The Case For Investing Your Emergency Fund

You may have heard the traditional financial advice: keep 3-6 months of living expenses stowed away in cash, uninvested, for a rainy day. This is conventional wisdom, and I have given the same advice to clients many times. This strategy makes sense for many people. If the emergency fund is in a savings account instead of invested in a brokerage account, we know exactly how much money is available when an emergency pops up.

The problem with savings accounts today, though, is that interest rates are near 0%, while the target for U.S. inflation is 2%. That means that the money in a savings account is expected to lose purchasing power over time. In other words, you have a negative inflation-adjusted return on your money. So it’s worth asking whether it makes sense to invest that emergency fund in the hopes of earning a positive return on your money.

What is an emergency?

An emergency fund in this context should be used to cover an unexpected expense that is too costly to pay for with your regular monthly cash flow. There are relatively smaller emergencies like replacing a refrigerator or a handyman repairing something broken in your house. These types of emergencies range from a few hundred dollars to a couple thousand, and we should expect them to happen at least a few times per year.

Then there are the larger emergencies, like replacing a roof or HVAC system, an unexpected surgery, or losing a job. These emergencies are less frequent but much more costly. You may go several years without needing to cover a big expense like this, but they will inevitably happen. The purpose of the emergency fund is to pay for the large, unexpected expenses without needing to take on expensive debt like credit cards.

You want to be able to cover the smaller emergencies without needing to sell your investments. This is where a high-yield savings account, or even a cash buffer in your checking account, is going to make the most sense. The money for the less frequent, but more costly emergencies is what we’re going to examine here.

What is the risk?

When considering investing your emergency fund, the main risk in play is that your investments will drop below the amount you invested at the same time you need to access the money, meaning you have to sell your investments at a loss.

Another complicating factor when investing your emergency fund is that your time horizon is unknown. You could need the money in a month, or you may not need it for 5 years. This unknown time horizon makes it difficult to know how aggressive or conservative you should be with what you invest.

I wanted to see how often, over different time horizons, you would net a positive return on your investment. I looked at various stock/bond combinations over the last 25 years and how often those investments had a positive return over different rolling time horizons. For example, of all the possible one-year periods over the last 25 years, a 40% stock/60% bond allocation had a positive return 87.6% of the time.

Table showing how often various allocations have positive returns over different time periods
Data from 6/9/1996 – 6/9/2021. Stocks represented by the S&P 500 TR Index, Bonds represented by the Barclays US Aggregate Bond Index. 1 year = 250 trading days.

Broadly, the results can be summarized as the longer your time horizon, and the more bonds in your allocation, the less likely you are to lose money. That trend is not surprising, but you may be surprised at how often the allocations, particularly the conservative allocations, had a positive return. In 95% of rolling one-year periods, a 20% stock/80% bond allocation had a positive return. While this analysis only looks at the last 25 years, those years include the tech bubble popping, the Great Recession, and the COVID-19 crisis.

What is the upside and downside?

Historically, the odds of a positive return are high, but you may be asking, “What’s the upside?” For each allocation and time horizon, I looked at the best return over that time horizon, the worst return over that time horizon, and the median return.

Tables showing best, worst, and median returns for various stock/bond allocations over different time periods
Returns are total returns, not annualized

Each individual should draw their own conclusions from the data and weigh the risk/return tradeoff for their circumstances, but again, I think a case can be made for some individuals to ditch the savings account in hopes for a higher return in the market.

Let’s say you had $30,000 set aside for those larger emergencies, and 3 years go by without needing to access it. If you had that money in a savings account earning 0.50% per year (a generous rate, as of today), you’re going to have roughly $30,452 after 3 years. If instead you had invested that money in a 40% stock/60% bond allocation and earned the median return for that allocation over the last 25 years (20.7%), you’d have $36,210 after 3 years. The emergency fund is an account you will likely have for most of your life so that additional return is going to add up over decades.

A sensible approach

It goes without saying that the future is unknowable. I’m looking at the last 25 years, but the next 25 could look completely different. Investing your emergency fund in a diversified allocation of stocks and bonds is not without risk, but leaving it in an account where inflation will slowly dwindle the purchasing power away is also not risk-free. If you don’t want to worry about the ups and downs of investing your emergency fund, keeping it in a high-yield savings account is a smart approach. However, if you don’t like the minuscule interest you’re earning on your savings, I think you can invest that emergency fund in a responsible way. It’s generally a good idea to keep some money in cash to cover those small emergencies (something like 1-2 months of living expenses, with a minimum of $5,000). Then consider investing the rest of your emergency fund in a diversified and conservative allocation.

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