Orange You Glad You're Saving

Vol #102: October 20th, 2022

“Are you still dating that dental assistant, Chad?.... Good luck once she sees your Orange account!” - American Stock Exchange ~2005

The trading floor teaches nothing if not life lessons. I probably learned as much about the do’s - and particularly don’ts - of personal finance and self control as I did about the greeks. 

Studded with cackles and sharp elbows, this kind of banter revealed a lot about NYC yuppie-hood before the Great Financial Crisis. Not the least of which was the fact that the biggest hitters from our AMEX office were talking about cash savings accounts and not aping into a new token. 

Orange blew up the savings account game when the Dutch titan ING stepped back into New Amsterdam in the year 2000.  They slowly gained steam as rates picked up in the middle of the decade. Short term cash could actually earn something meaningful and the initial wave of online banking was building credibility before FinTech was a buzzword. Brick and mortar was going away for everything - why not your local savings branch?

As someone who grew up watching the great banking consolidation of the 1990s change my passbook’s cover page every few years, I didn’t have a lot of loyalty to Bank of America. They’d gobbled up Fleet who had previously eaten Connecticut Bank and Trust. Young and with a new job to hopefully make some loot trading options, I wanted the same savings account these clever masters of the universe had. 

I was more nervous putting my money in an “online only” bank in 2006 than I was doing my first DeFi transaction fifteen years later.  There was no agent to help me if the numbers didn’t turn out like I expected, but there was the sweet promise of 3.8% APY.  Fortunately transfer number “22” went through, and I was generating passive income the old fashioned way. 

Ironically ACH transfers were just as clumsy as they are today, but I didn’t have a lot of experience with anything other than “deposit ice cream store paycheck” and “withdraw $20 of beer money.”  Now that I had access to yield on my cash, I could start playing the fancy money games that I’d read about in finance books. 

Thanks to the magic of G-mail, I still have the e-mail I sent to my mom after I got back on campus for my last semester of senior year. Like any good mother, she was asking why I had cashed out my meal plan and how I was going to be able to receive my credit card bill. (Fortunately I had a well rounded diet of meatball pizza in Medford, Italian subs for lunch at the Pru, and Ana’s Taqueria in Davis Square on the weekends.  Bills were paid - gasp - online. )

“I also actually opened an internet bank account the other week. It's basically the internet 'branch' of the bank ING. Because that division has much less overhead than a physical bank, they offer a great savings rate, 3.8% compared to less than 1% at Fleet or Ridgefield Bank. It’s completely backed by ING and FDIC insured. I also have it set up to automatically transfer money from when I get my paycheck to start saving.” 

Automatically transferring money between my checking and savings accounts became a yield optimization gimmick only an amateur can love. The rate on my savings account went up 6 times in the first year. 

After I moved down to the city to start full time work, this escalated quickly. Because NYC rent costs about half of your after tax paycheck as a lowly trainee, you have to be pretty disciplined about putting money away. Lest you’re spending the last week of the month looking out the window to read the phone number for industrial grade Chinese takeout. 

Rent was $900 a month to split a three bedroom apartment in Park Slope. (It’s nearly double that right now, inflationistas). This meant by moving $450 per paycheck to my savings account, I was printing a whopping 4% a year on this “idle” cash.

Assuming I nailed the execution, this is good for about $27 a year. Half my monthly rent gets the full year’s interest, the other half gets only half a year. (4% * $450) + (.5 * 4% * $450). I even confirmed they compounded daily, so the trade was unshakeable.  One month’s laundry paid for every year. 

I wasn’t getting this wash cycle for free, I was paying for it by assuming both execution (leg) risk and liquidity risk. I was a hop, skip, and a jump away from levered duration. Finance comes down to some pretty basic nuts and bolts.  There is one cycle that’s putting money into the account, and another cycle that’s taking money out of the account. Your earnings are the difference. 

The most obvious way that this trade goes wrong is when there’s an asynchronicity that temporarily puts your account in the negative. To capture this full $27 in value, I needed to move the money from checking into savings each month (ING didn’t accept direct deposits), and then make sure enough was in checking for when my barber and landlord cashed the check. If the money didn’t make it back, I was shorn. 

There isn’t a single person involved with financial markets who has not been tripped up by dates. Daylight savings time changes break the most arcane software dependencies. Good Friday market closures shift expiration dates. Columbus Day equity markets are open, Martin Luther King day they’re closed. 

So thus was foiled the great treasury operations plan for Mark Phillips Inc.. Because I wanted every drip of interest, I relied on the two day ACH clearing period, but didn’t account for bank holidays. Money went out, but didn’t quite come back in. Our buzz cut landlord cashed his check upon receipt, and I got dinged with a $25 overdraft fee. The money was “there” but it hadn’t “cleared”. A year's worth of theoretical profits wiped out due to a single miscalculation. 

An operational snafu costing a year's worth of profits is bad, and heads would roll in most treasury departments . Fortunately this was but a small side gimmick, and $25 is still only $25. The wound to my ego was much greater, and taught me an interesting lesson about how to manage cash flow.

They don’t say cash is king just because greenbacks look great stacked sky high. Cash means flexibility and capacity to do what you want today. It’s expensive because the opportunities of illiquidity tend to pay better rent. Public equities are easy access but volatile pricing. Private market investments smooth the roads with gated fences and periodic disclosures. Stick with either and they’ll most likely beat cash, just not necessarily right now. 

One of the more difficult challenges of managing an actual portfolio and not just a theoretical model is timing your money needs and wants with your cans and haves. The more esoteric the opportunities, the more liquidity timing gets complicated. There’s no right answer on the CFA for balancing your wedding, house, or tuition budget with the closing round of an angel investment.  It’s great to be able to deploy into opportunities that come up, but what is the expense of keeping cash around?  If you hold enough dry powder to always buy the dip, you’re not maximizing the rip. 

The pain of solving this question keeps many people working in jobs far longer than they have to. Earning a consistent wage and paycheck is an incredible defense against liquidity ebbs and flows. So long as your daily budget is met by your salary - and you keep in your boss's good graces - your personal finances are robust to almost any shock. Saying “no mas” is difficult partly because it shifts a significant burden back on the individual. 

There is also a pitfall in “over-solving” for this scenario. Financial engineering allows us to securitize and collateralize nearly anything, creating pyramids of wealth on foundations of sand. Murphy’s Law of Finance says that if anything can break, it will, and in unexpected ways. That hop, skip, and jump is exactly what many pension plans do, and what caused the recent turmoil in the UK government bond markets. 

Most pension funds are focused on a “Liability Driven Investment” strategy. Their liabilities are the promises they make to pension holders to pay them X amount in Y years. To pay those obligations, they invest in bonds and securities with a return profile to match.  Unfortunately it’s not always an easy plug and play, and there are often funding gaps. To close these deficits, pension funds borrow against their gilts (UK government debt) and invest in higher risk (return?) assets like equities. 

As with all schemes of leverage, this goes well until it doesn’t. Once you’ve got a leveraged position, you’re going to need to be able to move cash around to cover your margin requirements. When a calamitous series of midwit government proposals crushes your currency and rates explode by 127 basis points in one day (27 points above the high water mark on a stress test), the bonds you have as collateral will plummet. 

If this had happened smoothly, there would be no issue, and gradually the leverage could be supported. But as every student of dynamic hedging knows, you have to assume gap risk. The spot price WILL jump to a place that causes you a lot of pain, with no chance to hedge in between. 

So what is the right amount of cash cushion to keep?

As with all questions of personal finance, there’s an academic answer, and an answer that helps you sleep at night. There’s a difference between your risk capacity, and your risk tolerance. Just because you can, doesn’t mean you should. 

While most of us don’t have the UK gilt market riding on our backs, it’s pretty painful if you miss a credit card payment or get cut out of an investment because your money isn’t ready in time. Opportunity cost, late fees, or at worst defaulting could put a major crimp in your style. No matter how big your assets, no one wants to be cash poor. 

The standard rule of thumb is to have a few months (3-6) of readily accessible cash to cover every day expenses. If you’re still working, this gives you time to find a replacement for lost wages or weather cyclical downturns in earnings. While your asset mix will generally be more conservative in retirement, this is also a good figure to keep in mind. Depending on the complexity of your portfolio, you will want to have funds available for unexpected expenses but also unexpected opportunities. 

For investment dry powder, it’s going to depend on the frequency of your turnover, but if you’re an active investor there’s usually at least one fat pitch you’ll want to swing at each year. This could mean keeping anywhere between 2-5% of your portfolio as liquid cash. As a retiree using the benchmark 4% withdrawal rate, 6 months of living expenses is roughly equivalent to a 2% investment allocation. It might mean rebalancing your portfolio across future withdrawal schedules, but the ability to pull the trigger right now has a lot of value. 

Cash is the simplest but most powerful component of any portfolio. It is quite literally the starting point for every new investment. If years of zero interest rates have lulled you into cheap loans or neglecting cash balances in big bank savings deserts, it’s high time to look at the alternatives, and consider right-sizing that bucket. The interest rate isn’t yet 4% like it was when I started, but we’re a lot closer than we were six months ago.