3551: Should You Invest Your Emergency Fund? by Jesse Cramer of Best Interest on Calculating How Much to Save For an Emergency

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[00:00:51] This is Optimal Finance Daily Should You Invest Your Emergency Fund by Jesse Cramer of bestinterest.blog True story. In January 2019, my now-fiancé and I were stuck in a freezing cold Airbnb in rural upstate New York. It was supposed to be a relaxing weekend. Oops. But we were financially prepared. Booyah! It felt great. How?

[00:01:18] Because we had a fully funded emergency fund. We abandoned the Airbnb and didn't think twice. We knew we might never get refunded. But we didn't care. We had enough money in the bank to give us options. That's why emergency funds are so important. It's money you can count on when you need it. But there's a growing debate in personal finance circles. Should you invest with your emergency fund?

[00:01:44] Emergency fund basics. The traditional emergency fund is what I described. It's a pile of money that sits in your bank account available for quick deployment in an emergency. The financial order of operations discusses emergency funds in two ways. First, save about $1,000 in cash to cover insurance deductibles. Later, save three to six months of spending in case you lose your job.

[00:02:10] Furnace dies? Got fired? Car accident? Your emergency fund plays an important role in keeping your life afloat. The arguments for investing in emergency fund. The most popular arguments for investing in emergency fund are... Number one, returns. The traditional bank-bound emergency fund has near zero nominal returns. Those become negative returns when we account for inflation.

[00:02:39] Investing your emergency fund can yield better returns. And number two, liquidity. The traditional bank-bound emergency fund is highly liquid. It's cash. It can quickly be withdrawn and spent. For most of financial history, investments have been far too illiquid to be emergency funds. But investment liquidity has drastically improved in recent years. Most investors can liquidate and withdraw their investments within 48 to 72 hours.

[00:03:08] In other words, an invested emergency fund can outperform a cash emergency fund higher returns with similar liquidity. There's just one drawback. Risk. Risk and reward is the fundamental relationship in investing. Those who invest their emergency funds are taking on risk. But in my experience, they're aware and accepting of that risk. It's all good. They know their personal math.

[00:03:35] I invest my emergency fund in a total stock index fund. Because even if it dropped by 50%, I'd be okay. I'd still have enough money for emergencies. I have some thoughts here. Let's walk through some numbers. Brennan has a $30,000 emergency fund. He invests it in SPY, the S&P 500 ETF. I'm using Brennan only as an example. He's my friend and an excellent financial educator.

[00:04:03] He's free to do anything he wants with his money. I just happen to disagree with him here. After doing some mental accounting, Brennan figures, even if my fund gets cut in half down to $15,000, we'd still be okay. That's enough emergency money to keep us financially safe. Fair enough. But I have a counter argument to make. Everyone has a number in their head. And hypothetical Brennan's number happens to be 50% of $30,000 or $15,000. That's his pain point.

[00:04:34] If the market dropped 60% or 70% to $12,000 or $9,000, he wouldn't feel great about his emergency fund. To me, that means Brennan's real emergency fund isn't $30,000. It's $15,000. Brennan should not put the first $15,000 at any risk. It's earmarked for emergencies. If it went down, he'd feel stress. And Brennan should freely invest the second $15,000. It's earmarked for a future rainy day.

[00:05:04] If it goes down, he'd feel no stress. Money is fungible. It can easily be mixed together. But identifying each dollar's job is an important part of mental budgeting. An emergency fund is the money you can't go without. Everything beyond that? It's not in the emergency fund. Goal-based investing explains why. Goal-based investing and emergency funds. Goal-based investing simply asks,

[00:05:33] what are your financial goals? How far in the future are those goals? And what's your risk tolerance? Want a lake house in 30 years? Great. With a 30-year timeline, you have enough time to take lots of risk. You want a down payment for a house in three years? Awesome. But three years isn't much time to take risk. Instead, let's invest in short-duration bonds or a short-duration ETF designed for home savings. Kids going to college in 12 years?

[00:06:03] Your timeline is somewhere in between the two examples. A reasonable mix of stocks and bonds is appropriate. The future date you need the money determines the appropriate risk to take. What about an emergency fund? What's the timeline there? Let me ask that another way. When will your next car crash be? When will you get laid off? When will the termites in your neighbor's oak tree gnaw through that 40-foot limb?

[00:06:31] No, your garage will not be okay. The answer, of course, is you don't know. You don't know when an emergency will strike. But for all intents and purposes, it could be tomorrow. It could be today. The investing timeline of an emergency fund is zero days. Therefore, you should not put that money at any risk. If you think your emergency fund is different, I'd challenge you. Instead, I bet you just have too much cash in that fund.

[00:07:00] Just like hypothetical Brennan. The amount you're okay losing isn't actually emergency fund money. Only the money you're not willing to lose constitutes your emergency fund. And that money shouldn't be invested. SOS. This is one opinion in a sea of personal finance commentary. But I feel pretty good about it. An emergency fund is the minimum amount of cash you need to sleep well at night.

[00:07:26] If you invest your emergency fund, you're putting that cash and that sleep at risk. You're intentionally stressing yourself out. And if you say you're fine with losing that money in an investment, then it isn't part of your emergency fund to begin with. You just listened to the post titled, Should you invest your emergency fund? By Jesse Cramer of bestinterest.blog Summer's almost here.

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[00:10:10] First of all, I've parked my cash in an online high-yield savings account. It's SIT Bank if you're curious. I have not once in the many years that I've had that cash needed to tap into it. Yes, I know. I'm very fortunate. In theory, it could be earning more if that money was invested. And I know many people who keep their cash to a minimum. But here's the way I see it. The money I invest has the job of growth through the power of compound interest.

[00:10:39] The money I keep in cash has the job of liquidity and accessibility. One of the best things I do for my investments is simply leave them alone. I've literally never sold a stock and used that money for something. I look at the money I invest as a tax to my future self. It's gone. I have no claim to it now. I think if I had to sell stocks whenever I needed cash, it would cause me to watch my investments way too much. And that's dangerous.

[00:11:09] That could lead to something ludicrous like panic selling. I simply have no interest in watching the roller coaster of the stock market. Also, my cash savings goal was something that I reached years ago. It's not like I continued saving after that. Since I reached the goal of one year of expenses, all extra money has been invested. As my net worth grows, my cash position becomes a smaller and smaller percentage of my overall net worth.

[00:11:37] So over time, this cash position matters less and less. And that should do it for today. Have a happy rest of your day. And I'll see you on the Friday show tomorrow, where your optimal life awaits. Once again, I'll see you on the Friday show. .