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Everybody says you should keep an emergency fund of 3–6 months of expenses in cash or near-cash (CDs, treasuries, etc.). I know this is heresy but if you have funds for significantly more than 6 months of expenses (let's say 12 months), how risky would it be to put it all into stock index funds? In the worst-case scenario, let's say you have a financial emergency at the same time the stock market crashes and loses half its value. You could still liquidate the rest and have sufficient funds for 6 months. Am I underestimating the risks of this strategy? If it truly is an emergency fund then the odds of needing it should be very slim, so why live with near zero return on that money?

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One way to reduce your losses during a financial crisis is to have a stop loss of 20% or 25% off the latest highs for the index. That way you can remain in the market during normal market fluctuations, but get out if the market starts falling considerably. That way you will protect most of your capital and gains you have made. –  Victor May 13 at 6:59
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Some brokerages have features similar to banks offering debit cards, checks, even bill pay from their accounts. I deviate from what they say on the question you asked too. My money does not have the luxury of being used for a single purpose. –  user14218 May 13 at 12:48
    
Related: money.stackexchange.com/questions/21371/… –  Freiheit May 13 at 15:28
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I first read this as "How risky is it to keep my emergency fund in socks?" –  antony.trupe May 13 at 19:19
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@antony.trupe That's ridiculous, everybody knows under a mattress is the only safe place to keep money. ;-) –  Craig W May 13 at 20:20

7 Answers 7

I know this is heresy but if you have funds for significantly more than 6 months of expenses (let's say 12 months), how risky would it be to put it all into stock index funds?

Quite risky as if you do need to dip into it, how fast could you get the cash? Also, do you realize the tax implications when you do sell the shares should you have an emergency?

In the worst-case scenario, let's say you have a financial emergency at the same time the stock market crashes and loses half its value. You could still liquidate the rest and have sufficient funds for 6 months. Am I underestimating the risks of this strategy?

That's not worst case scenario though. Worst case scenario would be another 9/11 where the markets are closed for nearly a week and you need the money but can't get the funds converted to cash in the bank that you can use. This is in addition to the potential wait for a settlement in the case of using ETFs if you choose to go that way.

In the case of money market funds, CDs and other near cash equivalents these can be accessed relatively easily which is part of the point.

A staggered approach where some cash is kept in house, some in accounts that can easily accessed and some in other investments may make sense though the breakdown would differ depending on how much risk people are willing to take.

If it truly is an emergency fund then the odds of needing it should be very slim, so why live with near zero return on that money?

Something to consider is what is called an emergency here? For some people a sudden $1,000 bill to fix their car that just broke down is an emergency. For others, there could be emergency trips to visit family that may have gotten into accidents or gotten a diagnosis that they may pass away soon. Consider what do you want to call an emergency here as chances are you may not be considering all that people would think is an emergency.

There is the question of what other sources of money do you have to cover should issues arise.

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Your point about closed markets is an interesting one, and argues against keeping all of your emergency fund in stocks. However, I think few people envision an emergency fund as something where you would need to withdraw an entire six months' worth of expenses all at once. So not sure how that argument would apply to a strategy of "keep $X in a savings account and the rest in stocks". Also, some major cataclysms might result in bank closures as well. –  BrenBarn May 13 at 4:53

Keeping your “big emergency” fund in stocks if you have 12 months income saved is OK. However you should keep your “small emergency” fund in cash. (However I find that even my stock broker accounts have some cash in them, as I like to let the dividends build up enough to make the dealing charges worthwhile.

You don’t wish to be forced to sell at a bad time due to your boiler needing replacing or your car breaking down.

However if you lost your job in the same week that your boiler broke down and your car needed replacing then being forced to sell stocks at a bad time is not much of an issue.

Also if you are saving say 1/3 of your income each month and you have a credit card with large unused credit limit that is paid of each month, then most “small emergency” that are under 2/3 of your monthly income can be covered on the credit card with little or no interest charges.

One option is to check you bank balance on the day after you are paid, and if it is more than 2x your monthly income, then move some of it to long term savings, but only if you tend to spend a lot less then you earn most months.

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A major danger of keeping "emergency" funds in the form of stocks is that many of the scenarios where one would need quick access to the money will also momentarily depress the stock market. Someone whose emergency funds were in some other form could avoid selling stocks during a momentary downturn, but someone who has no other emergency funds would have no choice but to sell during the downturn (thus losing money as well as making the downturn more significant for everyone else).

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I've read the answers and respect the thought behind them. I'd like to focus on (a) the magnitude of the emergency, and (b) the saving rate of the people affected. 3-6 months is interesting. It's enough not just to fix the car, repair the A/C, etc, but more than enough to lose one's job and recover. (Let's avoid the debate of how long it take to find a job, no amount of 'emergency savings' can solve that.)

If one is spending below their means, any unexpected expense that can paid off within, say 3 months, doesn't really need to tap emergency funds (EF). And, at some level of income and retirement savings, one can more easily run a much lower EF.

My own situation - I had 9mo worth of expenses saved as EF. We were living well beneath our means, and I was looking at the difference between our mortgage (6%+) vs bank interest (near 0%). I used the funds to pay down principal, refinanced to a lower rate, and at the same closing got a HELOC. The psychology of this is tough, it then appears that for simple expenses, I'd be borrowing from my HELOC. On the other hand, the choice was between a known cost, the $5K/year the money was costing by sitting there plus the lower rate by going to a non-jumbo loan at the time, vs the risk of using 3% money from the HELOC. In the end, the HELOC was never tapped for more than a small portion of its line, and I never regretted the decision. Ironically, it's the person who isn't saving much that need the EF most. If you are a saver, you need to judge how long it would take to replace the funds.

I offer the above not as a recommendation, but as devil's advocate to the other excellent advice here. All cash flows are a choice, $100 going here, can't go there. I'd slip in a warning that one should capture matching 401(k) contributions, if offered, before funding the EF. And pay down any high interest debt. After that, the decision of how liquid to be is a personal choice, what worked for my wife and me may not be for everyone.

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"it's the person who isn't saving much that need the EF most" +1. Someone calls this "kicking Murphy out." (Dave Ramsay? Jesse Mechem? Elizabeth Warren?) –  Michael Deardeuff May 14 at 1:44

This is basically the short-term/long-term savings question in another form: savings that you hope are long-term but which may turn short-term very suddenly.

You can never completely eliminate the risk of being forced to draw on long term savings during a period when the market is doing Something Unpleasant that would force you to take a loss (or right before it does Something Pleasant that you'd like to be fully invested during). You can only pick the degree of risk that you're willing to accept, balancing that hazard of forced sales against the lower-but-more-certain returns you'd get from a money market or equivalent.

I'm considered a moderately aggressive investor -- which doesn't mean I'm pushing the boundaries on what I'm buying (not by a long shot!), but which does mean I'm willing to keep more of my money in the market and I'm more likely to hold or buy into a dip than to sell off to try to minimize losses. That level of risk-tolerance also means I'm willing to maintain a ready-cash pool which is sufficient to handle expected emergencies (order of $10K), and not become overly paranoid about lost opportunity value if it turns out that I need to pull a few thou out of the investments. I've got decent health insurance, which helps reduce that risk.

I'm also not particularly paranoid about the money. On my current track, I should be able to maintain my current lifestyle "forever" without ever touching the principal, as long as inflation and returns remain vaguely reasonable. Having to hit the account for a larger emergency at an Inconvenient Time wouldn't be likely to hurt me too much -- delaying retirement for a year or two, perhaps.

It's just money. Emergencies are one of the things it's for. I try not to be stupid about it, but I also try not to stress about it more than I must.

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There's something very important no one else has mentioned... times when the stock market falls dramatically are often the times when you're most likely to lose your job, and when it's hardest to get loans. So if you ever do need your emergency fund, it will more than likely be related to a dip in the stock market.

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This is an important point a lot of people seem to be missing. –  stoj May 14 at 15:37

From mid 2007 to early 2009 the DJI went down about 50 %. This market setback won't happen on a single day or even a few weeks.

Emergency funds should be in cash only. Markets could be closed for an unknown period of time. Markets where closed September 11 until September 17 in 2001.

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