Recently, I’ve been reading Nassim Nicholas Taleb’s book The Black Swan. Most of the book has to do with economics and mathematics and is not very relevant to personal finance at all, so I won’t bother doing a detailed review here. However, there are two pieces of the book that I think are worth talking about, so let’s dig in.

The Black Swan and Your Emergency Fund
The basic premise of The Black Swan seems like common sense: life is full of unexpected events. Big ones (like, say, 9/11), medium sized ones (like, say, a career shift), and small ones (like, say, your daughter wetting her pants just before you’re about to leave on an errand).

The Black Swan argues that our minds use a lot of tricks to hide these so-called “black swans” (his term for largely unpredictable and rare events) from us. We need to see the future as at least somewhat predictable, or else we wouldn’t bother making many plans at all. So, when we reflect on our past, it seems much more orderly than it actually was. Also, when we think about the future, we imagine something much more orderly than what will happen.

This idea makes a lot of intuitive sense to me. I know that quite often, when I think about the past, it does seem like an orderly progression of things. However, when I look at old diary entries and old videos, I see that there were actually a lot of “black swans” floating around. I didn’t see The Simple Dollar’s success coming at all, for one. When I went to college, I didn’t see myself working for a slightly eccentric German fellow who would basically set up my first career for me and also taught me how to pack effectively for business travel – he was a black swan.

Given that, I think there are a lot of things one can do in their own life that will prepare oneself for the arrivals of black swans of all magnitude.

Learn a wide variety of skills. I don’t just mean transferable skills, either. Know how to make things. Know how to build things. These skills will come in handy over and over again, often in unexpected ways.

Live frugally. I believe that’s one of the underlying messages here – frugality is a great economic and personal advantage. Knowing how to always maximize one’s resources makes one much more able to survive great changes in life – and also gives the person the ability to build up resources (as mentioned below).

Minimize your future costs. If you can use your money now to invest in things that will reduce your costs in the future, do it. The fewer resources required in the future to maintain your way of life means that fewer “black swans” can disrupt you.

Have a large, stable emergency fund. Having a large amount of cash reserves makes it possible for you to ride right through any small and medium-sized “black swans.” Your car unexpectedly dies? Not a problem. A career opportunity comes up? You can jump at it. You lose your job? Not the end of the world.

Have a good “opportunity” fund, too. Sometimes the unexpected comes along and it requires you to have resources. For example, there’s a large chunk of land near our house for sale. If it suddenly makes a nice drop in price, I’ll jump on it. If I happen to see the owner sometime soon, I may negotiate. It’s been up for sale for quite a while, so something nice may happen soon – not quite a black swan, but a good example. A real “black swan” might be that a neighbor is in a pinch and puts a sign on his car that says “$5,000 or best offer” and you can walk over there with $3,000 in cash, snipe it, then resell it for $5,000 with some footwork.

In short, keep some resources at hand, make yourself more useful, and minimize what you’ll need in the future.

The Black Swan and Investing
One particularly interesting point in The Black Swan comes when Taleb briefly discusses investing. His suggested portfolio for taking advantage of black swans is very unusual, yet it makes some sense.

He advocates putting 85-90% of your investment money into something extremely stable, like treasury notes. The other 10-15%, invest it in the riskiest things you can find – things where a black swan might make it go crazy.

So, let’s translate that into dollars. You have $10,000 to invest. You put $8,500 of it into treasury notes, which return 2% annually. You put the other $1,500 into Bangladeshi startups (for example).

At the end of the year, even if you lose all of the Bangladeshi money, you still have $8,670 – your total loss is only 13.3%. On the other hand, let’s say that your Bangladeshi startup goes bonkers and you get a 900% return on that investment, turning $1,500 into $15,000. You now have $23,670 – a 136.7% return.

Basically, Taleb’s argument is that, as I mentioned above, there are many more black swans out there than we initially believe there are, so one should take them for a ride without too much exposure to risk.

My feeling is this – if you have enough risk tolerance in your investments to put them into stocks, there’s some logic in using Taleb’s investment ideas. It puts a floor on the worst case scenario and gives a lot of upside.

Much of the rest of The Black Swan suffers from the same condition that befalls Taleb’s other books – lots of good ideas, but also lots of ego and self-congratulation. It’s thought provoking, but at times you want to go wash your hands.

Every other Sunday, The Simple Dollar reviews a personal finance book.

The second I picked up Oblivious Investing by Mike Piper, I was immediately reminded of Michael Mihalik’s excellent Debt Is Slavery.

The two books have much in common. They’re written by people who aren’t personal finance gurus – instead, they just bring a lot of very specific passion about a very specific topic to the table. The books are short and very tight, drilling right in on their points. Their ideas are realistic and sensible – and the concepts are repeatedly backed up by both life experience and with the more lofty and scholarly writings of others.

While Mihalik drilled in on the dangers of debt, Piper’s focus is simple: investing can and should be simple and it shouldn’t require all your focus. Worrying about market fluctuations is bad. Picking stocks is a nerve-wracking gamble. Moving your money around all the time requires too much attention. Instead, Piper argues that we should be largely oblivious to our investments – and the idea is backed up with a lot of sound principles.

Piper’s book has two interconnected parts.

Part One: The Plan
Piper’s plan is very simple, but in those few pages he incorporates quite a lot of the ideas that have been written about for years by hundreds of investing experts – Burton Malkiel, John Bogle, and so on.

Here’s the idea. It’s possible to pick the best stocks if you have all of the information. However, there is so much information that it’s actually impossible for people – even people who devote their lives to the study – to absorb enough information to make those picks consistently.

What we can do is step back and look at some bigger patterns. Over the short term, the stock market fluctuates a lot – one only has to look at 2007 and 2008 to see that. Over the long term – ten to fifteen years or more – the stock market shows positive returns. Over even longer terms – twenty years or more – it shows very nice positive returns.

So, the first step is to figure out your goals. What are you saving for? How far off is that goal? If it’s not very far off, avoid the stock market – it’s too volatile. If it’s very far off (more than ten years), invest in the stock market – but invest in the whole stock market and do it as cheap as you can.

How do you do that? Buy index funds. Extremely broad index funds (like, for example, the Vanguard Total Stock Market Index) let you own every stock in the stock market all at once, and the costs are very small.

So, your investment plan is this: if your goal is short term, invest a certain amount each week/month into bonds or CDs or something else very stable and with positive low returns. If your goal is long term, invest a certain amount each week/month into a broad based index fund. Then, forget about it until you get close to your goal.

Part Two: The Noise
Once you’ve made the decision to invest, the real trick is to filter out the noise.

First, train yourself to ignore what’s going on today, this week, this month, and this year. The stock market is volatile – live with it. The trick is to remember that you’re investing for the long term. Volatility doesn’t equal long-term risk. Another thing to remember is that short term stock market volatility is entirely unpredictable. So just ignore it.

Second, don’t bother chasing the “best” funds. Instead, just put your money in an index fund that matches the market for cheap. Why? A fund that’s the “best” one year is quite likely to not be the best in subsequent years – the market changes, investors herd into the fund and flood it with too much money so that the strategy doesn’t work any more, and there’s a lot of cost in jumping from fund to fund. Just pick a steady, average fund and leave it there – ignore the “fund of the minute” and the talking heads on CNBC.

Third, ignore specific stock tips. The ones in the media are often placed there by analysts who are set to profit from people following that tip. The one from your uncle might be useful or it might not be – but don’t bet your future on it. Ignore all the specific investment tips.

If you’re filtering out all of that, you’re left with just one thing: your plan. Keep investing, steady and surely, and don’t sweat the little swings or the panicked talking heads.

Is Oblivious Investing Worth Reading?
Oblivious Investing does a fantastic job of laying out the “buy and hold” strategy in layman’s terms that anyone can understand. For a person who simply wants to begin investing their money for the long term but doesn’t want to spend every day praying at the altar of CNBC, Oblivious Investing is a great read.

If you want detailed advice on portfolio management, this isn’t your book. If you want comparisons of individual investment strategies, this isn’t your book. Piper makes one big point throughout this book – he makes it thoroughly and clearly, but Oblivious Investing doesn’t try to be a Swiss Army investment book. If you want that, read The Bogleheads’ Guide to Investing.

I should say, though, that I subscribe to the investing strategy in Oblivious Investing. It works well for me and this is the best layman’s description of it that I’ve yet read.

Quite often, financially intelligent young professionals get out of school, start in the professional world, and actually stick quite strongly to the “spend less than you earn” mantra. They fund their Roth IRAs and their 401(k)s, but they still find themselves spending much less than they’re bringing in. And they wonder what’s next.

“Fred” writes in with a question along these lines:

I’m in my mid 20′s and just got my first job, currently make ~$50k. In 3 years I will graduate from medical residency and be making 3-4x that. I’ve had a very fortunate upbringing- no student loans, no credit card debt, and about $100k invested in securities. My question is regarding IRA and 401k contributions. Once I’ve contributed up to my 401k’s match, and max out my Roth IRA what should I do next? The current wisdom is to max out my 401k contribution. I feel quite certain that my taxes (once I make ~$200k annually) will eventually be much higher because of our spiraling debt/ Obama tax plan. Would it still be wise to max out my 401k?

There are several pieces of the puzzle worth discussing here.

First, never, ever count your chickens before they hatch. The most common mistake that I see people making is their assumption that they will be earning more in the future. That may be the plan, but plans can change – they are often derailed by life, health, changing interests, opportunities both missed and otherwise, and so on. Do not make spending decisions now based on what you hope will happen in the future.

When I found myself in a very long-term stable job in 2004, I made the mistake of essentially betting that I would have that income in perpetuity – nothing would keep me from earning that money until retirement. Flash forward to 2009 and what do I see? An opportunity came along and I jumped on board. I’m earning less than I might have otherwise, but every morning I feel absolutely that I made the right choice.

So many things can happen over the next few years. You might become disenchanted with your current work. You might fall in love and have a child. You might fall into ill health. In each of these events, you likely will not be earning three times your current salary in a few years.

Instead, a much more prudent path is to build a firm foundation for whatever may come. As I noted above, many people are at least peripherally aware of this, investing money into retirement. But retirement investing is just the start.

Build a very healthy emergency fund. It’s always useful to have at least six months’ worth of living expenses available in a very liquid place, like a high-interest savings account. Don’t be afraid of the size of the goal – just start an automatic plan to scoop some portion of your paycheck right into that savings account. Hold onto it – use it for big emergencies, then replenish it afterwards.

Invest in yourself. Never be afraid to invest money in making yourself better. Lose weight – if you have difficulty doing it on your own and can afford it, hire a trainer to motivate you. Get your teeth straightened and cleaned. Work on your self-confidence and take opportunities to speak in public. Invest in clothes that are well-made and durable – ones that will last through whatever may come.

Invest in a taxable account. If you’ve got an emergency fund, no debts, and a well-padded emergency fund, start investing in a taxable account. How exactly you do this depends on your risk – my recommendation is to invest in index funds using a buy-and-hold strategy. Hold onto that money for now and wait for opportunities to come to you. That money may eventually become a home. It may become the basis for a business. It may become the backbone of a very early retirement. Whatever it is, having it in a taxable account means you can utilize it for whatever you need, whenever you need it.

What about investing more for retirement? If you’re already maxing out an IRA and picking up all of your employer’s matching in your 401(k), your bases are pretty well covered for retirement. Investing beyond that can be helpful over the long run, but if you’re doing it at the expense of an emergency fund, your own personal health, or other personal goals, you should spend some time asking yourself what your true goals are.

My argument is simply this: money invested in a taxable account is likely a good option in this situation. While you do have to pay capital gains tax on the dividends (as well as on the gains if you sell the investments), that money can be used for any purpose without penalty: retirement, a home, startup money for a business, a wedding, education for a new career, or anything else that might come your way. Your future is not set in stone – don’t set all of your savings and investments in stone, either.

Good luck!

A very kind reader recently sent me a link to a fascinating article at Salon.com entitled How I Learned to Haggle. The article outlines a woman’s experience with haggling, culminating with the author actually requesting a discount at a dollar store:

So before I can think too hard about it, I drive to my kids’ favorite place of business, the 99-cent store — where everything is now upward of $1.29 — to shop for an upcoming holiday. My extended family is coming to town for a big celebration, so I stock up on several items in bulk. Taking deep, relaxing breaths and focusing on the joy the plastic doodads I’m clutching will bring to my offspring and their cousins, I wait for the long line at the register to taper off. Then I unload the contents of my basket onto the raised counter, look up at the woman on the platform behind it and say, with a surprisingly steady voice, “I’m buying a lot. Would it be possible to get a discount?”

She looks at me, clearly taken aback and a little irritated. “I’d have to get the owner,” she says, as if that will end the conversation.

“OK,” I say.

She rings up three more customers while I wait, probably hoping I’ll give it up and go away, then reluctantly rouses herself and comes back with the owner, a kindly man to whom I repeat my question and fall silent.

He smiles at me. “Well,” he says, “you are buying a lot.”

He turns to the woman at the register. “Charge her 99 cents for these,” he says, pointing to eight items in my basket priced at $1.29. And these,” he says, waving at eight more priced at $1.49.

Then he looks at me apologetically, eyeing two large items selling for $1.99. “I can’t go any lower on those. Just the delivery charges have gotten so expensive.”
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“I understand,” I say.

Then he says, “OK, charge her $1.49.”

The woman at the register sourly does as she is told. I thank them both and pay in cash.

Unsurprisingly, with a story like that, the comments are pure gold, alternating between people sharing their own haggling tips and cheering on the writer to others disgusted at the thought of haggling at the dollar store.

My thoughts were pretty diverse on the issue, but I largely support what the woman did. Here are some of my thoughts on haggling – many of which I’m sure will generate some discussion.

A person’s desire and ability to haggle depends on their personality. Some people are born to haggle. Others are brought into it culturally. Others simply have neither the innate desire or the cultural pressure to do so – or only feel like it’s appropriate in some situations. Given that there are so many personal feelings about bargaining and there are vastly different cultural expectations about it in different parts of the world, it’s pretty much impossible to come to a single clear set of rules about what’s appropriate and what’s not when it comes to this art.

At the same time, it seems that in a world of haggling, introverts are directly financially penalized. A person who is naturally introverted or timid will simply not negotiate as strongly as an extroverted person who is willing to make a public scene to save a few dollars. Should the introvert be financially penalized for their nature? Would it be similarly appropriate to financially penalize people for other aspects of their nature – for the color of their skin, perhaps?

It’s because of this that I largely support standardized pricing within stores and competition among stores – everyone gets the same deal and the people who are rewarded are the people willing to put in the footwork and do comparison shopping, not the people who are willing to be pushy for it.

Businesses that expect haggling will price accordingly. Take yard sale pricing, for example. Whenever I run a yard sale, I usually price things on the high end of what I think is a reasonable yard sale price and I allow and encourage haggling. As the weekend goes on, I drop my prices over time.

This is true of many businesses, particularly “mom and pop” type businesses and also businesses from other cultures outside of the United States. They expect some degree of haggling from some percentage of customers and price accordingly. Quite often, I don’t mind not haggling at these events and paying their face price because I like supporting local businesses, but I have no qualms with haggling if a price seems particularly out of line.

Businesses that don’t expect haggling won’t tolerate it. On the other hand, in many stores, haggling simply does you no good. Large chain stores – particularly on less-expensive items – simply have no room at all to change prices. They’ll simply refuse – and you’ll simply have wasted your time. So, don’t haggle over the price of a tube of toothpaste at your local Target.

Taking those factors into account, I see no reason not to ask for a discount in many situations – but doing it where there’s no real chance of it working is annoying to those around you and potentially damaging to your reputation. If you’re standing in line at the local department store (that is obviously not a place with a haggling reputation) and make a big scene over trying to haggle over a few items, your only outcome will be to frustrate and annoy those around you. Even worse, some of those people might remember you – and your annoyance to them may come back to haunt you later.

My final point is perhaps the biggest one of all. If you feel the need to haggle for the item, why are you buying it at all? Take the example in the original story. Why is that person in the dollar store at all? Are “plastic doodads” from the dollar store really a worthwhile purchase?

While I can surely appreciate the sentiment of wanting to make a child happy, why not actually do something special with that time and money, like make a batch of their favorite kind of homemade ice cream together? Or even play a few simple games in the yard with them? Children are happy whenever you show them genuine love – it doesn’t have to take the form of a “plastic doodad” you bought for a buck at the dollar store.

This expands into a more general principle. Most of the items you might haggle for aren’t necessities at all. Unless you truly do want the item (and it passes the ten second rule), don’t even bother haggling over it or putting it into your cart. Just walk away and keep that cash in your pocket. Haggling to get a “deal” on something you don’t truly want and don’t need is just another way to watch your money slip through your fingers.

I look forward to your comments on haggling.

Amy writes in:

You often talk about investing in bonds. I don’t even understand what bonds are, let alone how to invest in them!

Well, let’s start at the beginning.

What Is a Bond?
To put it simply, a bond is a way for an investor to buy a piece of someone’s debt, usually a government or a large company.

Here’s a clear example. Let’s say your city wants to raise money to put in some new roads. They don’t have enough money in their current budget to pay for it, but they’re quite able to put aside money in future budgets for the bridge.

The city’s solution? Issue bonds. They sell bonds to the general public for a certain price (the issue price) to raise money. Investors buy these bonds from the city, putting their money directly in the city’s coffers.

What does the bond buyer get? A bond states that on some regular basis, the person buying the bond will receive a certain small payment (known as the coupon). Then, when the bond matures, the person who bought the bond will receive the face amount of the bond.

So, here’s another example. Let’s say you buy a $10,000 bond from the city. It’s set to mature in ten years (meaning the city will give you back your $10K at that time). Until then, the bond states that you’ll receive a payment of $175 every six months – that’s the coupon rate.

Usually, bonds are issued by governments and large corporations to finance big purchases that they don’t have the cash on hand to pay for at that moment. But that’s a risk, right? What if they can’t make good on that payment? That’s why bonds come with bond ratings, which give an indication of how reliable the organization issuing the bond is. Some issuers are very secure (like the governments of first world nations), while others are much less secure (companies that are in poor financial shape) – the latter are usually called junk bonds and aren’t solid investments for laypeople.

Advantages of Bonds
The big advantage of buying bonds is that they’re reliable. The bond issuer is legally bound to make those regular payments to you and to pay you back the face value when the bond matures. The only real risk is the stability of the bond issuer, which is why many people not involved in financial careers stick to very safe issuers, like the federal government.

Thus, if you stick to big issuers like the federal government, they’re quite safe, too.

Another benefit of bonds is that some types of bonds (particularly municipal bonds – ones issued by cities for improvement projects) have tax advantages. Most municipal bonds are exempt from federal and state income tax.

Disadvantages of Bonds
So why would you not invest in bonds, if they’re so safe? Typically, very safe bonds don’t have a very strong return at all.

Take, for example, current returns on bonds issued by the U.S. government. Short term ones (3 month, 6 month, and 1 year treasuries) are paying no coupon rate at all, which means that all the government has to do to fulfill the bond is pay you back the face value at the end – no interest, no nothing. The only way to make money on these right now is to buy them a bit below their face value – thankfully, the government sells these at auction, which means that you can buy them just a bit below their face value (but still return less than 1%). Alternately, you can lock your money down for thirty years – but you’ll only get 3.5% of the amount you invest in annual payments, which isn’t great, either.

While this is an extreme example that’s only occurring because of the special economic times we live in, the basic idea is still true – bonds typically don’t earn great returns. What they do is earn safe returns.

Buying Bonds
So how can you buy bonds?

If you’re interested in buying them from the federal government, you can buy them directly via Treasury Direct. For many people who want to handle all of their own investing, this is a great way to buy individual bonds.

If you’re interested in municipal bonds, you’ll likely have to buy them through a brokerage. Some municipalities allow individuals to buy bonds directly from them, but minimum investments are usually well into the thousands.

If you want to buy other types of bonds (bonds issued by other governments or by corporations), you’ll likely have to use a brokerage for such purposes.

My recommendations are pretty simple. Either buy federal bonds directly from Treasury Direct, or buy a bond index fund from a reputable investment house, like Vanguard (the one I use). Going beyond this requires both a strong sense of risk and a lot of time to appropriately research your options.

As I mentioned before, I started saving for my children’s college education as early as I possibly could – in mid-2005 for my son and in mid-2007 for my daughter. In each case, I opened up a 529 plan with myself as a beneficiary as soon as we knew the child was coming, then I changed the beneficiary to the child as soon as the child arrived – this allowed me to start saving prenatally.

What’s a 529 plan? “A 529 plan is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. It is named after section 529 of the Internal Revenue Code.”

Since my investing goal was a pretty long term one – college is at least fifteen years away for them, even now – I chose an aggressive portfolio for the investing – 90% stock index funds and 10% bonds. I then set up an automatic investment plan – $100 a month for each of them.

Notice the start dates, though – mid-2005 and mid-2007. In each case, my investments for their college education caught the full force of the recent stock market downturn. I’d log on every month or two to check on the investments to find that the balance had gone down, even after the contributions.

If it were simply an investment for my own retirement, I could internalize it with no problem. I can stomach losses for my own future, because I’m secure in my own knowledge that over the long run, the tendency of a diverse stock investment is to go up.

But I would look at the terrible 529 investment return, look at the pictures of my kids on my desk, and I’d feel guilty.

“I’m putting aside money for their future like I should be, but it’s falling through my fingers like sand. Their future is slipping away,” I would think to myself as I looked at the pictures, and I’d be sorely tempted to change that investment around to put the money into something more conservative.

It is incredibly easy to let emotions get in the way of rational choices when you’re a parent. You see your children so full of happiness and love, yet still dependent on you for so much, and you want desperately to ensure that they’re safe and that a bright future awaits them.

But emotional investing is the most dangerous kind of investing. When you invest with your emotions, you try to time the market. You sell late into panics and buy late into rallies. You often undo many of your earlier good choices. And, in the end, you’re left with much less than you would have had otherwise.

Instead, if you’re investing for the long term, you’re far better off removing your emotions from the equation as much as you can. Set up an automatic investment plan, sit back, and wait. Make adjustments only because you’re moving closer to your target date, shifting to more conservative options as the big day arrives (or, even better, invest in a plan that does this automatically for you). Look at the balance if you’d like, but don’t let a few poor balances cause you to make radical changes.

In short, be patient.

I look at those two pictures on that desk and I see two young children who rely on me to make many decisions and choices for them. I invest for them, of course, but I also do things like prepare their meals, help them get dressed, and regulate how much candy they can eat and how many DVDs they should watch. As much as I love them and want to maximize their safety, sometimes the best choice isn’t the one that my heart yearns to make.

Ada writes in:

Like you, I think the stock market is near the bottom right now and will go up greatly in the next three to five years. I have some extra cash (about $10K) but I don’t know exactly what to do with it to get on board. How would you do it?

In fact, I’m already doing it. My wife and I made the decision to start investing much of our long-term savings for a home into stocks because we both feel that the market is at the bottom right now and is poised for a big rebound in the next five to ten years.

So, what are we doing?

What Are We Investing In?
Most of our investment is going into index funds. For those unaware, index funds are a way to invest in a lot of stocks at once at a cheap price. A given index fund is usually governed by a simple rule – all stocks in the S&P 500, for example. Index funds have long been lauded as a great way to easily diversify at a very cheap cost.

We’re investing all of our money equally into two funds – the Vanguard Total Stock Market Index (which basically covers all domestic stocks) and the Vanguard Total International Stock Index (which broadly covers all international markets). In other words, the money is as diverse as we can make it.

At the same time, there are a number of individual companies that my wife and I particularly believe in for one reason or another (Apple being one, for example). While we both recognize that individual stock investing is a risky proposition, we also know that our investment choices reflect the things we believe in.

So, we’re allocating a small portion of our overall investment into a diversity of individual stocks – 20, to be exact. Each month, we’re automatically investing a small amount into each of these twenty stocks. Our investment amount in individual stocks is about 25% of the amount we’re putting into index funds.

Who Are We Investing With?
Our index fund investments are handled by Vanguard. We’ve trusted them for years – they’re known for their low-cost index funds and their reliability, which is exactly what we want. They’re also managing my Roth IRA, which they’ve done quite well.

Our individual stocks are being managed by Sharebuilder, which we decided on after a fair amount of hand-wringing. Their automatic investment plans were simple and reasonably priced (without any of the factors that made us nervous about the few brokers that undercut Sharebuilder in price), plus we weren’t restricted in our investment choices (as many of the companies we wanted to invest in didn’t have direct plans for investing). Since we’re planning on just doing automatic investing until the time comes that we actually need the money and then we’ll sell all of it (no market timing here), the actual management of the money for tax purposes will be pretty straightforward, too.

Isn’t This Risky?
Undoubtedly it is. That’s why we’re not putting any of our emergency fund, any of our retirement, or any of our short-term saving goals at risk. The money we’re investing here is money that we will only tap in the long term (ten or fifteen years or so) for the place in the country we’ve always dreamed of. Ideally, the stock market will help take us there a bit quicker than we might be able to otherwise, but if it doesn’t work, we’ve not really risked anything that affects our day-to-day lives, then or now.

Also, this plan merely reflects what we’re doing. You might want to be more conservative with your own savings for long term goals like this, and you certainly wouldn’t want to do anything like this with money you will need to rely on in the future.

We’re only able to start doing things like this because we’ve cut our spending drastically over time and we live by a mantra of spending less than we earn. Because of that, we can now make choices like this, paving the way to our dreams.

Dennis writes in with the following question about CD rates:

My credit union has CDs. The rate for a three-month CD is 1.88% while the rate for a one-year is 2.37%. Is my math reading correctly when I come out with $2.37 (on a $100 deposit) for 1 year but if I chose to deposit in the three-month CD four times in a row (thus equaling the 1 year CD) that my return would be $7.52 (assuming the rate remains the same)? At the moment I’m not debating whether or not a CD is the best investment, simply asking about this particular set up.

This is actually a fairly common misconception that people have about how certificates of deposit work. In truth, the one year certificate of deposit will earn you noticeably more than the three month CD. Let’s dig into how this all works.

CDs are quoted with their annual rates of return. When you see a rate quoted on a certificate of deposit, you actually are seeing the annual rate of return on that CD – in other words, that’s the percent of your investment that would be earned if you held the investment for a full year. So, the three month certificate of deposit above would earn 1.88% only if it were held over the course of a full year.

A very simple example So, let’s say Dennis buys one of those three month CDs. This CD only pays interest upon maturity and earns 1.88%. Dennis buys one for $1,000. Over the course of a year, this investment would have earned $18.80, but the CD only lasts for three months, thus earning Dennis $4.70 after three months. If he were to take that $1,000 and buy another CD, then do it again, and again, at the end of the year, Dennis would have earned his $18.80.

Compounding Many certificates of deposit compound monthly, which means they pay out 1/12th of the year’s interest at the end of each month. So, in the above example, Dennis would actually see an interest payment of $1.57 every month.

Many certificates of deposit also allow you to put that earned interest directly onto the balance of the certificate of deposit, meaning it would also earn interest along the way. Let’s say Dennis bought a three month certificate of deposit under these conditions for $100,000. At the end of the first month, the certificate would earn $156.67 in interest, which would then be added to the balance of the certificate, making it worth $100,156.67. At the end of the second month, the certificate would earn $156.91 in interest, bringing the balance of the certificate to $100,313.58. At the end of the third month, the certificate would earn $157.16 in interest, at which point the certificate would close. As you can see, compounding monthly is much better than compounding annually.

Buying a certificate of deposit When you go to buy a certificate of deposit, it’s not enough just to know the rate and the term. You also need to know how often it compounds (the more often, the better) and if that compounded money rolls into the balance of the certificate (if it does, that’s better). Although these factors aren’t enough to overcome a large difference in rates, they do make all the difference for small differences in rates.

Dennis, in your situation, if you’re wanting to put your money away for a full year, the one year certificate of deposit is the best option. Buying consecutive three month certificates will not earn you as much as the one year certificate will.

Good luck!