A better way to manage your emergency fund.

The question I get the most is, ‘Should I invest my emergency fund in the stock market?’ Bank interest rates are at all-time lows and are not rising with interest rate hikes any time soon. Banks have enough consumer deposits and don’t need to compete.   

With inflation surging and the S&P 500 returning a blistering 14.36 % for the last 10 years, it’s painful to see your .5% bank account lose money in real terms.   

Your bank account has never been great at making money. For all but 3 of the last 20 years, inflation has beaten CD rates, which are usually a bit higher than regular bank account rates. The late 80s and 90s were the last time one could reliably make a little money after inflation in a bank account. 

 “Emergency fund” is the common phrase for a household source of financial liquidity. Liquidity is the ease with which we can convert our investments to cash so we can use them for unexpected spikes in short-term expenses.  You can sell your car, but that’s not always easy, so it’s not liquid. Your 401k has rules and penalties about withdrawals. Loans and credit cards are a source of liquidity, but with fees and interest. And banks have been known to cancel lines of credit in a financial crisis. 

How big should your emergency fund be? Generally, three to six months of household expenses is considered a good rule of thumb. Save more if you are single or have a risky job, less if you have two incomes and safer jobs.   

What counts as a household expense? Usually everything you must spend each month. Don’t include luxuries you can ‘turn off’ like eating out and vacations, but do include streaming services and the gym membership if they are important to your comfort and well-being.    

Emergency funds are generally kept in bank savings accounts. I also like I-Bonds for emergency funds, especially if you are the type that likes to dip into the emergency fund for non-emergencies. I-bonds are a little bit of work to redeem, and it might deter you.   

If you have enough money in a taxable investing account, you might not need a separate emergency fund.  However, because that account is likely invested heavily in stocks and not cash or bonds, you should consider the possibility that stocks will be crashing the moment you need the money.   

If using your taxable investment account, you will need more than three to six months of expenses for the times when your stocks are down 50%, which happens about once every 15 years. If stocks make up 100% of that taxable account, you need twice as many emergency fund months invested (6-12 months.)  The formula is: number of needed months / (1- (Stock%/2)). 

Many of us don’t have the means to save that much money in a brokerage account. Perhaps more importantly, it’s frightening to see the emergency fund drop by 50% in a crash. This fear can cause us to make behavioral investing mistakes and sell stocks when they are down, locking in losses forever. (This is a moment where a planner and investment advisor are very valuable.)   

Here’s a simpler way that I do my own emergency fund. Let’s invest in just enough stocks (20%-30%) to cover most inflation which, has averaged 3.26% since 1922. The rest is in bonds or cash. There are single funds you can buy that create this exact portfolio for you!  Vanguard LifeStrategy Income mutual fund (VASIX)  and iShares Core Conservative Allocation ETF (AOK) are one-fund portfolios that have 20-30% equities and the rest in bonds.    

VASIX is a little safer with fewer stocks (20%) and has returned 3.86% over the past 15 years. You should add a half month to your emergency fund for VASIX.   

AOK is a little more aggressive with 32% equities and has returned 4.25% over the past 10 years.  Add one month to your emergency funds to reflect the higher equities. ETFs are available in most brokerage accounts for no-fee purchases and withdrawals and are more tax-efficient than a mutual fund. (Not investment advice!)

If you choose not to go this route and want to keep your emergency funds at .5% don’t worry about it. Think about the emergency fund as an anchor for your financial ship in a storm. It’s allowing you to avoid having to dip into other investments, sacrificing long term gains, or using credit cards at penurious interest rates.    

It may not be exciting, but would you set afloat without an anchor?