causes most investors to underperform the market averages.

Invariably, at times like this, my colleagues come by to visit, because they know I enjoy tinkering in the market. The conversation invariably goes something like this:

Them: How 'bout this market?
Me: Wow, a bit scary isn't it?
Them: Yeah, so what are you doing, selling?
Me: Oh, I'm just working my system of diversification, dollar cost averaging, and rebalancing, which at times like this mean I'm generally buying.
Them: So, you are optimistic? You're pretty sure that the market has bottomed?
Me: Well, I'm optimistic in the long term, but who knows if the market is near the bottom? I'm just trying to keep the emotion out of it and working my system.
Them: Well, I'm thinking of selling until I'm surer what the market is going to do.
Me: If you do that, I predict you'll start buying just when the market hits the next peak.
Them: Oh, no, I'll reinvest when I'm sure the market is on an upward trend.
Me: Right, I think that is what I just said.

It is amazing how consistently this conversation plays out with each market dip. And each time, I become more convinced that it requires a disciplined, mechanical system to me a successful invester. Trying to predict where the market is going over the short term is impossible and is a recipe for underperforming the market.

So, remember. Set up a diverse allocation that makes sense for you in the long term. Dollar cost average. Rebalance. Above all, don't try to change your system in times of stress. Particularly so, if all the "experts" are telling you it is clear where the market is headed tomorrow or next week. When all the experts are in agreement, they almost invariably are wrong.