Should You Invest Your Emergency Fund?

by Michael on Aug 9, 2013 · 5 comments

Image of 911 Emergency Sign

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?

Sure enough, Betterment is arguing that “you can do far better by investing your safety net fund in a diversified portfolio.” But is this really a good 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…

1 Kurt @ Money Counselor August 9, 2013 at 10:47 am

Personally I’ll take the loss in purchasing power (a temporary phenomenon, I hope, due to the financial meltdown) by investing in cash rather than the risk of having to stomach a big loss if I’m compelled to liquidate my emergency fund. I do agree though that, at some net worth level, one doesn’t need an emergency fund.

2 krantcents August 9, 2013 at 11:17 am

I like having my money working for me. My emergency fund is a variety of places. I keep a small amount in my (interest bearing) checking account and the rest is in the stock market. I have a line of credit as a back up too. I have no debt except for a small mortgage and car loan.. Both will be paid off in less than 4 years.

3 Scott Frazee August 9, 2013 at 12:12 pm

Another way of looking at things (once your portfolio is large enough) is that your emergency fund is a fraction of your bond/fixed income portion of your portfolio, after all most people keep their emergency fund in a fixed income account (aka savings/CDs). To illustrate the point: if you’ve decided that a 70/30 stock bond mixture makes sense for you and you need/want X dollars for an emergency fund to cover Y months of expenses, take that dollar figure into account when you’re measuring 30% of your portfolio. This would be true whether you’re keeping that mentally separated emergency fund in bonds or separately as cash/CDs/MMA. You might still overweight the emergency fund allocation within bonds because they do fluctuate.

So for example if your portfolio was $100,000 including $22,000 (12 months expenses for you) you’d set aside in a CD as an emergency fund, you could allocate $70,000 in stocks, which would be an 90/10 split if we weren’t considering the emergency fund as part of the total. This would leave you with $8,000 in bonds if you kept the emergency fund in a CD, but if you put $30,000 in bonds, the bond portion would represent 136% of your emergency fund requirements, while giving you greater ability to rebalance.

As this scenario points out, you need a somewhat sizable total portfolio before it would make sense not to have a separate dedicated emergency fund in cash. In addition, further considerations would be made for assets split between taxable and not taxable accounts, especially being careful not to put emergency funds into an account (e.g. IRA) which you pay a tax penalty for early withdrawal. This would also further complicate the rebalancing process.

4 Grayson @ Debt Roundup August 9, 2013 at 12:23 pm

I read this same article and I decided to act on it. One thing I have been doing is pushing a lot of money into my savings. I just got out of credit card debt a year ago, so stashing cash away in a savings account made me feel very safe. Well, being so conservative will get you almost nowhere. I decided to take a portion of my emergency fund out to fund a moderate “efund” in Betterment, which I already use for my Roth. I think it will be the best strategy for me right now. Once I feel more comfortable and my net worth grows, I will push more into the Betterment account.

5 Martin August 13, 2013 at 12:23 am

I actually read that article and not only I liked the idea, I am even practicing it myself. Roughly a year ago I was mad having large chunk of cash sitting in a savings account making 0.40% APY and being blocked for 5 years otherwise you would pay an early withdrawal penalty. If you take a look at the emergencies you could potentially have you can sort your savings that way too. But in its nature an emergency is for emergency and not for anytime-whatever-the-need-is withdrawal. With that in mind, you can end up having your emergency cash sitting idle in a savings account with zero-zero-nothing yield for years. Not for me! So I structured my emergency into a few allocation if you will. I still have 2000 in a savings account, but the rest is in stocks – dividend paying blue chips and some cash will also be in Lending Club account (but I am not there yet). Both are high yield investments and I am willing to take the risk.

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