Conventional wisdom says that safety net funds should be held in a savings account or a similarly risk-free asset. But is this really the wisest way to manage your rainy day fund? Our analysis finds that you can do far better by investing your safety net fund in a diversified portfolio.
First, let’s get one myth out of the way: Cash savings accounts are not risk free. Why? Because after accounting for inflation there is about a one in three chance you won’t get back the money you put in, in real terms.
Today, with nominal cash interest rates hovering far beneath 1 percent, it’s almost guaranteed that you’ll make a negative real return over the next few years. This means your safety net fund will need topping up year after year to maintain its real value. It also means that you’ll have a significant amount of wealth that is not growing, potentially for a long period of time.
Intelligent Investing Is Safe, Even for Your Safety Money
The better solution is to have a safety net fund and grow it too. For those with a fully funded safety net fund, we recommend investing in a moderate risk portfolio with allocation set between 30 percent and 50 percent stocks. Betterment’s default advice for a safety net goal suggests a 40 percent allocation.
While this flies in the face of traditional advice, our analysis below shows that it stands up to critical examination.
Let’s work through an example to explain our advice. First, everyone should consider having some kind of safety net fund based on his or her monthly expenditures. (Read our blog post about how to calculate your own safety net target amount.) If you have not fully funded your safety net yet, we recommend saving regularly to get there.
For a worker earning around $110,000 in annual salary, a safety net target might be $18,000 (assuming minimum expenses of $4,500 per month for four months). This saver has two options: put this money into a savings account or invest it. We think investing is the smarter choice. However, to be smart investors we want to also protect ourselves against potential losses. This is why we recommend adding a buffer of 30 percent¹ to your original target amount. For example, to maintain an $18,000 safety net we recommend starting with $23,377.
On the chart below we’ve plotted the actual returns for every five-year period since 1955 for a $23,377 safety net fund with a 40 percent stock allocation. As you can see, the returns — like those of any investment — can vary on both the upside and downside. However, over any five-year period it is rare to find the value of the safety net fund dip below $18,000. On the other hand, for the saver who keeps a safety net in cash, inflation is likely to chip away at that amount in real terms.
Value of Safety Net Fund Since Original Investment
Monthly Safety Net Fund account value over every 5-year period since Jan 1, 1955
SOURCES: Betterment analysis of S&P500: Yahoo Finance; Federal Reserve Economic Database; Bureau of Labor Statistics
Reinvesting Gains in Your Safety Net Fund
The benefit of investing a slightly larger amount than you need is the opportunity to earn returns. If the original investment of $23,377 grows at around 5 percent per year (an approximate long-term annual return for a Betterment account with a 40 percent stock allocation), it will be getting bigger than necessary on a regular basis. This is a good problem to have.
To prevent your safety net from getting too big, we advise transferring the excess to another goal in order to bring it back down to the correct level every time it gets to be 20 percent bigger than it needs to be. That excess growth not only makes up for the original buffer you invested, but it can now be transferred to help along other goals like IRAs, retirement, or a vacation around the world.
In fact, the best scenario is that you will never need your safety net fund at all. Even the poorest returns on investing will still handily beat cash over 50 years. In other words, cash is a very poor long-term investing — or safety net fund — strategy.
We do not have a crystal ball and do not know exactly what markets will do in the future. But what we can see in recent history is that the downside of taking some risk is not terrible — but the upside is very powerful.
¹ Increasing your target amount by 30 percent will allow the investment to absorb a 23 percent decline while preserving the target amount. We are using 23 percent because it represents the greatest peak-to-trough percentage drop a Betterment 40 percent stock portfolio would have experienced since 2004 (the drop took place between July 2008 and March 2009). Prior to 2004, insufficient data is available to test the Betterment portfolio’s performance with confidence. However, to demonstrate a longer historical view, the graph above uses performance of a portfolio consisting of 40 percent S&P500/60 percent 5-year Treasury Bills, going back to 1955. There is no guarantee that a future drop would not be steeper, but we feel it is useful to demonstrate the impact of historically exceptional volatility on a buffered safety net fund. Please see our full disclosure of our methodology for model historical returns.
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I’ve just recently started with Betterment for this exact reason. I noticed the returns on my savings safety net was getting lower and lower with sub 1% rates so I transferred all but a small amount into my Betterment account. We’ll see how this plays out in the long term but I’m confident that, since I’m still in my early 30’s, I’ll be able to weather the ups and downs. Even since the crash in 2008 the market has rebounded tremendously. You know what they say, the market only goes up over the long term.
The complete and total failure of this article is the very premise that you should treat your safety net like an investment – then they pile on that to say you should invest in the very vehicle that will be tanking in value when you have the highest probability of actually needing it. The kicker? That to start off with they tell you that you need 28% more money to start with in order to make their plan work. Save yourself the 28% and invest that – then treat the safety net like it should be treated… invest it – so when layoffs are widespread and you NEED that safety net, it looses 20%-50% of it’s value? Again, your safety net isn’t an investment! What’s next, cancel all your insurance policies and just invest the money to make more? If you’re the 80% that never need it, it works out great for you. But if you’re the 20% that do, you’re screwed. Why? Because you shouldn’t treat your insurance needs like you do your investment allocations.
Your safety net isn’t an investment – it is an insurance policy. Treat it appropriately.
I’ve recently started with Betterment but not for my emergency savings. I don’t think I’d ever put my emergency savings with Betterment for two reason 1) accessibility and 2) I don’t invest 100% of my emergency funds due to risk and back to point 1). IMO, if you have an emergency, you need the funds right away. My two cents is to split the fund – invest some and keep the rest in a savings account you could get to the cash the same day. Yes, I am losing financially on the amount I have in a regular ol’ savings account but it gives me piece of mind. Isn’t piece of mind why you have an emergency fund anyway??
I agree to an extent, but the funds are readily available for all intensive purposes. A credit card could cover the gap in availability of funds with no cost for up to or exceeding 30 days.
I’m one month from reaching my emergency goal, and this article is very timely. The graphical analysis is undeniable. I look forward to transferring my emergency funds to Betterment. Love the site – keep up the great work!
Good points, Gracie. However, you can get access to Betterment funds in about a week’s time. I agree, in some circumstances, you’ll need access to emergency funds faster. But, keep in mind you don’t need access to several months of safety net all at once (job loss). I like to keep a couple of weeks worth of cash in a savings account with anything more than that going into a betterment safety-net.
Hi Gracie, AP and James,
Gracie – this is a good point, which I think James touches on well. We’ve assumed that you’d have access to sufficient very-short term cash or credit in the case of a very urgent emergency. A withdrawal from Betterment does take 3 -4 business days, so you’d need enough cash to cover that period.
Thanks for the comments!
Dan
But what about the tax implications of having ~60 of your emergency fund in Bonds, within a taxable account? Especially over a 10-20 year period?
I’m curious about this as well. However, tax implications may not matter if the funds are used only for safety-net reasons. It’s certainly less expensive tax-wise than taking loans from a 401K or IRA.
Hi Kyle,
You pay tax on interest earned regardless if it’s in a savings account or from bonds. And you wouldn’t want to keep your safety account in a illiquid or tax-advantaged account like a 401(k) or IRA, because taking the money out has even worse consequences.
The simple answer is that you’d pay more tax… because you’ll likely have higher investment income. Which is better – paying 30% tax on $100, or 10% tax on $20? I’d rather have $70 than $18.
This reminds me of recent research on “tax aversion” – the idea that people will irrationally pay more than $1 (say in accounting fees) to avoid $1 in tax. Don’t let tax minimization lead you to avoid good investments.
Best,
Dan
I have been with Betterment for a year now. I believe the advice to invest emergency funds is completely wrong. It might be good for those who will or never had an emergency fund but for those that have the discipline that fund needs to be 100% liquid, and if the return is negative then that is fine as other hedges against inflation should be in place. Also, I disagree with the standard methods of definition when it comes to how much you should have in an emergency fund, 4 months or 6 months worth of expenses seems ridiculously low. My personal emergency fund cash is around 18 months worth of expenses and I consider it ok at this point. In addition, I believe the perfect allocation of investments (business), real estate and cash should be modeled closer to what the Talmud says on the subject:
http://www.joshuakennon.com/the-talmud-asset-allocation-model-portfolio/
http://www.myplaniq.com/articles/20120108-the-talmud-strategy/
So investments are to be treated as part of business (or all if you have no other business), cash and cash derivatives (I would actually sneak a bond element into this but not to reduce my emergency fund) and real estate are to be allocated equally…I’ll be there soon!
Best regards!
This is a great blog article. I am actuallly taking a blended approach. I had about a 15k emergency fund, and I am putting about half in betterment while keeping the other half in cash. I am going to contribute monthly to the betterment account and the long term goal is to get to about 130% of my emergency fund.
As I get there, I will be slowly removing money from my cash emergency fund, ultimately leaving only a couple thousand for true emergencies, and the rest in betterment that I can transfer and have available 48 hours later… Most of my emergencies however I can just put on my credit card and pay when the bill comes, so the need for hard cash is pretty minimal and I can’t think of too many cases where lack of cash would be detrimental.
The trouble with investing your safety net in traditional markets isn’t that you might lose some money – it’s that the time when the markets crash is also the time you are most likely to need it.
Tough to beat i-Bonds as a safety net, at least with the factors I value: Inflation protected. As safe as a cash account. No correlation with markets. Accessible within a couple days when needed.
Hi Patrick,
I’d like to first point out that many safety fund needs – health, natural disaster, significant loss of property – are not correlated with stock market falls.
And while crashes do precede increases in unemployment, it’s less than you might think. The Fed’s target unemployment rate is about 6.5%, and at its peak (early 2010) unemployment was 10%. At that point, the stock market had actually recovered, and your safety net fund would be worth more than you initially deposited (if you started investing at the top in 2008).
Finally, that’s the point of the buffer. The important thing isn’t that you’ve recently lost money – it’s that you have enough money to see you through the rough patches, and you’re growing it in the good patches.
Best,
Dan
This was a good read. Thank you.
This post suggested: Increasing rainy day fund 30% and invest in 40/60 stock/bonds.
Why not: Increase rainy day fund 50% and invest 60/40 stock/bonds?
Or even Increase rainy day fund 100% and invest 100/0 stock/bonds?
Would it still be considered a rainy day fund?
Hi Richard,
That’s certainly a valid way of approaching it. You could likewise do it the opposite way – a smaller buffer, and taking on less risk. It just depends how much buffer you feel comfortable saving, and how much risk you’d be comfortable taking on.
Best,
Dan
Do you recommend this approach for downpayment funds? I’m trying to save up for downpayment in addition to a safety net. My downpayment has been sitting in my savings account with a measly 1% interest rate and I’m wondering if it’s a good idea to move it to my Betterment account if I anticipate using it in 2-4 years.
Hi Joan,
That depends on how certain you are about the down-payment amount and time, and if you’re comfortable with the risk.
I recommend using the advice function inside the app to help you make this decision.
Best,
Dan
I think this is a good advice. I’ve been playing with this idea for some time because I didn’t like holding me emergency account in savings accounts. I want that money work for me while sitting idle and waiting for some disaster.
I decided to invest them into dividend paying stocks (these are considered lazy stocks, so if something goes wrong they won’t crash that deep and that fast) and they pay dividends.
I only wasn’t comfortable holding the entire account in stocks, so I split the amount and still have 2000 dollars in a savings account and the rest in stocks. It works for me so far.
I wrote on this strategy on mu blog, since I call this strategy an “Infinite banking 2.0” The only difference is that the life insurance is out of the equation.
What a great blog article.
This is a no-brainer. Most all “giant monster mega-banks” (as the great Clark Howard would say) offer a measly 0.01% annual percentage yield (APY) through their savings account programs. Now, one may be eligible for SLIGHTLY greater APYs, although still measly, if one jumps through a number of hoops including linked accounts and/or savings balances greater than, say, $15,000. If you’re lucky, you may earn up to 0.15% if you have a savings account balance greater than $1,000,000 through one popular giant monster mega-bank! Now, it is apparent that these banks rely on their customers’ difficulty with calculating percentages, or their collective fear of investing, because it just makes no sense to keep one’s money growing at 0.01% per year. This equates to about $1.50 annual interest growth on a $15,000 balance, or just 13 cents per month! A better move than this would be to open a high-interest savings account through reputable online banks, which presently offer APYs around 0.75%. Keep in mind that 2013 inflation rates presently range from about 1 to 2% from month to month, so low savings balances with APYs less than this are really losing money in the long run. Not so much the dollar amount, just its worth with regard to the overall economy. So, an even better move would be to use Betterment.
Obviously, you need to evaluate your current situation. Is there much of a chance that you will lose your job in the near future? Do you have health concerns? Do you have immediate financial obligations? If you have the financial freedom, then why not open a safety net account with Betterment? Yes, the market fluctuates with peaks and slumps, but historically the market trends in the positive direction over time and you’ll earn dividends which are automatically reinvested and rebalanced by Betterment. What a great deal!
I hope this helps shed some light on this advice article. Thanks Dan!
Under circular reasoning see circular reasoning. This is nothing more than a ploy to prop up an unsustainable stock market.
Great post. This truly does make sense, when thinking about in comparison to the traditional advice.
This whole idea of using a safety net for stock and bond investment purposes is oxymoronic. A diversified portfolio in stocks and bonds (and commodities?) might in general be safer than one that isn’t diversified, but it is certainly not guaranteed by anything other than a wish and hope. As for the loss of purchasing power of funds put into a safety net, those funds should be assessed at regular intervals and modified according to any changes and needs. In general it should be minor modification in the foreseeable future because as the author points out (in one of the few things he says that common sense will allow me to agree with), inflation is low. Therefore any such adjustments due to inflation will also be small. I have no problem with choosing to invest some funds in a less risky fashion than those funds could be invested. But the instant those funds are subject to loss, either temporary or permanent, they no longer safety net.
This article is marketing, not advising. It should be ignored. Money in a savings account IS risk free, and insured … If put $1000 in you are guaranteed to get $1000 out … And while the purchasing power of those dollars may change over time, you are not losing any dollars. With these shiesters however you CAN lose dollars. Don’t do it!
Overall, this article is mainly advertising for Betterment mixed in with a little common sense. When you are starting out, your first priority should be to establish an emergency fund. I would suggest something like 6 months of livings expenses depending on how secure your job is. Then you need enough money to cover large expenses that you expect over the next several years such as a down payment on a house. After that, you should get started on a diversified investment portfolio and the emergency fund will just become part of that. As your investments grow, the money invested in completely safe things will only be a small portion of your investments. The important thing is to keep your investment expenses low. You should consider low cost index funds or individual stocks that you buy directly. These days it is extremely simple to do yourself if you use index mutual funds or ETF’s – of course you can make it as complex as you want.. You do not need Beterment which adds another layer of expenses and fees. The expenses and fees may sound small, but over a lot of years expenses and fees take a good chunk of your real return (the amount left after subtracting inflation and taxes).
While there are fees associated with Betterment, it is only 0.25% when you have over $10,000 in funds. This is a steal!
You suggested buying individual funds. Where can you purchase funds incrementally without extreme transaction costs? At even the best of about $6-8 per trade per fund, you’re giving up 6% per investment of $100 every single time. Then, consider the costs of selling these individual funds as you have to manually diversify, which is even more than the up front investment costs.
Even if you have an institution such as Vanguard, which is known for having some of the lowest fee investment options (no coincidence these make up the majority of Betterment funds), you’re still going to pay account management fees nearing or exceeding 0.25%.
Betterment is a steal. It’s not their fault that simple logic actually helps their business model. Seems like a win-win to me.
This advice makes perfect sense if you never need your emergency funds. If, however, there is an emergency which just happens to occur at the same time as a down market, you will take a big hit. Money that you won’t need in the next five years could probably be invested. Putting your emergency funds in the market is folly, don’t believe these guys.
This is the dumbest advice ever. Why not increase your emergency fund by 80% just in case a market crash occurs that results in a 76% loss. Or, alternatively you could keep your emergency fund in cash. By the same logic you would gain 76%.
This blog post is not meant to be a one size fits all approach for how to handle emergency funds. It’s meant to encourage one to think about how he or she invests, or doesn’t invest, his or her money. In that goal, it has succeeded…obviously.
Emergency fund planning is all about risks, and how one person perceives his or her risks as compared to another’s is not the article’s goal to determine. Nevertheless, it gives the investor (or non-investor) a solid historical basis for its argument. True, it is possible that the perfect storm of major market downturn and the emergency status of one’s life *could* coincide. But, for most of us, we plan to never have to use our emergency funds – so why not allow all or part of them to be exposed to significant gain?
Not to mention, if one has an “emergency” and need his or her funds, what is the likelihood that he or she will need 100% of it on day one? I think of it as being my own insurance company. Sure, I might have to pay out a claim, but in the meantime, I you want me money working for me? And if, heaven forbid, something does happen, I’m sure that I’ll manage to get by with the resources that do I have.
Obviously some editorial mishaps in there…gimme a break, it’s Friday afternoon.
Seriously? I should invest my liquid assets into a non-liquid fund and increase the invested amount so I don’t lose money .. because oh, I might lose money in a savings account because of inflation?
In reality, you should be doing both. You should have an emergency fund that you can take cash out of today in the event you need it. Emergencies seldom wait for you to make a transaction in your investment accounts.
I keep 3 months of living expenses in cash in the event of some emergency. Once it is funded, you can forget about it for the most part, only reviewing it occasionally to ensure you have the right amount .. not too much, not too little. Then invest 15% of your income into some decent growth mutual funds. You will get a whole lot more bang for your buck and you will have liquid assets if you need them.
If you have $23,377 to start with, your cash safety net is $23,377, not $18,000. The dotted line should be at $23,377. The graph is accurate but is comparing apples to oranges.
Thank you for furnishing me with an excellent example of a misleading graph for my Statistics class.
You’re narrowly reading the graph without the supporting text. The text clearly states that if your true emergency need is 18k, they recommend ~23k to dramatically decrease the odds that market downfalls will take your funds below your true need.
Of the nearly 60 lines (each year since 1955), there are only a few that drop below the true 18k emergency need over a 5 year period. This is illustrating that while there are risks, they can be minimized by investing the appropriate amount above your true emergency need. It is not trying to compare a before/after of 18k invested.
How about, if I place $18,000 in a savings account with a mere 3/4% interest (yes they are available, you just have to look) . Over the last 5 years, I would have “lost” a mere pittance to inflation, while negating the possibility of a huge loss in the markets.
The idea that I have to invest $23k to be sure I have $18k just tells me that I can expect to lose $5k on the deal. At least if I put the $18k under my proverbial mattress, I am losing a mere $1500 to inflation.
I did read the article and understand your idea. I believe the issue is an interesting one and worthy of discussion. I was not mislead by the graph but was pointing out that the graph could easily be misinterpreted. Let me explain.
The title of the graph reads: “Value of Safety Net fund since original investment,” and the dotted line is labeled “Safety Net Fund.” This is misleading. The dotted line should be labeled “True Emergency Need.” And to make it even more clear a new line, perhaps a darker one, should be added to show the actual amount invested. I suspect it would be a far less convincing graph if you are trying to persuade people to invest.
Graphs are valuable tools to illustrate concepts and ideas. My point is that, whether intentional or not, they can mislead the reader. The graph should support the text, not vice versa.
Expectation to lose and the possibility to lose are totally different concepts. While you have the possibility of dying in a car accident each time you get behind the wheel, you don’t expect to each time. There is a risk. What you purport may happen. No wise person would disagree.
However, as the author points out and as I have pointed out repeatedly, there is also the potential upside that is more than just marginal, and one’s foray into these waters should always account for individual risks and risk averseness.
Furthermore, the average long-term average rate of inflation from 1913 – 2013 is over 3%. If you net 0.75% in a savings account, and the market performs at or above average, you’ve “lost” over 3 times the amount that you’ve earned in the savings account. Not to mention your “mere $1500” over 5 years would only amount to 1.67% inflation assuming $18k over 5 years with no compounding. In the last three decades average inflation has been 3%, 2.5% and 2.3%.
The article talks about investing over a 5 year span and attempts to show the folly of not investing. This is why I only used a 5 year span. Incidently, my “mere $1500” was using the CPI calculator from the Bureau of Labor Statistics subtracting the interest gained on a savings account. Thus the mere $1500 or $300 a year is a pittance when compared to the losses one can garner in the market.
Sure we all want to make money, and we want our money to be safe from loss and inflation, but moving your cash from savings or a money market account to a non-liquid asset is simply silly, especially if you have no other cash to fall back on in the event of an emergency … and they do happen, like the transmission goes out in the car or a tree falls through the roof. Sure, these are not common occurences, but then using that argument, why have an emergency fund at all.
Bottom line: if I have to invest 28% -30% more to be sure I have the original $18,000 I might as well put 5% more in my 3/4%APY savings to hedge against inflation.
The 28%-30% investment doesn’t guarantee anything. It merely provides a larger investment with which you can lose money.
Don’t get me wrong, I’ve built a very nice retirement fund by investing wisely, but then I also maintain at least 3 months of cash on hand to be liquid.
A good example of why this is necessary, at least from my perspective is that given the current nature of real estate, great deals move fast. I don’t have a week to wait on the investment broker to get me cash to make a deal happen. When the deal comes available, I have to act today, not tomorrow or next week, because someone else does have the cash. I can always move money from my investment accounts to savings if I am not liquid enough, but I can’t wait till the cows come home to make a deal that is fleeting.
It is my belief that emergency funds are not meant for automobile repairs, nor are they expected to be used in the case of incidents in which home owners insurance would be utilized. Furthermore, in what world are emergency funds held with the intent of procurring real estate? That argument, if you want to call it that, is irrelevant to this article.
You probably took one data point, from 2008 – 2013 on the calculator, which yields the approximate $1500 number. But, we are experiencing some of the lowest inflation in the history of the U.S. right now. This article shouldn’t be interpreted with only today in mind, but the future as well, which could mirror other past 5-year periods. Consider as another example 1990 – 1995. In that case, it’s almost a $3000 difference.
We love to see this spirited debate, thanks for all the comments folks! Cheers, Catherine
An emergency fund is a positive net worth. As long as a person has assets greater than debt, a person can survive financial loss whether to injury, job loss or market downturns.
What type and how much of a financial emergency fund a person should have depends upon the type of assets a person has and how quickly they can be sold for paying needed expenses.
It’s the positive net worth that covers a person in the troubles of life. An emergency fund is a forced savings that can be added to the positive net worth that many people might not save for otherwise.
Poor advice from a service that we generally respect. The data is not wrong but the conclusions are very wrong and dangerous. It turns out that when you need your safety net tends to be highly correlated with market downturns – people tend to get fired right when the market goes bad (think 2000 or 2008).
Right when you need your money, you have less of it because of a market downturn. Worst of all outcomes and at the absolute worst times. A household is far better off holding a consistent emergency fund in cash and then investing everything above that level, usually by directing monthly savings towards their investment portfolio. Read research by Professor Lubos Pastor (http://faculty.chicagobooth.edu/lubos.pastor/research/investment_news_052409.pdf) to understand that probability of shortfall is not the only measure that matters, when there is a shortfall, the shortfall tends to be highly significant.
Hi Nirav,
Thank you for sharing your thoughts.
We did consider the correlation between stock market crashes and safety net needs when crafting this advice. In brief, we believe we’re still right because:
1. Not all financial emergencies are due to economic downturns. Health, natural disasters, and significant loss or property are not correlated with stock market declines, but are still reasons to have and grow a safety net fund.
2. This advice was crafted based upon the worst case scenario you mention – investing precisely at the top of the market, and needing all the money precisely at the bottom. In which case you’d still have 61% of your invested amount. The reason we recommend a buffer is to take that worst-case scenario into account. However, it’s highly likely you would need all your money at once, rather than taking it out month by month as another commenter has mentioned.
3. Actually, unemployment lags stock market crashes significantly, and the correlation, it’s less than you might think. The Fed’s target unemployment rate is about 6.5%, and at its peak (early 2010) unemployment was 10%. At that point, the stock market had actually recovered, and your safety net would be back to positive return territory. So while they are correlated, it’s not of huge magnitude, and it’s lagged significantly.
Best,
Dan
Hi Dan,
Well, let’s hope we don’t lose our jobs early into the next downturn :).
Seriously though, I understand your data, but it misses the point of an emergency fund. An Emergency Fund is all about liability immunization (read the Boots Pension Case study from HBS) vs. asset growth. The minute an investor moves that money into an investment portfolio above the risk-free rate, the risk becomes non-zero that there is a shortfall.
This is much like selling out of the money options. The vast majority of the time you will come out ahead, but over time there will be large drawdowns. That doesn’t mean that this is a bad strategy, in fact, most institutional portfolios have a lot of risk metrics in common with selling tail-risk (read this paper to see how it’s similar to hedge fund portfolios http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019482). This is because it is an expected positive return construction with very small probabilities of drawdowns, but its not risk-free.
Now Betterment is a popular service, let’s say that 10,000 people take this advice. Well there are going to be a non zero amount of these clients who will have an emergency fund shortfall (maybe 50, 100, 200) but it will be non-zero.
Imagine you grow and have millions of accounts, you are going to have thousands of clients who shortfall because they took your advice, when that number should be zero, and telling them that it’s too bad that they happened to fall on the wrong side of the distribution when they are trying to pay their bills isn’t going to go over well.
You could put something in place to move the entire account to cash if they hit the emergency fund threshold (somewhat like a principal protected note) but what would be easier is to keep their emergency fund as an immunized 0% shortfall probability portfolio.
As other commentators have also mentioned this allows them to take advantage of the tax breaks afforded most savers through 401(k)s, Roth IRAs, and other tax-advantaged but illiquid accounts, and come out ahead overall.
Hi Nirav,
I understand your point, and I know where you are coming from. There is a categorical psychological change that happens when you move from ‘no risk’ to ‘any risk’, which is different from moving from ‘a little risk’ to ‘a little more risk.
However, I don’t agree that Safety Net funds have to be completely risk free, nor that investing them in a ‘risk-free’ asset actually is risk-free. To make your decision based only on one extreme tail of potential outcomes, and ignore the potential growth which could happen in the interim, means you will forego significant expected benefits. It’s smart to drive slower & safer while carrying precious, fragile cargo… but you don’t decide to not to drive at all. And (at least right now), investing them in a risk-free asset is an almost sure loss in real terms. That means your constantly having to top-up your fund anyways.
The dynamic management is something we’re actively looking into. It’s good to hear it’s something you’d be open to.
D
The market took a real beating recently, losing about 7% of its value. My savings just gained another 3/4%
If I have to invest $23k to be sure I have $18k in 5 years, I may as well invest $18k now to ensure I will have $18k in five years .. in the end I will probably be better off … if not, so what, it will not make a huge difference in 5 years anyway.
On the other hand, if I invest 15% of my income into growth stock mutual funds on a regular basis, (aside from my cash on hand) I will have a huge retirement account in 30 years.
Fundamentally flawed. If you need your emergency fund in a market downturn, you will have less money available to you when you need it most. This was demonstrated millions of times over in the recent market crash. Investing “safety” funds in products that can fluctuate greatly in value in not “safe”. While the rest of your portfolio should be invested with growth in mind, the fundamental principle of your small “safety net” is to keep those funds safe.
I think some people are missing the point. While I certainly wouldn’t put ALL of a safety net fund into a conservative investment, putting MOST of it away is a great idea.
Nobody’s suggesting you put your emergency fund into a risky investment. But if you put $100 into a no-interest account, next year it’s worth $97, the year after it’ll be worth $94.09, etc. Check the TIPS prospectus: their WORST quarter since inception was -4ish%, in 2008. I would have LOVED to have only lost 4% in 4Q 2008.
Think of it this way: Betterment’s bond allocations have betas of 0.14 and -0.02. a 30% stock/70% bond portfolio would therefore grow very slowly in a good economy, and drop very slowly in a bad economy. A market crash like 2008 would not wipe out your safety net.
Keep a couple thousand in cash. But you definitely need to protect your money from eroding due to inflation.
Mike,
There are a few things that you may be overlooking. In your scenario of a 70/30 bond/stock portfolio there is a lot of risk that you may not be considering.
1)With the stock portion of this portfolio, remember, we are not talking about the normal day-to-day fluctuations in the market. We are talking about an emergency crisis in which you could wake up to the market down 20% or more in a single day. While conservative stocks may not go down as much as riskier stocks, in a panic selloff like that, people start dumping stocks of all types in very fast market conditions. Just using these conservative figures, a 20% drop in your stock portfolio would represent a 6% loss to your total emergency fund…in a single day at the beginning of a period of likely sustained financial turmoil. If you had a $30,000 emergency fund, $1,800 of it (conservatively) was just wiped out.
2)Also, with respect to the bond portion of this account, most of these types of accounts invest in bond funds as opposed to buying the actual bond and holding it to maturity. Because of the nature of an emergency fund, you are going to want to keep these funds in relatively short-term bond funds. The problem here is that the Fed has been buying these shorter maturity bonds for years and keeping the interest rates at the short end of the market at artificial, historic lows!
The thing you must be aware of when investing in bonds is that bond yields (interest rates) move in opposite direction proportional to bond prices. Therefore, to have historically low interest rates means we have historically high prices on bonds.
When you buy a bond and hold it to maturity, you get back your investment plus the coupon, or interest rate, associated with that bond. But when you buy into a bond fund, the fund manager trades bonds on the secondary bond market much like stocks. Rather than getting the interest on the bonds, the managers are trying to get capital gains on trading these bonds since their prices fluctuate like stocks do.
The problem is that just like we have stocks at all time highs, we also have bonds at all time highs. Once the Fed stops, or tapers, their buying of these bonds on a monthly basis, we could easily see bond prices begin to fall….and consequently, bond fund investors losing capital from the 70% bond fund investment they have their emergency fund invested in.
Both stocks and bonds are overbought and artificially high right now due to Fed intervention. Be very careful being lulled into believing that “safe stocks” and bonds are a conservative investment. In the past they have been, however we are living in a period of historically unusual market activity.
I’d rather lose my two or three percent per year to inflation and top my account off periodically than wake up one morning to a financial crisis that is devastating the financial markets. That just lets me sleep a little easier at night!
Hi Randall,
Thanks for taking the time to share your thoughts. While it’s clear we’ve both put some thought into this, we have come to a different conclusion.
The first thing to remember is that it’s unlikely the market crashing will cause your personal need for emergency funds on the same day, even the same month. Unemployment peaks lag stock market crashes by up to a year, at which point your portfolio has a good chance of having recovered. Remember – stock markets are a leading indicator, not a current one. Often stock markets experience normal up and down movements that have no bearing on the job market, or other real-world activities.
Second, I don’t believe that the purpose of an emergency fund is that it’s value doesn’t ever fall, or happens to fall when you need it. I think what matters is that you have enough money when you need it. Consider an extreme example of someone living on $3,000 a month, whose safety net fund has grown to $100k: if the market tanks by 50%, AND they pull all their money out on that day, their emergency fund is worth half what it used to be. Yet they still have 16 months of expenses available to them. The same logic applies with a smaller buffer – you can grow your funds, while staying safe in terms of having enough money when you need it. This is what matters.
Third – a diversified portfolio including stocks & bonds of differing maturities can be just as safe (defined by similar expected drawdowns), but with a higher expected return than an all bond portfolio. This is not just because of diversification, but because growth before a drawdown dilutes the effect of a drawdown. If my safety net fund grew 20%, and then experienced a 10% drawdown, I’m still 10% ahead of where I’d be otherwise. Volatility matters in the short term, average returns in the long term.
As for sleeping better at night – while it’s true that many people opt out of growing their wealth at all because they get stressed, I’m not sure that stuffing it all in their mattress is the right move. It’s risky too (especially if you have well-meaning children): http://www.theguardian.com/world/2009/jun/10/million-dollar-mattress-thrown-away
Thanks for adding to the discussion.
Dan
Hi Dan, I
You know, I do find this an interesting topic, however your are correct in saying that we disagree in our positions.
First, I agree with you that it is unlikely…and I might even add HIGHLY unlikely…that the market will crash causing you to need funds overnight. However, with that said, the unexpected can and sometimes DOES happen! That is the very reason for the existence of an emergency fund at all! If it were not for the unexpected “curveballs” life throws at us on occasion, there would be no need for an emergency fund. By their very nature, emergencies are unpredictable and can be difficult to plan for.
Much like having car insurance, I hope to NEVER need to actually USE it! When I purchased my policy, I was neither planning on having an accident nor envisioning what the other economic circumstances would be at the time or in the immediate period thereafter. Rather I purchased the policy based on coverage limits that would hopefully be adequate to meet my needs when or if an accident occurred.
Now let’s say, theoretically, that my insurance agent offered me a discount of up to 5% or so per year in exchange for knowing that if I had a claim against my policy my coverage was variable and I would not know exactly what the policy would cover until the day I filed the claim.
This is the exact same scenario. In exchange for a relatively small ROI, you would suggest that it would be okay not to know for sure how much your emergency fund would be worth until the day the emergency occurred and you needed to use those funds!
I want to KNOW what my “policy limits” are when I have a car accident! I don’t want to have to wait until I file a claim to find out that I wasn’t as prepared as I thought I was.
Next, let’s consider the example of the individual you mentioned that had $3,000 per month in expenses and had and emergency fund of $100,000. This person current has 33 months of living expenses in their emergency fund. This is NOT the correct use of an emergency fund. The individual should probably not have more than $20,000 in their fund (which would meet their needs for approximately 6 months).
Most financial planners recommend an emergency fund of somewhere between three to six months…depending on the type of work that you do. So even at $20,000, the individual would be at the long end of that range. The remaining $80K – $90K should be used for other financial objectives. If that objective is investing, then by all means the individual should invest in a portfolio that includes riskier assets such as stocks, bonds, gold, real estate, etc that will likely provided a very handsome return when held over a period of time.
So bottom line, with this scenario, in an emergency I KNOW my “insurance policy” is worth exactly $20,000. Meanwhile I am investing my $80,000 as is appropriate for my circumstances. The amount of inflation loss I am experiencing on the total $100,000 is relatively small – and as my net worth grows and my investments increase, the relative inflation loss becomes even less.
I don’t deny your primary point that especially in today’s very low rate savings accounts, our emergency funds are losing buying power to inflation. However this is a period of time in our history…not the norm for our entire lives. Interest rates rise and fall. At the moment they are artificially low because of Fed intervention however this will not be the “norm” forever.
I’m just not that upset about the minimal loss in buying power of my emergency funds for a decade or so, that I am going to step outside of time tested principles of financial management to chase a few points of interest on a relatively low percentage of my net worth.
I wish you the best of luck with your strategy sir. It should work out very well for you as long as there is no financial crisis. Perhaps the average over time will also favor your strategy…it would be interesting to have some long-term data based on your strategy to compare, however until there is real data to back up the idea I will continue to support and recommend my more conservative approach.
Just reading through Dan and Randall’s responses, I have a few additional thoughts.
First, as an economist, I think in real dollars, not nominal dollars. If my purchasing power goes down, I’ve lost money. Emergency funds need to be adjustable – as prices change, your spending will change, and therefore 6 months of expenses will change. An account that increases with price inflation is doing it’s work for you. In reality, your emergency fund should increase by both inflation and wage increase percentages. Tough to do in today’s savings/money market situation.
The corollary of this is – as Randall points out – that today’s interest rates are artificially low. When 3% savings accounts and 4% money market accounts come back, I’ll definitely be singing a different tune.
Second, you never need all of your safety net fund at once; this is why I would recommend keeping a couple thousand in cash (that’s a cash investment, not in dollar bills) like a savings/money market. Check out NerdWallet for a comparison of savings accounts that yield about 1%. Unless you’re buying off a mob hit squad, you can delay withdrawals from your safety net until better times. It doesn’t all need to be liquid.
Finally, as an economist, the stock and bond markets should ALWAYS be at an all time high! Exactly 3% higher than last year, with 3% growth predicted for this year :)
I think a key middle point is to tranche your emergency funding. Cash is prone to albeit low inflation at this point, but frankly in the real world, say one moved their investments to a blended growth fund with 45% invested in bonds during the financial crisis, they would have only lost 10% that year with the following years’ rebound greatly exceeding that.
SO tranching where one has 1-6 mos of cash equivalents and investing another 6-24 mos in blended funds that have half their portfolio in high grade debt is precisely the ballast one needs to dampen huge shocks and just as importantly rebound robustly when the markets reverse course. The biggest mistake is most people don’t understand the pareto nature of rebounds – that the top 10 days of biggest losses and top 10 days of gains account for 80% of activity. Keeping too much in cash and withdrawing prematurely from the market are the biggest reasons why investors fall behind their retirement goals
Ted,
Great point. I ‘ve heard of this 98%/2% rule of the market. Makes timing a very important, or maybe not important at all.
Would you mind giving us an idea of how you get into the market? I imagine that if its on a per stock basis, some valuations is involved. But say its for non sophisticated types, how would you approach putting your money in the betterment way. i.e. on cruse control?
Hi Antonius,
We’ve actually done a bit of writing on that already. You can read up on getting into the market here:
https://www.betterment.com/blog/2013/01/29/should-i-dollar-cost-average-into-the-market/
Best,
Dan
No, sorry. I can’t buy this. Granted, inflation will erode your purchasing power, but it will do so ever so gradually, compared to a rout in the financial markets which can erode your purchasing power overnight. The argument for investing your emergency fund is akin to not buying insurance and investing the premium.
Here on the 5th anniversary of the financial crisis, just imagine if you had taken this advice in 2007 or so. You would have found your investments worth half what they had been and possibly been out of work at the same time. If you’re recommending a 30% buffer, then I would not invest more than that buffer plus 10-15%.
Hi Steve,
I understand your disbelief – this stuff is counterintuitive. Thankfully, we have numbers to cut through our instincts.
A statement like “your investments would have been worth half what they had been” is exactly the kind of exaggerated perception that we are trying to address. A properly balanced portfolio would not have lost anywhere near half its value. Front page losses loom large in our imagination, whereas consistent erosion that is “gradual” is dismissed as basically harmless.
Our risk assessment gets cloudy even for recent events, where exact numbers are available. An individual who had taken our advice would have been just fine through the crisis. Let’s say the individual requires $100 for their safety net. Following our advice, they invest $130 on January 1st, 2007. The graph below depicts the value of their $130 through time. As you can see, rises, then falls, but does not break the $100 safety net requirement. Their account recovers by late 2009, and by 2010 (when unemployment peaks), they are back in positive territory. The graph below assumes a 40% stock allocation. See here for disclosure on model historical returns.
And in case they did not need it through the crisis, they now have $171, far more than their required $100.
Best,
Dan
Steve, I think the key here is risk. You’re willing to take inflation risk, but not investment risk, right? Essentially, what you’re conceding with that is that the longer you have your emergency fund, the less you’ll need in it. In reality, as your wages and expenses increase, your emergency fund should be bolstered accordingly. I’m not terribly excited about setting up transfers every time I get a raise or when energy prices go up, so I’d rather have the markets do the work for me.
So back to risk. I like looking at a fund’s beta and standard deviation, which measure the fund’s movement relative to the market and how far it moves from its average return, respectively. Together, they make up a good analogue for risk. For an emergency fund, a low StDev is better, while the beta I (personally) want to hover around 0.1 – meaning that when the stock market gains or drops 100 points, my fund would gain or drop 10 points. So there would be no huge gains or drops no matter what the economy looked like.
YMMV, and you definitely should keep a couple thousand in a money market account. But the chance of an emergency fund losing value even short term to inflation is 100%, while the chance of an emergency fund losing value to investment losses is much much lower than 100% even in the short term. I’d much rather take investment risk than inflation risk.
@Dan Egan Thanks for your response. I’ve been thinking about your answer and still would like to run my own numbers, but I’d like to know what assumptions you’re making with respect to rebalancing. How far off your 40/60 mix will you go before you rebalance?
Hi Steve,
No problem. This analysis ensured the portfolio never drifted by more than 3% from it’s 60%/40% split. This is actually fairly conservative compared to Betterment’s portfolios, which very rarely drift outside of 1% of their allocation. This is due to the smart use of inflows such as dividends and new deposits.
Best,
Dan
But the very purpose of “emergency” funds is for them to be available in an emergency. If you invest your “emergency” money, you won’t be able to use it in an emergency, unless the emergency lasts long enough for all the necessary transfers to go through, and occurs while the market is open.
Thanks for your comment Botze. Yes, it’s true there is some lag time — around three days for funds to transfer from an investment account to a checking account. However, some of things you need a safety net fund for — such as a temporary loss of employment — don’t require funds in that short amount of time. It’s always a good idea to have a small amount of cash on hand (or a credit card in good standing) for an absolute crisis emergency. However, this strategy is meant to truly provide a robust safety net for you and your family on a long-term basis.
Best regards, Catherine
I want to also add this scenario for you,
if you started investing 10k into a moderate risk portfolio in middle of 2008. You would lose around 25% by middle of 2009, market was crashing and suddenly you were laid off because your company started to downsize. You needed to tap into your Emergency fund, but realized that you only had $7500 left and took a big portion out, your emergency fund never recovers because of the withdraw.
Although it sounded like something I made up, it actually happened to alot of people back then.
Never recovers to what? If you withdraw money, do you really expect it to recover without additional deposits? Would an FDIC insured account “recover” after you make a withdraw. Short story is you might lose 25% in a scenario kike this, but the advice is about maximizing the delta between opportunity and risk.
Hi Robert,
You touch on two different but important aspects of this.
First, it is possible to experience some combination of circumstances which are worse than we’d expect or plan for. There’s no certainty that a worse financial crisis and recession won’t happen in the future, and we should save more. Conversely, there’s also no certainty that one won’t need their rainy day fund over their whole life. It’s a question of balance. While one should definitely have some buffer against bad luck, I’m not sure avoiding risk entirely is reasonable or helpful. Driving is quite dangerous, but also quite useful.
Second, reacting to a change in your circumstances is the smart thing to do. Reacting to market movement isn’t. While the lower safety net balance is cause for concern and potentially adjustment in living expenses, it’s happened. You are right that removing money from the market at a low guarantees that it will not recover, despite all admonitions to ‘buy when lower, sell when higher”. This is a behavioral problem, but one that doesn’t effect most Betterment customers. More on that soon…
Best,
Dan
Hi Dan, just found this site linking from other personal finance articles and can’t wait to dig in a little more. Before I get to my question I have to share one of my favorite all time behavioral economic/finance results, from the research of Barber and Odean http://faculty.haas.berkeley.edu/odean/papers/gender/BoysWillBeBoys.pdf:
“We document that men trade 45 percent more than
women. Trading reduces men’s net returns by 2.65 percentage points a year as
opposed to 1.72 percentage points for women.”
Yay for overconfidence!
Anyway, my question is does this plan for investing the rainy day fund account for the issue of taxes? If you have to liquidate from a taxable investment fund instead of withdrawing cash from a savings or MM account, you will be subject at least to OI taxes, if not ST gain taxes, depending on how deep into your cost basis/holding period you have to liquidate to cover your emergency. Does your 30% buffer account for taxation?
I am assuming you would recommend this fund be held in a regular taxable account due to the fines/taxes associated with pre-retirement withdrawals from tax deferred accounts.
Thanks,
Dan
Hi Dan,
It doesn’t account for taxes, because it doesn’t need to. It’s very important to remember that you only pay taxes on gains, not on principal. Thus if I invest $3,000, and it doesn’t make any gains, I don’t pay any taxes when I withdraw it. That’s true for losses as well – if I’m using my buffer (because the market is down), I won’t be paying any capital gains tax.
Say you invest $3,000, and it would grow 10% to $3,300 over a year. If you then withdrew the full $3,300, you’d only pay tax on the $300 gain – at 20% capital gains tax that’s $60. So you still get an 8% return ($240), net of tax return.
You should also know that you have to pay tax on your savings account, potentially at a higher rate (your income tax rate). You’ll get a 1099-INT at the end of the year from your saving account provider detailing how much interest you earned, which you’ll need to figure into your income. Only short-term capital gains are taxed at the same rate as interest – long term gains are taxed at up to only 20%, and losses aren’t taxed at all.
While thinking of things net of tax is correct, that includes not avoiding a 8% net of tax return, just because you happened to pay 20% tax on a 10% return. It’s still generally a better deal than savings accounts.
And yes, in most cases it’s better to hold it in a taxable account than a tax-deferred because of penalty withdrawal rates from the tax-deferred accounts.
Best,
Dan
I have a Cash safety net because I don’t want to have to borrow money I need for monthly expenses at high interest rates such as credit cards or payday loans. If I was to get laid off from work or the transmission was to go out in my car that is cash I need now. I also do not see the capital gains taxes added into this investment strategy. This is another problem to get the $1000 out I need to fix my Car I have to really take out $1200 to pay for taxes. Not everyone makes $120,000 a year and has an extra $20,000 to invest.
Hi John,
First, I agree that you shouldn’t *pay* high credit card interest or use payday loans. THe credit card usage would solely be for the 3-4 days it would take you to move money out of your Betterment account. As most credit cards don’t charge interest on the first 30 days of a given transaction, you’d pay no interest on the short-term loan as long as you used your Betterment withdrawal within the month to pay off the credit card.
Second, you’d only pay $200 tax on a $1000 withdrawal if the full $1,000 was investment gains. You do NOT pay capital gains tax on an amount invested or a withdrawal per se, except inasmuch as they include gains. And you only pay tax on the gain, not the principal. So if you invested $1,000, and it grew *100%* to $2,000 in a year, and then you withdrew $1,000, yes, you’d need to pay $200. However, you are still $800, or *80%* better off than you would have been. Paying 20% tax on a 100% return is a great problem to have.
It’s far more likely you’d invest, say $1,000, and it would grow 10% to $1,100 over a year. If you then withdrew the full $1,100, you’d only pay tax on the $100 gain – at 20% capital gains tax that’s $20. So you still get an 8% return ($80), net of tax return.
While thinking of things net of tax is correct, that includes not avoiding a 8% net of tax return, just because you happened to pay 20% tax on a 10% return.
Best,
Dan
Hi John,
I’m not sure what credit card you have but most don’t require you pay interest rates if you pay them off in the next billing cycle. This would be more than enough time to get your money out of the market, even if you were to place the charge on your credit card the day the billing period closed.
Perhaps John is thinking of cash advances on a credit card. There is no grace period for cash advances.
By definition, Safety Net Fund is the money you don’t plan to use (vs a college fund or a retirement fund) except in an emergency. So, why not get a personal line of credit as your Safety Net Fund? You don’t have any potential opportunity loss if it’s money yet to be borrowed.
My 2 cents
I would never recommend that someone borrow money in an emergency. The reason for needing money in the first place is a monetary emergency (you cannot meet your financial obligations). Borrowing money during a time when you can ill afford to pay it back is not a smart move.
Now, if you are talking about unexpected bills that come due, perhaps expensive car repairs or a new roof, then using a line of credit might be a way to resolve that problem.
That being said, everything financial obligation in your life should be managed. Putting a sinking fund in place for these items will ensure your life’s emergencies will be so much less of an emergency when life happens.
I thought that the conventional wisdom is that bond funds should not be held in taxable accounts because the dividends generate taxable income, regardless of what happens to the price of the bond fund. I like the idea of investing my emergency fund in a 40/60 portfolio, but wont that generate tax liability even in years that I don’t sell anything?
Hi BB,
It’s incorrect to say that ‘bond funds shouldn’t be held in taxable accounts” – it’s a symptom of tax aversion, which we should avoid.
Both bonds & stocks generate income – bonds from coupons/interest, and stocks from dividends. Under certain circumstances, income generated by bond ETFs can taxed at a higher rate than income generated by stock ETFs. It is also true that any income will be taxed on an annual basis if it’s held in a taxable account (and taxed later or not at all in a tax-advantaged account). At the margins, given a very specific set of circumstances, all of this could mean that asset allocation for long-term retirement goals across taxable and tax-advantaged accounts can be tweaked for some level of tax optimization. But it certainly does not mean that you shouldn’t hold bonds in a taxable account, which is a blanket misinterpretation of some very nuanced tax-planning considerations, none of which apply to short or medium-term savings.
First, liquidity is paramount for your safety net fund. Keeping your safety net in IRAs and then paying the large early withdrawal penalties if you need it will wipe out any conceivable benefits you might get from setting up your safety net this way. But just because you use a taxable account doesn’t mean you should hold only stocks – your safety net fund should be appropriately low risk. The primary role of bonds in your safety net fund is to control the level of risk you are taking on, with the income they generate in a distant second.
Second, while it may seem that you are “generating tax liability without selling anything” – you are being taxed on dividends you’ve actually received, and which are reinvested immediately for your benefit and convenience. Yes, you may need to sell some of those to pay your tax liability if you have no cash available elsewhere, but you’d be selling (a relatively small) piece of something you didn’t even have at the beginning of the year! Owing tax on income is not a reason to avoid the income! Would you stop working in order to bring your income tax liability to zero? You’d definitely pay less tax, but you’d be much worse off overall. Imagine your portfolio yields 4% income, which is taxed at 30%. If you invested $100,000, you’d earn $4,000, and pay $1,200 in tax, leaving you $2,800 net-of-tax income. You should not avoid earning $2,800 because you’d also have to pay $1,200 tax while doing so.
So while I agree that you should maximize your net-of-tax returns, it’s another story entirely to avoid gains or income for the sake of minimizing tax. Pick the right risk level for your goal, and stick with it .
Best,
Dan
Should I always max out my Roth IRA first before creating or adding to an emergency fund since contributions can always be withdrawn?
Second question:
What about inflation indexed bonds (TIPS)? I found that I am able to buy an otherwise restricted TIPS fund (VIPSX) in my regular brokerage account because I have shares in my empolyer retirement fund. This fund is plenty liquid. Do you think their adjustment for inflation is good enough?
Third:
What about investing a higher percentage in stocks if you choose relatively safe ones, especially dividend paying stocks?
Hello,
1. There are two issues with using a Roth as your emergency fund.
First, Roth’s are not completely penalty free. While contributions can be withdrawn without penalty, a withdrawal of earnings or roll-overs from a Roth IRA are tax-free and penalty-free if:
– The withdrawal has been invested for at least five years
AND one of the following conditions is met:
– Over age 59½
– Death or disability
– Qualified first-time home purchase
A non-qualified withdrawal is subject to taxation of earnings and a 10% additional tax unless an exception applies.
Second, once withdrawn, you cannot later re-invest the withdrawn amount back into the emergency fund. So there is a tax-advantaged opportunity cost.
2. I’d say that right now, using only inflation protected products is *not* sufficiently better than a savings account. First, inflation protected bonds are not a guarantee of an above-inflation return. For example, VIPSX has an average maturity of about 8 years, so you are getting as much, if not more, interest rate risk than inflation protection. Vanguard’s own research warns against this, and it’s important to be aware of.
https://personal.vanguard.com/pdf/icrtips.pdf
https://institutional.vanguard.com/iam/pdf/ICRLSTPS.pdf
Because of this, I’d expect that buying only VIPSX will result in a worse risk/return profile than a properly diversified portfolio which includes VTIP, but also other exposures such as corporate bonds, international bonds, and some stock exposure.
3. Finally, on investing in ‘safer’ stocks – if you can actually identify ‘safer’ stocks, you could overweight them. However, I’d warn against the siren’s song that it’s easy to find stocks which are actually safer (AOL? Enron? WorldCom? Lehman Brothers?). Dividend paying stocks are not inherently safer in any way – when a company pays a dividend, it’s market cap (and thus price) simply falls by exactly how much cash it just paid you. In terms of investment strategy, it’s equivalent to saying you know better how to invest the cash than the company does, and then invest more in companies that believe this.
Finally, I think it’s more important to remember that ‘safer’ stocks are still stocks, and so are going to experience more volatility than the bond component. I don’t think you’ll earn a positive return on the amount of work & effort doing this, compared to keeping it simple.
Dan,
You are mistaken on your first point. Roth contributions may be withdrawn at any time with no tax or penalty. Earnings and conversions less than 5 years old must follow the rules you listed.
Please refer to IRS Publication 590.
Regards.
Withdrawals of your direct contributions to a Roth IRA are never subject to taxes or penalties. Restrictions , penalties and age limits only apply to earnings and rolled over funds.
That means if you put your emergency funds into a Roth IRA you will not have access to any appreciation or earnings without paying penalties. But you will have access to the funds you actually deposit.
Petunia and Ross – you are correct. I’ve updated the original response for future reference. Thanks for your attention to detail and keeping us 100% correct.
Best,
Dan
I really like this idea of using Betterment for my emergency fund since once fully funded, my account should continue to grow to at least keep up with inflation. If it grows too fast, I could always withdraw that money or move it to another goal.
One issue a lot of people are saying is that if they have an emergency, they wont’ have immediate access to your funds. But that’s really the case for all accounts unless you keep it in cash at home (and can get home to get your cash). What if an emergency happens after hours or on the weekend? You’d have to wait until the next business day to get your funds anyhow. For savings accounts, the online ones seem to give the best interest, but they take just as long to withdraw money to your account as Betterment (Betterment may even be faster now with their new banking hours). But none of that matters to me. I don’t pay for anything with cash. Everything goes on my cash rewards credit card and I’ll pay the full statement when its due. So if I have a medical emergency or an issue with my car, I’ll pay it with my credit card and then make the withdrawal from Betterment to pay my card off. Simple as that.
Really enjoyed reading the article and comments and thanks for the graphs Dan.