A reader named Austin recently wrote in to ask the following question:
Can you please comment on Betterment’s recommendation of a “moderate risk” portfolio including 30-50% stocks for one’s emergency fund instead of cash. What do you think of this idea?
Their view is based on something that is undeniably true: cash is far from risk-free. While the “price” of cash doesn’t fluctuate (at least not in a local sense), and so it seems like a safe choice, cash is most definitely subject to inflation risk.
In other words, the risk-free rate of return (think savings accounts, CDs, etc.) is typically well below the inflation rate. Thus, you’re virtually guaranteed to earn a negative real return on your cash holdings. So what should you do?
According to Betterment, those with a “fully funded safety net fund” should consider holding this money in a moderate risk portfolio that includes 30-50% stocks to improve returns. What’s that? Stocks in an emergency fund? Are they crazy?
Well, they do go a bit further. Because the addition of stocks increases the risk of loss (while increasing expected returns) they argue that you should simultaneously increase the size of your emergency fund by 30%.
As an example, let’s say that you’ve decided you keep six months of expenses on hand at a rate of $4k/month. In that case, you’d have $24k sitting more or less idle. Instead, if you ramped up your goal to ca. $31k, you could afford to take a bit of risk and (probably) earn a better return.
Given that the single worst year for a 40/60 portfolio of stocks and bonds saw returns of -18.4%, a strategy like this could make sense — depending on your circumstances, of course.
Yes, you’re risking having to sell when the market is down, but with that buffer in place it’s unlikely that you’ll drop below the 100% threshold if you start at 130% of what you need. Impossible? No. But relatively unlikely.
Really, this is just a baby step toward not having an emergency fund at all. No emergency fund? You’re kidding, right? Nope, not kidding. My wife and I don’t actually have a dedicated emergency fund.
Yes, there was a time in our life that we kept cash on hand to deal with the unforeseen. But as our portfolio grew, so did our ability to take things in stride.
If we were to face a crisis today, we’d just sell a bit of whatever is overweight in our portfolio and go from there. Yes, we have some cash on hand, but it’s mostly in the form of long-term CDs that we’re holding as part of our “bond” allocation.
So, back to Austin’s question… Should you invest your emergency fund?
The answer (imho) depends on your circumstances. If you’re just starting out, then cash is probably the best and most reliable option. But as your assets grow, your ability to deal with the unexpected changes.
In fact, you might even wake up one day wondering whether or not you really need a dedicated emergency fund…