The importance of an emergency fund is both fundamental and necessary in building one's foundation of personal wealth. We can plan on regular expenditures such as a monthly mortgage payment, car insurance or our five-week haircut. The things that are most apt to create financial woe are the things that we cannot plan for; such as a car crash or emergency dentistry. (After all who among us has a root canal fund?) So how much do you need for an adequate emergency fund? Suze Orman has the standard go-to of eight months worth of expenses. For me, it's whatever amount that you feel comfortable with. Financial satisfaction cannot be had without understanding what you would do in an emergency.
The problem of course is that emergency fund money is essentially sitting under your mattress. This point was made perfectly clear to me personally when I recently witnessed my savings rate drop from 0.25% to 0.15%; abysmal by any calculation. True, there are higher yielding alternatives such as Ally and Discover bank. However, I would conjecture that many are bound to their banks by habit, convenience or personal relationships. This appears to ring true as Bankrate.com pegs the national average rate for a $10k savings account at just 0.19%; while 1% offerings are posted without hesitation.
So besides sitting on cash in a savings account, let's look at some risk-free alternatives. A 5-year CD has a national average APY of 1.12%, the 10-year treasury is boasting a 1.47% yield and for those really looking to get above the 2% mark, why not go straight to the 30-year treasury rate of 2.53%. The problem, much in the same manner as sitting on cash, is what I like to call "old man par" or more explicitly 'inflation.' Let's say that you have $10,000 in cash set aside for emergencies for the next 10 years. You hope to never use it, but it's there if you need it. For illustrative purposes, let's peg inflation at 3% a year on average. In 10 years, in order to buy the same amount of goods as today, you would need no less than $13,400. If you simply bought a 10-year treasury your money would have grown to just over $11,500. So while you did make more money, you lost to "old man par" and your purchasing power declined by nearly $2000.
Effectively the loss of purchasing power is what you have decided to pay in an 'insurance premium' for having money readily available. While there is no doubt that one needs an amount on hand for the inevitable, it is clear that these days that amount is being squeezed by less than favorable circumstances. I would suggest that, after your comfort level has been reached, not a penny more be devoted to losing purchasing power over time.
So where do we go from here? As any investor will tell you there is a positive relationship between risk and reward such that one cannot obtain a higher level of return without taking on more risk. If it were possible to obtain a risk-free 10-year return of say 3% today, people would simply do that instead of investing in U.S. treasuries. But I think I have a solution for those of you looking for long-term CD like investments that not only preserve but also build purchasing power through time. My answer, as it is to most questions, is: dividend growth stocks.
Specifically I am talking about well established companies with reasonable dividend yields and a long and storied past of not only paying but also increasing dividends by a rate that far outpaces inflation. I'm talking about companies like Coca-Cola (KO), PepsiCo (PEP), McDonald's (MCD), Johnson & Johnson (JNJ) and Procter & Gamble (PG).
Let's review some basics of these companies before unearthing the logic in investing in them.
Coca-Cola (KO) - Has increased its dividend for 50 straight years, 2.8% current yield, 54% payout ratio, 10-year average yearly dividend growth rate of 10.1%.
PepsiCo (PEP) - Increased dividend for 40 straight years, 3.2% yield, 53% payout ratio, 10-year average dividend growth 13.3%.
McDonald's (MCD) - Increased dividend for 35 straight years, 3.2% yield, 52% payout ratio, 27.4% 10-year dividend growth rate.
Johnson & Johnson (JNJ) - Increased dividend for 50 straight years, 3.95% yield, 67% payout ratio, 12.4% 10-year dividend growth rate.
Procter & Gamble (PG) - Increased dividend for 56 years, 3.7% yield, 70% payout ratio, 10.9% average dividend growth rate.
Obviously this is just a sampling of the available opportunities out there. One would want to hold much more than just these five wonderful companies in their portfolio. Additionally past performance does not that indicate future results. However, given the strong shareholder commitment of these companies over the last half-century one can feel reasonably confident that this trend will continue. Even if these companies only raise their dividends by 5% each year going forward (unlikely in my estimation) this still beats inflation and the current risk-free counterparts.
But they aren't risk-free! I hear you clamoring. Here's my suggestion: Treat dividend growth stocks as a 10-year CD. Or even better a 20- or 30-year CD.
Here's the logic: You don't look at the principle, that is the price of the securities, for the next 10-years. After-all how often do you check in on your CD's principal? Each quarter you receive your dividend check and either reinvest it or take a night on the town. For illustrative purposes let's say your portfolio is similar to investing $10,000 in equal parts of the five aforementioned companies. You would have a yield around 3.37% and a dividend check of $84.25 each quarter or $337 in the first year. Because these are dividend growth stocks, in the next year let's say they increase their payouts by an aggregate 6%. Now you receive $357 in year 2 (outpacing inflation) or about $89.30 a quarter. You can see without doing a single thing your payouts beat inflation for you. The effect is compounded more so with reinvestment. If you fast forward to year 10, using the same conservative 6% growth estimate, your payments have grown to $569 a year.
In total, without reinvestment, you would have collected about $4400 in dividends as compared to the $3400 needed to keep up with inflation. Your purchasing power has increased by about $1000 and would continue to do so in the future given the same assumptions. But, we haven't talked about principal yet and now it is the end of year 10. Your guess is as good as mine as to what precisely your securities will be priced at. (Notice I said 'priced' instead of 'worth', the true value is the stream of dividends that you had been and would continue to collect) However, given risk-averse investors, required returns and the fundamentals of business it is at least inherently likely that your securities will be selling for a greater amount in 10-year's time than they are today.
This is especially true if you buy wonderful companies at attractive prices. Overpaying, even for quality, can hamstring any fundamental investment strategy. But the universe of dividend growth stocks is vast such that there is nearly always something intelligent to do with your money. I can't tell you what the market will do next week or next year, but I have a feeling that in the next decade people will still be drinking Coca-Cola, eating Lay's potato chips, taking the drive-thru for a McDonald's hamburger, patching up cuts with Neosporin and Band-aids and trusting their daily shave to Gillette.