Emergency Fund

Any good assembly-line article on financial planning or financial security or money generally or one on the rising costs of bagels will seemingly always remind you not to forget to stash some savings for an emergency fund.  If you couldn’t make your father proud of you for anything you’ve done in life, at least having an emergency fund would keep him from disowning you completely. 

The notion is typically as follows: have at least six months’ of your recurring expenses saved up and tucked away to protect you if something bad happens, like if you lose your job or get injured or your roof caves in.  That six months’ worth should be the sum total of unavoidable expenses: housing payment, cars, utilities, and a baseline minimum of necessities like food.

Makes sense, right?  I’m not opposed to the notion at all.  It’s good to have some security so that you don’t have to go into debt, or worse, if you face one of life’s curveballs.  The 2020 coronavirus pandemic and its overnight eradication of millions of jobs is a stark reminder of the unpredictable nature of the universe’s relationship with its human interlopers.  

But the economics of this sage wisdom can otherwise change when you turn your focus to saving for early retirement.  The perpetual reminders to set aside an emergency fund make absolute sense for someone who otherwise has no source of liquid capital if an unforeseen expense arrives.  The point is that you don’t want to be selling your house and your hair to pay for food until you weather the storm.

Say you’ve pursuing FIRE, or some type of retirement of the sorts, for a few years, the result of which is that you’ve amassed a respectable net worth comprised of capital assets like stocks and bonds.  And assume further that if you were to cash out those assets, the after-tax cash pocketed would be more than sufficient to keep you afloat for a few (maybe six) months if an unplanned shock were to strike.  Would you consider this to be sufficient to cover you in an emergency?

Take it one step further and assume that you’ve got your FIRE savings sitting in the market, pursuing a long-term growth strategy on your behalf.  You’ve also got a fairly robust heap of cash sitting in a savings account waiting for a rainy day.  The money in that savings account is, I’m assuming, generating minimal – even de minimus – returns.  The question is: are you needlessly foregoing potentially higher returns in exchange for the relative liquidity and security offered by your savings account?

Realistically, most stocks are fairly liquid assets.  Unless you’re trading some low-cap, dark web types of stocks, most major stocks have decent liquidity – you can place an order and it’ll execute within fractions of a second.  Typically it might take a day or two or three for the funds to clear and your account allows you to withdraw them, but that should be enough time to cover most expenses other than kidnapping ransom. 

So why not just count your investment accounts as your emergency fund?

Let’s consider one extreme example.  Say you have an emergency fund for a rainy day and the worst happens. All your stock value vanishes, you’re out of work, and the economy is in shambles.  Were this scenario to unfold, I’ve got news for you: your emergency fund might not be of much help at this point.  You’re talking about the sort of systemic shock that vanquishes the entire economy.  If you think there’ll be anything other than foraging for liquid assets, think about the true severity of your posited situation. 

While this scenario is unlikely to happen, the point is that unless you put all your money into a single stock, or a single industry, it’s highly unlikely that one economic shock can wipe you out.  As long as you’re properly diversified, the odds of you losing all of your stock value at once are slim.

So if you have any emergency (cash) fund in addition to your accumulated brokerage account, you’re foregoing returns in exchange for additional liquidity.  This is not entirely a bad thing.  That liquidity might save you from incurring capital gains taxes if your only means of obtaining cash is to sell some existing assets.  It might also save you some load costs if you were to sell off a mutual fund before the no-load holding period expires. But is this extra liquidity actually costing you more than it’s worth?  

For example, say you have about $1,000 in a checking account that you use for ordinary bills and maybe another $1,000 in a savings account, with nothing else held in cash.  On top of that, you’ve reached $300,000 in your FIRE investments, mostly stocks, ETFs, and mutual funds, and then another $150,000 in a 401(k).  You’re sitting on your couch drinking a pina colada (why not, right?) imagining that you’re already on a beach and not working.  It’s even 92 degrees outside, just like that beach, but it’s ok for now, because the A/C is keeping you cool.  And then you hear a clunk and a second clunk and your A/C sputters like one of those cars from the 50s, belching out a death rattle before finally succumbing to the sweet release of death.  Within 10 minutes, it’s 81 degrees inside, and then in an hour, it’s 92.  Your pina colada melted and the light rum buzz is gone.

You now need $10,000 for a new HVAC system – where do you get it?  My guess is that it would take too long for you to siphon off your paychecks to get that system in as fast you need it, and of course, you don’t have the cash sitting in the bank.  You’re not going into the 401(k) – that would be foolish (because of the early withdrawal penalty).  So you sell off $10,000 worth of stock that’s been sitting in the account for 7 years, for a nice $6,000 of taxable gain.  And then you realize that, assuming a long-term capital gains rate of 15%, you get a tax bill for an additional $900.

How would this compare if you had kept $10,000 in savings account that you could have used instead of selling stock and realizing a capital gain.  For the past 10 years, the best rate of return on a high-yield savings account has been about 1%.  For the sake of argument, say you already had the $10,000 on hand and put into a savings account 7 years ago.  On the day your A/C broke, you would have had $10,721 in the savings account, not accounting for the taxes you would have paid each year on the interest earned.  

Let’s say instead that you had put that $10,000 into your brokerage account and saw a rate of return of about 6%, leaving you with a total of about $15,000 on that $10,000 contribution.  After purchasing your A/C, the high-yield savings account has $721 left, or your $10,000 investment in your brokerage account is down to about $4,100 in value after taxes.  ($15,000 – $10,000 – $900).

In this scenario, had you invested the money, you’re able to cover the expense, and it nets out in your favor, even with the taxes you paid.  Now, of course, this assumes a favorable rate of return on your investment.  Seven years is not very long, so that 6% could be higher or lower.

The point I’m making is simple: if you have enough invested toward FIRE, you may not need the full 6 months of emergency funds.  Yes, there’s more risk involved in holding equities over cash, but by and large, if you’ve got enough cushion, holding too much idle cash comes at a significant opportunity cost.  Depending on your risk tolerance, the conventional wisdom of holding a 6 month emergency fund in cash may not be as relevant when you’re sitting on a pile of invested assets.

A final word of caution that’s worth repeating: I am not condoning investing your emergency fund if that’s your only extra money.  If you have $0 invested and $40,000 in a high-yield savings account – KEEP IT THERE!  Wait until your brokerage account is at least equal to, if not significantly higher than, your emergency fund, then think about putting some of that cash in the market.

One thing I like to do is take the earned interest from my emergency fund and place that in the market.  It’s never that much but every little bit counts.  As long as you’re comfortable with it, put that money to work.