A question that we have been fielding more frequently than normal lately has been…should I invest my emergency fund?
Before we dive into answering that question, if you have built an emergency fund you deserve to be congratulated on having one in the first place! Only an estimated 41% of Americans can cover an unexpected $1000 expense, so clearly even having an emergency fund is an accomplishment in and of itself.
Let’s get to the question, should you invest that emergency fund? The answer, as always, is it depends. The key question you have to ask and answer is…how comfortable am I accepting short-term volatility in order to pursue higher long-term returns?
The first thing you should do is address the “how comfortable am I” part of the question.
If you are an experienced investor, think back on highly volatile periods in your investing history. How did you react? Were you cool as a cucumber or did you have sleepless nights? Be honest with yourself about your experience, that is probably a very good guide of how you will experience the next market event.
If you are new to investing, it may be helpful to draw on other high-stress experiences in your past to best predict how you will experience a market downturn in the future. How did you react in the heat of the moment? There are also plenty resources available online that attempt to help you determine your investor profile. In my opinion, the best investor profile tests are based on academic principles rooted in behavioral psychology and are scientifically valid. If you would like to try one of these tests, you CLICK HERE to learn more about your investing composure.
Generally speaking, if losing a single penny in your emergency fund causes anxiety or a valid investor profile tool categorizes you as a “Conservative” investor, keep the money in your high-yield savings. There is absolutely nothing wrong with keeping that money in cash and peace of mind is invaluable.
The second part of the key question to address is “accepting short-term volatility in order to pursue higher long-term returns”. In plain English, if you take on risk by investing your emergency fund how much could you lose and how much could you gain?
Shown below, let’s look at two hypothetical portfolios:
Portfolio 1 is a simple cash holding meant to reflect keeping money in a high-yield savings account. Portfolio 2 is invested in a conservative 20% stock and 80% bond portfolio. This is a hypothetical portfolio which is just one of many potential portfolios for investing your emergency fund
The time period that we ran a backtest for was from January 1987 through August 2020. We feel this good gives context for two reasons. First, the need for an emergency fund doesn’t go away. This should be considered a long-term holding and should be evaluated over an appropriate time period. Second, this particular time period contains several significant investment events such as COVID, the Great Recession, the tech bubble, and Black Monday.
An obvious word of caution, there is absolutely no guarantee that historical results will look anything like future results. Being comfortable with uncertainty is a requirement to achieve higher returns!
So if you were holding these portfolios, what is your downside and how much could you lose? Here are the 10 largest drawdowns over the tested time period:
The first obvious result is that Portfolio 1 experienced zero drawdowns. That is exactly why you hold cash! It is equally obvious that Portfolio 2 provided plenty of opportunities to lose money!
Going beyond the obvious, there are a couple of key concepts that I want to highlight in this chart:
- A drawdown is a decline in value and is shown in the column on the far right. The largest historical drawdown for Portfolio 2 would have been 9.54% during the Great Recession of 2008. In dollar terms, this means if you have $10,000 invested in Portfolio 2 and a drawdown of 10% occurs then you will have $9,000 in your account. Investing always comes with a risk of loss. You must be willing to accept a short-term loss in order to achieve long-term returns. No pain, no gain!
- Underwater Period
- Underwater period is the second column from the right and represents the length of time your account was below it’s previous high value. For example, if you invest $10,000 in Portfolio 2, you experience a drawdown to $9,000, the underwater period represents the length of time to get back to $10,000 again. There were three underwater periods that were a year or longer! Successful investing requires maintaining a disciplined long-term focus. Investing and life, patience is a virtue!
So what’s the upside? What is your historical reward for accepting this risk?
Here you go:
CAGR stands for Compound Annual Growth Rate, basically how much did your money grow. Despite all that uncertainty and all those drawdowns, Portfolio 2 grew by 6.73% over the tested time period and $10,000 grew to more than $89,000! Portfolio 1 would have earned 3.10% over the same period and $10,000 would have only grown to just shy of $28,000.
The return of Portfolio 2 is not guaranteed, but this is a perfect example of the long-term reward you hope to receive for being willing to accept short-term risk and uncertainty.
If you were to choose to invest your emergency fund, I would also suggest that you maintain a “margin of safety”. Let’s say that you determine that an adequate emergency fund for yourself is $10,000. Let’s also assume that you select Portfolio 2 which has a maximum historical drawdown of 9.54% over the tested time period. In order to make sure you always have $10,000 for an emergency, it may make sense to save a bit more until you can invest $11,500 in your emergency fund investment account. By doing so, you have created a “margin of safety” for yourself so that even if you experience a worse-than-worst-case drawdown you would still have the $10,000 you need in case of emergency.
I want to emphasize that your choice should not be based on expected rate of return, but whether you can own your choice and stick with it. Investing may produce better returns over the long-term, but if the associated volatility is not your cup of tea you will end up far worse trying to invest rather than simply staying in cash!
Ultimately, the choice whether to invest your emergency fund is yours. The best I can hope for is to provide you the knowledge and context so that you can feel confident in making the best decision for you. Bottom line, it boils down to whether you are comfortable with uncertainty and temporary drawdowns in pursuit of higher long-term returns.
Notes on results: Past performance is no guarantee of future results, which may vary. Investing involves risk, including possible loss of principal. The value of the investments and the income derived from them may fluctuate over time. All portfolio returns presented are hypothetical and backtested. Hypothetical returns do not reflect trading costs, transaction fees, or taxes. The results are based on information from a variety of sources we consider reliable, but we do not represent that the information is accurate or complete. The results do not constitute investment advice or recommendation, are provided solely for informational purposes, and are not an offer to buy or sell any securities. The results are based on the total return of assets and assume that all received dividends and distributions are reinvested. The annual results for 2020 are based on monthly returns from January to August. CAGR = Compound Annual Growth Rate. Drawdown analysis is calculated based on monthly returns excluding cashflows. The results assume annual rebalancing of portfolio assets to match the specified allocation.