Should you invest your emergency fund?
Exactly $ 219.25. This is the amount that I have earned in interest on my emergency fund so far this year, at an online bank paying just under 1%.
On the one hand, it’s over $ 200. On the other hand, it’s pennies on the dollar, thanks to an era of low interest rates.
Low interest rates have dragged on for almost seven years. It’s long enough that some people, including me, rethink the long-held advice that emergency funds shouldn’t be invested because the goal is liquidity, not returns.
Is this archaic in the age of credit cards? Is the risk of no return greater than the market risk and therefore my account bottoming out?
There is no avoidance of risk
Dan Egan, director of behavioral finance and investment at robo-advisor Improvement, thinks. The company advises clients invest their emergency money in a portfolio that has a 30-50% allocation to stocks. (Wealth front – Improvements biggest competitor – does not agree. Communications manager Kate Wauck told me the company “doesn’t think an emergency fund belongs to the stock market.”)
“You don’t get a bill for inflation, it doesn’t remind you at the end of the year, you can’t log into your cash savings account and see that the amount has gone down,” says Egan . “But part of understanding risk and return is knowing you’re still exposed to risk – and in the case of a cash savings account, your main risk is inflation.
“You have to be honest with yourself that your cash savings account is going to lose value each year, and you will need to continually top it up,” Egan continues. “Every year your expenses will increase, expenses such as utilities will increase, and your savings will not.”
I listen, but with a side of terror. My husband is a freelance writer; he has a stable income but it is not salaried work. He would also tell you that I am, shall we say, a saver by nature. I like having money in the bank; I get a dizzying little thrill, a la Scrooge McDuck, every time I make this transfer.
So the hair on my neck is standing on end just thinking about how I would feel if I lost some of that money to a market correction.
Ed Gjertsen, founder of Engage Wealth Group, a fee-only financial planning and investment advisory firm, agrees that there is a risk of low interest rates, but that does not change his view that money from urgency should not be invested.
“With zero interest rates, whatever, it’s more expensive for people to leave money in safe places. You just aren’t making a relatively good return on that investment, ”explains Gjertsen. But you need this money accessible in an emergency, and “by its very nature, it should be safe,” he adds.
It’s a personal decision
Everything in an emergency fund is personal. the frequently cited rule of thumb that you should set aside three to six months of expenses, that’s exactly it; that doesn’t take into account how easily you might find a new job or how much debt you have.
The other question, of course, is to what extent your work relates to the economy. As Gjertsen points out, “If the economy is doing badly and you lose your job, the stock market is very likely to be bad too. “If your emergency fund is invested,” he says, “you just make your problems worse.
And then there’s the risk tolerance: Those who panic and loot the account when the market plunges will easily nullify their potential returns.
But it’s also financial
I am fortunate to have a few credit cards, but no real credit card debt. I can’t think of many scenarios where I would need quick cash, rather than just quick access to cash – i.e. a credit card – which is much different. I could easily put an expense on a credit card and then transfer money from one brokerage account to reimburse it.
This idea has one notable flaw, however: it assumes that the money will always be there and will not have dried up due to a stock market crash.
Egan’s response to this: Those who invest their emergency money should overfund the account, depositing 30% more than necessary. If I want $ 15,000 in an emergency fund, I should invest $ 19,500. This protects against a market crisis draining the account; the market could drop as much as 30% and I will still have as much as I need.
But this solution also has flaws. Most people find it difficult to build up minimum cash flow; adding 30% to that could push the idea out of reach. And I would say the extra money would be better spent in a tax-advantaged account, like a Roth IRA, where it could grow tax-sheltered for retirement. Because a Roth IRA allows contributions to be withdrawn at any time, it can function as a middle ground for the emergency fund.
there are compromises
When I can’t make a decision, which I often do, I like to share the difference. In this case, that would mean keeping some cash on hand in a savings account – the one with the best interest rate I can find – and putting it into a fairly conservatively allocated investment account, as Betterment suggests.
This protects against a number of things. First, it helps ensure that I get a decent return on at least some of that money. And it protects me against simple bad luck: If an emergency arises when the market is down, I can first tap into the cash and avoid selling investments at a loss.
The bottom line
No returns should come at the expense of your peace of mind. I’m halfway there, in terms of risk, which means the above tradeoff will work for me. I also probably have more storage for an emergency than what a financial advisor would suggest that I would need, as my definition of need is paranoid. I will leave most of this money in my savings account, where I know it is safe and warm, and invest what little I consider to be excess.
But if you can’t stand the idea of investing even a portion of your own funds, get the highest FDIC insured interest rate you can find and be done with it.
After all, there’s one thing I think Egan and Gjertsen would agree on: just having an emergency fund is a major step towards financial security.
Ready to start investing? Here are some of our top picks for the best robotics advisors: