Financial pros and cons of having a rainy day fund in a savings account versus invested?

Question

I used to have about 4 months of expenses in a savings account as a "rainy day fund" in case of emergencies.

The last year or so, though, I've switched to having a minimum of expenses (about 1 month's average expenses) in my savings account and moving everything else into investments. I keep my investments in a robo-advisor account, so when I make withdrawals the robo-advisor calculates the optimal shares to sell to minimize my tax burden. Withdrawals take less than a week, which suits my needs.

When I suddenly need cash, I just withdraw from the investments. Yes, I have to pay taxes on the withdrawal, and sometimes I catch a cycle where I need to withdraw money while my index fund values are down. However, both of these costs seem drastically outweighed by the financial benefits of having 3 months of expenses actually invested year-round rather than sitting in a savings account and not earning.

Am I misunderstanding the cost-benefit calculus here? All constructive criticism is very welcome!

Answer 1

It's a tradeoff.

If you had an emergency fund invested in stocks, rather than cash, and you didn't use it in 20 years, you lost out on roughly tripling it.

However, if you do need it, more likely than not it will be in a broad economic downturn, so you could be selling it at a 50% loss.

A middle ground would be to invest the emergency fund in bonds only. You'll get a better return than a savings account, and if you need it in a downturn it will be most likely 100% there.

Some robo-advisors let you set up a separate account for your emergency fund. Betterment, for example, recommends a low-volatility mix of 30% stocks/70% bonds that's 30% bigger than your cash-only emergency fund would be, in case of any downturns.

Answer 2

If you think your emergency fund is to fix an alternator on your car. Do whatever.

If you think your emergency fund is to claw your way through your basic expenses after being laid off when there's a broad economic down turn and there is no available credit for several months; cash is king. Selling investments you've had for years when they're getting clobbered is compounding a bad situation. An emergency is when your income disappears.

When you're young and single, your whole life is an emergency. The idea of letting a, relatively, large amount of cash sit idle doesn't make a lot of sense to me. But similarly, if you're budgeting by putting your anticipated car insurance premium in a robo advisor fund to try to juice an extra $50 out of it before you need to renew your 6-month policy, that's silly. You're just setting yourself up for a dumb problem.

If you're older, married, have kids, a mortgage, etc, you really don't want to be selling clobbered investments to make a mortgage payment when the economy is in the tank; in part because you simply have less time. When you do this you're stealing from your future.

I sleep better at night with a strong allocation of cash. It's the worst investment. But I've seen theses cycles come, I've watched friends struggle. You need to plan as though no one will come help. As you get more established and have more obligations to other people you should be sitting on more cash. You just don't want to find yourself making decisions out of necessity.

Finding out you have less money than you think when you're in an emergency is like finding out your life vest is only rated for half of your weight while you're drowning. You just don't need to be in that situation.

Answer 3

One thing skirted around by other answers is that costly personal emergencies tend to be strongly correlated to periods of losses in the stock market. The reason for this is that during a recession or crash you are more likely to be put out of work and therefore consuming the cash you have put aside leading you to have to withdraw your money from the markets at their (local) minima. The reason for this is that when you don't have the money to take care of a leaky tap or a leaky radiator (i.e. you are saving on maintenance) you are increasing the chances of a catastrophic event such as a household flood or a vehicle breakdown. In this case you might get your money in less than a week but you may do so by taking a large haircut by selling quickly at the bottom of a market.

A calculation you probably need to do is the expected shortfall for your investments in a stressed scenario. If that value is less than you need for 6 months including a large, potentially correlated, household emergency then you are probably fine.

The real question here might be are your investments being diversified properly to account for this or is your robo-adviser simply tax harvesting as you suggest in your post? If the robo-adviser is blindly doing as you say it might be putting cash into tax advantaged risky investments that could fail altogether. Trying to reduce taxes at the cost of all else is a fool's game and you need to think about whether the tax savings are worth potentially missing out on returns and whether the instruments being invested in are worthwhile investments in their own right. Don't let the tax tail wag the investment dog.

Answer 4

There's not a "right" answer so long as you can get to the cash in a reasonable time (e.g. a day or two at the most). One con of having the emergency fund in risky investments is that the value of those investments can go down. Granted it's less likely historically, but math tells us that downturns are relatively harder to recover from - meaning that after a 10% down period, for example, your investments need to go up by 11.1% to recover. Again, that recovery happens more often than not, but it shows that downturns and upturns are not equivalent.

Plus, if you have an emergency at the end of a down period, you may be hesitant to sell at a loss, instead opting to borrow the money or find some other means.

Since the point of a liquid emergency fund is to NOT borrow money to pay for emergencies, this can be a negative consequence of keeping your emergency fund in risky investments.

Plus, at some point, your emergency fund should be much smaller than your retirement or other investments, so the potential gain is not significant relative to the gains in your other investments.

I'm not saying that it's a terrible idea, but you do need to be aware of the risks associated with investing your emergency fund.