Emergency Funds: The Advice Nobody Gives (but should)
Every piece of advice I give is from the perspective of "what I would do if I were you." And there has never been a scenario where I told someone to keep 12 months of cash in an "emergency fund."
Traditional financial advice tells you to keep anywhere between 6 and 12+ months worth of living expenses in a savings account “in case of an emergency.”
I can't buy into that. I understand the premise: your business fails or a loved one falls ill, you want the peace of mind knowing your bills are covered. But if I play the scenario out, I never need that much cash collecting dust in the bank.
My industry does a terrific job of scaring us - just turn on CNBC - but fear driven decision making and financial planning don’t play nice in the sandbox.
“You probably won’t get hit by a bus when you walk out this door.…but you could. And what will that do to your family? Are you prepared to leave them scraping by, picking up the pieces? Sign here for this overpriced, unnecessary life insurance policy that doesn’t make sense for you.”
“You’re in the golden years of retirement. Why would you put your money at risk in something as volatile as stocks? Sign here for this guaranteed annuity…which will almost guarantee you’ll be working at Home Depot to supplement your income in 10 years after inflation erodes your buying power.”
“You’ve worked hard for your money. You should have at least twelve months of living expenses in an emergency savings account in the event of a catastrophe - you lose your job, someone becomes ill, etc.”
Emotionally, I connect with that. If my son or daughter is in the hospital and I want to be by their bedside without stressing over finances, having a year of living expenses in the bank sounds helpful.
So why don't I agree with the advice? Let me show you how this plays out...
For easy math, let’s say you need $10,000/month to live. According to this theory, you should have $120,000 in a savings account.
Now let's assume you saved well and live a relatively healthy lifestyle, and not surprisingly, haven’t experienced any catastrophes for an entire decade. According to my “platinum status” interest rate in my savings account at Bank of America, 0.05%, you now have $120,601.49 in your emergency fund.
The goal of this fund isn’t growth, I get it, but I can’t help but wonder what that money could do for 10 years if it was working for me instead of collecting dust in a savings account?
What if you conservatively invested that money instead? Let’s use a lower than average growth rate, 3% (which also is widely accepted as the historical average of inflation). At the end of 10 years you would have $161,922.43…not bad!
But the argument for keeping it “safe” is that it might go down when you need it most, in which case you’d have less than what you started with.
That doesn’t make me feel good.
The stock market experienced its worst decade ever from 1999-2009, where the S&P 500 lost an average of 3.3% per year. So, for argument’s sake, let’s say your life blew up at the exact same time as the end of the worst decade in the roughly 200 years of recorded performance of the market.
You’d be left with roughly $86,000.
In other words, if you simultaneously experienced a traumatic life event while the market was at the end of its worst decade ever, your emergency fund would be about 3.5 months short.
Not great, but not as scary as the industry makes it seem...
Now think about how unlikely it is for you to experience a catastrophic event at the same time as having the worst decade in the history of the stock market. Very unlikely.
What if the emergency fund is costing you more than it is helping? What if our “emergency fund” was held in a conservatively invested, highly liquid investment account?
First, we can access that money any time, so in that way it operates just like a savings account.
Second, the market is up more often than it is down, so statistically we have a better chance of making money, not losing it.
Third, I’m not one to sit on my heels if life hands me lemons, and I bet you aren’t either. People like us don’t need 12 months to get back on our feet.
The thought of keeping 12 months on the sidelines when the opportunity cost is so huge is what really keeps me up at night, not worrying about whether or not I have the cash saved for 12 months of expenses.
My recommendation, rethink your “emergency fund” using your brain, not your heart. Consider setting a percentage of your emergency fund aside in a conservative, highly liquid investment instead of keeping it in money's version of the graveyard: a savings account.