Safety Net Funds: Why Traditional Advice Is Wrong

We recommend that everyone should save regularly towards some kind of safety net based on their monthly expenses.

Conventional wisdom says that safety net funds should be held in a savings account or a similarly risk-free type of account. But is this really the wisest way to manage your rainy day fund? Our analysis finds that you can do better by investing your safety net funds in a diversified portfolio.

The Risk Of Holding Cash

First, let’s get one myth out of the way. Cash savings accounts are not risk-free. Why? After accounting for inflation, you may not get the money you put in back—in real terms.

Today, with nominal cash interest rates hovering around 2%, money in a traditional savings account could actually earn nothing, or even make a negative real return over the next few years. This means your safety net fund will need to be topped up year after year in order to maintain its real value. It also means that you’ll have a significant amount of wealth that is not growing. This could even be the case for a long period of time if you find that you aren’t needing to dip into it.

Invest Your Safety Money Intelligently

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 an allocation that’s set between 30% and 50% stocks. Our default advice for a safety net goal suggests a 40% stock allocation.

While this flies in the face of traditional advice, our analysis below shows that it stands up to critical examination.

Example

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 help protect ourselves against potential losses. This is why we recommend adding a buffer of 30% to your original target amount.

We chose 30% because that was approximately the greatest peak-to-trough percentage drop a Betterment portfolio made up of 40% in stocks has experienced since 2004. The drop took place between the end of June 2008 and the end of February 2009 and was about 23%.

For example, to maintain an $18,000 safety net, we recommend starting with $23,377.

Once You Reach Your Target

The benefit of investing a slightly larger amount than you need is the opportunity to help earn more returns. Since the average annual return of our 40% stock portfolio is 5% per year, your safety net might get bigger than necessary on a regular basis once you’ve reached your target amount.

Because of that, we advise transferring any excess to another goal when it gets to be about 20% bigger than the target amount. That excess growth can be transferred to help other goals, like retirement or a vacation.

Experience The Upside

We do not have a crystal ball and we’ll never know exactly what the stock market will do in the future. But, what we can see in recent history is that the downside of taking some risk is not terrible—while the upside can be very powerful.

Have questions about your safety net, financial goals, or the amount of risk you should be taking on? Speak with a CFP® professional to review your current financial situation.