One of the most commonly heard rules of thumb in the financial world is that every person should keep at least 6 to 12 months’ worth of expenses in an “emergency fund”. Most financial professionals will tell you that these funds should be kept in either a savings account or some other type of low-risk account. Of course, like all rules, sometimes it might be a good idea to break it.
The Journal of Financial Planning recently released new research showing that, at least for affluent investors, keeping all of their emergency funds in a savings account or other low-risk account may not be all that good of an idea.
The reason, as you might guess, has to do with interest rates. Frankly, very few banks are offering interest rates that are interesting to anyone keeping a close eye on their money. Anyone that can smartly diversify should be able to not only grow their emergency fund much better than in a bank but also still have access to it if necessary. The study also was quick to point out that it does come with some risk, especially if you’re forced to take your money out of your investments when markets are tumbling, but as far as statistics go they felt it was worth the risk.
Dr. Jacob Sybrowsky, co-author of the study and the director of personal financial planning for the Woodberry School of Business at Utah Valley University, agrees. In his own words “there’s a lot of pressure on families to save for retirement, so every dollar counts.”
Stock and bond data going all the way back to 1926 as well as statistics from unemployment rates as far back as 1948 were used in the study to simulate portfolio returns and emergency situations. What they found was that keeping 6 months’ worth of expenses in either a normal bank account or in cash not only significantly lowered a person’s overall wealth when they retired but also frequently failed to actually cover emergencies when they arose.
By using stocks and bonds to diversify their investments a consumer is able to not only grow their emergency fund more quickly but have more money available if and when an emergency does arrive. As Dr. Sybrowsky noted, “if you have money effectively just sitting on the sidelines, there’s an opportunity lost.”
Of course financial planners are quick to emphasize that every person’s needs are different. For example, someone that’s just starting out should probably be more conservative and keep their emergency fund dollars in a safer location like a normal bank account. On the other hand, someone who’s been working for quite a few years and has more of a “financial cushion” can afford to take a few more risks with their emergency fund money.
If you do decide to invest your emergency fund money rather than keep it in a bank account, you should put it into stocks and bonds that allow you to withdraw it quickly and without penalty. Also, you should put the money into a broadly diversified range of investments. Dr. Sybrowsky recommends using not only stock and bond funds but also real estate, precious metals and other asset classes. He notes that being more widely diversified will help you to create a broader safety net so that if you have to access your money when the stock market is down it doesn’t damage your finances nearly as much.
If you have any questions about emergency funds, investing or personal finances in general, please let us know and we’ll get back to you ASAP with advice and answers.