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A lot of financial advisers say you should have an emergency fund, in addition to whatever else you're doing. I don't really see the benefit, but let me be more specific.

I definitely see that it's good to "have money available" so that you don't have to put an unexpected expense on your credit card, thereby incurring exorbitant rates. This also protects you if your unexpected expense can't be paid with credit card at all, or if there would be a fee for doing so.

What I don't get is why I should setup a separate savings vehicle known as an emergency fund. If an emergency happened, I could just sell off some of the stocks in my main investment account.

I guess this is a specific case of a more general question, which is: Why is it helpful to set up "goals" in these online investment advisers?

I guess I can try to answer my own question: If you give the goals different risk profiles, you can have a different mix of assets. So for the emergency fund you can have relatively more bonds, so it's still growing (just a bit more slowly), and less likely to be "down" when you need it. Not sure yet if I can do that, I just signed up...

  • "A Crash Course in Risk Analysis: Why Six Months in an Emergency Fund is a Necessity." covers why the recommendations are for an FDIC or NCUSIF insured savings account rather than other uninsured investment vehicles. – zzzzBov Aug 7 '17 at 3:09
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    Emergency fund? How about reframing the suggestion: you should have significant cash (or other highly-liquid asset) reserves. There are lots of reasons why (too long for a comment). – Jared Smith Aug 8 '17 at 16:03
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    If you want to answer your own question, just use the "Add an answer", not add it as a part of the question. (Except if you actually want this as part of the question, i.e. so other people answer on it ... but your last paragraph doesn't look like that.) – Paŭlo Ebermann Aug 9 '17 at 17:11
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    @PaŭloEbermann I have done that in other cases, and I would have done that here if my answer were more complete, but it was just an idea and not very developed. Also, I wasn't sure if I was right (which is why I am asking the question in the first place). – Stephen Aug 9 '17 at 18:38
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    "so that you don't have to put an unexpected expense on your credit card, thereby incurring exorbitant rates" I'm not sure about other countries, but in the U.S., regardless of the magnitude of the expense, if you put it on a credit card on which you do not carry a month-to-month balance, the "exorbitant rate" you'll pay until you can transfer funds to pay off the card is zero. As long as you pay off the balance in full before the due date for the statement on which it appears, you won't pay any interest on it at all. – reirab Aug 10 '17 at 5:49
61

Emergency funds have a very specific and obvious benefit; you'll have money sitting around in case you need it. A lot of people think a big car repair or some unexpected home repair is an emergency, and that's fine. Emergency also expands up to "I lost my job four months ago and we're a year in to a recession, the stock market is down 30% and I need to pay my rent or mortgage." Sure, you could just sell some of your stocks that have lost 30% and pay your rent.

I know nobody likes to think about it, but the stock market can go down. I know nobody likes to think about it, but the economy can slink in to a recession. In fact, here's a small list of recent U.S. recessions:

  • July 1981 - November 1982
  • July 1990 - March 1991
  • March 2001 - November 2001
  • December 2007 - June 2009

No competent investment adviser would advise that your emergency funds should be subject to market volatility because that completely defeats the purpose of an emergency fund. It's possible that this manager wants you to indicate a separate emergency fund to allocate a portion of your account to a low volatility US Treasury fund or something of the like, this would be materially different than investing in a broad market/large cap fund like VOO or VTI.

The effects of inflation are not so bad that you should put your emergency money in the market. Who cares what inflation was if you have to sell an asset at a loss to pay rent?

One last point. Index fund ETFs are not "safe." Investing in diversified funds is safER than buying individual company stocks.

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    Great answer. However, the recessions you noted appear to happen on average once every decade. So statistically we can expect to have 5 years of appreciation before we need our money in a recession. Even at 8% return (low if not including a recession during that period) that's a 46% gain on principle. Even if your holdings are down 30% from that value and sold, they're still worth more than the principle. So is this strategy just to protect against the risk of a recession in the next 3-4 years (after which time it becomes counter productive)? – Nicholas Aug 7 '17 at 13:20
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    @Nicholas Using data from this site, if you had $10K in the S&P500 starting at the beginning on 1999, it would be worth less than $9K at the beginning of 2009. Say you needed $5K in 2009. In 2017 you end up with around $10K. If instead you kept 5K in cash and started with $5K in investments, you end up with $12K in 2017. Obviously this is oversimplified. You would be adding money all along and the emergency fund is mostly in the beginning. But it demonstrates the risk of not having the rainy day fund. – JimmyJames Aug 7 '17 at 15:09
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    @Nicholas Actually it's more like $11K and $13K in 2017. I should also note that if you put the full $10K in and never touched it, you end up with more than $25K. So, basically it comes down to risk tolerance. Your investments should, over the long run, dwarf your emergency fund. – JimmyJames Aug 7 '17 at 15:20
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    @Nicholas, The recessions I noted are just the last four and that is not nearly enough to determine the average occurrence of a recession. The country has existed for ~240 years, the NYSE has existed for ~200 and in the last 35 there have been four recessions of varying significance; there is no statistical significance there to "expect to have 5 years of appreciation." In fact, the 5th most recent recession started Jan. 1980. This "strategy" seems like little more than a way for the adviser to get more assets under management. Emergency funds are meant to be available, not appreciate. – quid Aug 7 '17 at 15:23
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    @Nicholas, the presented table doesn't include October 19, 1987, "Black Monday", with a one-day market drop of 22%. There was a quick recovery (it wasn't a recession), but if you were in equities and your emergency need came up on October 20, good luck. – user662852 Aug 7 '17 at 16:28
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My take on this is that this reduces your liquidity risk. Stocks, bonds and many other investment vehicles on secondary markets you may think of are highly liquid but they still require that markets are open and then an additional 3-5 business days to settle the transaction and for funds to make their way to your bank account.

If you require funds immediately because of an emergency, this 3-5 business days (which gets longer as week-ends and holidays are in the way) can cause a lot of discomfort which may be worth a small loss in potential ROI.

Think of your car breaking down or a water pipe exploding in your home and having to wait for the stock sale to process before you can make the payment. Admittedly, you have other options such as margin loans and credit cards that can help absorb the shock in such cases but they may not be sufficient or cause you to pay interest or fees if left unpaid.

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    But the investment advisers (WiseBanyan in this case) are advocating an emergency fund which would also be held in stocks and bonds. So they don't even have different liquidity from my main investment account. – Stephen Aug 7 '17 at 2:38
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    Well this changes the question a bit then. I would advise you to maybe include the reasons you are referencing so that we can better answer. I can see that there could be tax implications and/or restrictions on 'fire sale' type events in some account types and not others. For example, in Canada it is very penalizing to sell investments in Registered Retirement Savings Plans for various reasons (higher taxes, double counting of contributions, etc) and additional restrictions apply. For this reason, it is frequent to hold different investing accounts which may end up containing similar products. – ApplePie Aug 7 '17 at 2:44
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    @Stephen An emergency fund should by definition be immediately accessible which completely rules out holding it in those investment products. A quick look at WiseBanyan reveals them to be a "free financial advisor" though "low-cost online investment account" seems to be a better description. It seems to me like they'd have a vested interest in recommending stocks and bonds over a savings account and recommending multiple accounts to increase the number of transactions. But I'd suggest asking about that specific advice in a separate question. This question is useful in its own right. – Lilienthal Aug 7 '17 at 7:38
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    Under what circumstances would a 3-5 day delay really be a problem? You could always pay with a credit card, then pay the credit card balance when the funds become available from the broker. Unless you've already hit your credit card limit, which seems like a serious problem on its own. – Barmar Aug 7 '17 at 14:31
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    I agree w/ Barmar - probably most people who could save up thousands in an investment account are also in the position to have a credit card with a high max (8-12k). Once you factor in rewards programs, it's even superior. The risk of the market being down seems like the only real problem, and you have to weigh that against the risk of missing out on market gains by not investing your emergency fund. – Stephen Aug 7 '17 at 14:45
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There are a few major risks to doing something like that.

First, you should never invest money you can't afford to lose. An emergency fund is money you can't afford to lose - by definition, you may need to have quick access to that money. If you determine that you need, for example, $3000 in emergency savings, that means that you need to have at least $3000 at all times - if you lose $500, then you now only have $2500 in emergency savings. Even if it's just the result of a temporary fluctuation, what if you lose the $500 right before you need it? Imagine what could've happened if you had invested your emergency savings right before the 2008 crash, for example; you could easily have been in a position where you lost both your job and a good portion of your emergency savings at the same time, which is a terrible position to be in. If the car breaks down, you can't really say "now's a bad time, wait until the stock market bounces back."

Second, with brokerage accounts, there may be a delay before you can actually access the money or transfer it to an account that you can actually withdraw cash from or write checks against (but some of this depends on the exact arrangement you have with your bank). This can be a problem if you're in a situation where you need immediate access to the money - if your furnace breaks in the middle of winter, you probably don't want to wait a few days for the sale and transfer to go through before you can have it fixed.

Third, you can be forced to sell the investments at an unfavorable price because you're not sure when you're going to need the money.

You'd also likely incur trading fees and/or early withdrawal penalties when you tried to withdraw the money. Think about it this way: if you buy a bond that matures in 5 years, you're effectively betting that you won't have an emergency for the next 5 years. If you do, you'll have to either sell the bond or, if you're allowed to get the money back early, you'll likely forfeit a good amount of the interest you earned in the process (which kind of kills the point of buying the bond in the first place). Edit: As @Barmar pointed out in the comments, you may also have to pay taxes on the profits if you sell at a favorable price. In the U.S. at least, capital gains on stuff held for less than a year is taxed at your ordinary income tax rate and stuff held longer than a year is taxed at the long-term capital gains tax rate. So, if you hold the investment for less than a year, you're opening yourself up to the risks of short-term stock fluctuations as well as potential tax penalties, so if you put your emergency fund in stocks you're essentially betting that you won't have an emergency that year (which by definition you can't know).

That being the case, a $3000 emergency fund could end up being significantly less than $3000 if you consider possible losses due to market fluctuations or being forced to sell at an unfavorable time, potential fees and penalties associated with early withdrawal of the money, taxes, and trading fees.

The purpose of an emergency fund is just that - to be an emergency fund. Its purpose isn't really to make money.

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    In addition to fees, there are also capital gain taxes if you're forced to sell during a good market. – Barmar Aug 7 '17 at 14:32
  • @Barmar Good point. There's also a tax penalty (in the U.S. at least) if you withdraw or borrow the money from a 401(k) prior to turning 65. – EJoshuaS Aug 7 '17 at 14:34
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    "An emergency fund is money you can't afford to lose". Can you clarify what you mean by that? My understanding is that it's smart to put the majority of your money that you'll need for later in life into safe investments. But by definition if you need it later in life, then you can't afford to lose it. – spacetyper Aug 7 '17 at 15:32
  • @spacetyper I edited to clarify. Basically, if you determine that you need $3000 in emergency savings, you need to have at least $3000 in emergency savings at all times (meaning that if your investment loses money in the short term, you may end up with less than $3000, at least temporarily). – EJoshuaS Aug 7 '17 at 16:06
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You're absolutely correct. If you have maxed out your retirement investment vehicles and have some additional investments in a regular taxable account, you can certainly use that as an emergency source of funds without much downside. (You can borrow from many retirement account but there are downsides.)

Sure, you risk selling at a loss when/if you need the money, but I'd rather take the risk and take advantage of the investment growth that I would miss if I kept my emergency fund in cash or money market. And you can choose how much risk you're willing to take on when you invest the money.

  • I don't agree that there's not much downside here - the fact that you risk selling at a loss if you need the money is a major downside IMHO. Plus you're investing money that you can't afford to lose - if you determine that you need $3000 in emergency savings, by the time you pay trading fees, it may not be $3000 when you go to spend it, especially if you lose money. Even if you do gain money, you'll have to pay capital gains taxes on it. Essentially, if you do that you're betting that you won't have an emergency in the short term, which by definition you can't know. – EJoshuaS Aug 7 '17 at 14:41
  • If I've already maxed out my retirement accounts and I have additional savings I can use as an emergency fund, it is indeed money I can afford to lose. (But I'd rather see it grow, obv!) OP is just asking if he should always keep his emergency fund in a cash equivalent. I'm saying no, it is not always necessary in some cases. – Rocky Aug 7 '17 at 15:27
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Budgeting

From a budgeting perspective, the emergency fund is a category in which you've budgeted funds for the unexpected.

These are things that weren't able to be predicted and budgeted for in advance, or things that exceeded the expected costs.

For example you might budget $150 per month for car maintenance, and typically spend some of it while the rest builds up over time for unexpected repairs, so you have a few hundred available for that.

But this month your transmission died and you have a $3,000 bill. You'll then fund most of this out of your emergency fund.

This doesn't cover where to store that money though, which leads me to my next point.

Accounts

Emergencies are emergencies because they come without warning, without you having a chance to plan.

Thefore the primary things you want in an emergency fund account are stability and quick access.

You can structure investments to be whatever you think of as safe or stable but you don't want to be thinking about whether it's a good time to sell when you need the money right now.

But the bigger problem is access. When you need the funds on a weekend, holiday, anytime outside of market hours, you're not going to be able to just sell some stocks and go to an ATM.

This is the reason why it's recommended to have these funds in a checking or savings account usually.


The reason I mentioned the budgeting side first is because I wanted to point out that if you're budgeting well, most of the unexpected expenses you have should have been expected in a sense; you can still plan for something without knowing when or if it will happen.

So in the example of a car repair, ideally you're already budgeting for possible repairs, if you own a home you're budgeting for things that would go wrong, budgeting for speeding tickets, for surprise out of pocket medical costs, etc.

These then become part of your normal budget: they aren't part of the emergency fund anymore.

The bright side about budgeting for something unexpected is that you know what that money is for, and do you likely also know how quickly you'll need it. For example you know if you have unexpected medical costs that happen very quickly, you're not likely you need a bag of cash on a moment's notice.

So those last two points lead to the fact that your actual emergency fund, the dollars that are for things you simply could not foresee, will be relatively small. A few thousand dollars or so in most cases.

If you've got things structured like this, you'll be happy to have a few grand available at a moment's notice.

The bulk of the money you would use for other surprise expenses (or things like 6 months of living expenses) is represented in other specific categories and you already know the timeframe in which you need it (probably enough time that it could be invested, risk to taste).

In short: by expecting the unexpected, you can sidestep this issue and not worry so much about missed returns on the emergency fund.

4

Given that the 6 answers all advocate similar information, let me offer you the alternate scenario -

You earn $60K and have an employer offering a 50% match on all deposits. All deposits. (Note, I recently read a Q&A here describing such an offer. If I see it again, I'll link).

Let the thought of the above settle in. You think about the fact that $42K isn't a bad salary, and decide to deposit 30%, to gain the full match on your $18K deposit. Now, you budget to live your life, pay your bills, etc, but it's tight. When you accumulate $2000, and a strong want comes up (a toy, a trip, anything, no judgement) you have a tough decision. You think to yourself, "after the match, I am literally saving 45% of my income. I'm on a pace to have the ability to retire in 20 years. Why do I need to save even more?"

Your budget has enough discretionary spending that if you have a $2000 'emergency', you charge it and pay it off over the next 6-8 months. Much larger, and you know that your super-funded 401(k) has the ability to tap a loan. Your choice to turn away from the common wisdom has the recommended $20K (about 6 months of your spending) sitting in your 401(k), pretax deposited as $26K, and matched to nearly $40K, growing long term.


Note: This is a devil's advocate answer. Had I been the first to answer, it would reflect the above.

In my own experience, when I got married, we built up the proper emergency fund. As interest rates fell, we looked at our mortgage balance, and agreed that paying down the loan would enable us to refinance and save enough in mortgage interest that the net effect was as if we were getting 8% on the money. At the same time as we got that new mortgage, the bank offered a HELOC, which I never needed to use. Did we somehow create high risk? Perhaps. Given that my wife and I were both still working, and had similar incomes, it seemed reasonable.

2

I treat the concept of emergency funds as a series of financial buffers.

One layer is that I have various credit cards with a small positive balance, that I can max out in an emergency should I go broke and not be in employment (those have saved me once or twice)

My final level of emergency funds, is kept at home in the form of cash, I've never needed it, but it protects against getting locked out of the financial system (I lose my debit cards, banking system freezes all withdrawals, zombie invasion). It also doubles as my destitution fund, as if all else fails I still have raw cash to buy food and thus I won't starve (at least for a few months).

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    Taking on high-interest debt in an unemployment scenario frankly seems... shortsighted. If you don't have the money now, why would you assume that you have it in a few weeks when the bill comes due? (Of course, if you do have the money, then it's a different matter.) – a CVn Aug 8 '17 at 10:40
  • Such is the life of a IT contractor, no job security but access to highly-skilled high-paying roles on the cutting edge of technology. If I am broke and unemployed now, then it may still require a month to properly refresh my skills and get myself back into the computer programming headspace and then a few weeks of full time job hunting. None of this is of course possible if I have completely run out of cashflow and have to spend my time firefighting low-level problems such as food or rent, rather than focusing on the big picture. Emergency money to fix emergency situations. – James McGuigan Nov 3 '17 at 11:01
  • "Emergency money to fix emergency situations." It's also a completely avoidable emergency. If one's income is liable to fluctuate that much, then a buffer of some kind is absolutely essential. What if a client defers payment for some reason? A few months' worth of living expenses in an easily accessible savings account can mean the difference between having to take on the risk of a loan, and sailing through a down period with little to worry about. – a CVn Nov 3 '17 at 11:05
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Let me first start by defining an emergency fund.

This is money which is:

  • Immediately Available

Because emergency's usually need to be deal with ASAP, boiler breaks, gears box in a car. Generally you need these to be solved as soon as possible, because ou depend on these things working and you can't budget for this type of expenditure using just your monthly salary.

  • Available without cost

This is a personal opinion but I prefer investment types that don't have another fee on access. I really don't like having another fee on top on money that I need right now.

Investment Options:

Market based investments should be seen as long term investments, therefore they do not really satisfy requirement one, they can also have broker fees, therefore you might pay a small extra charge for taking money out, and so do not satisfy requirement two.

Investment Options for Emergency Funds

You want to get the best return on your money even if it's your emergency fund. So use regular saving accounts, but from you emergency fund or use tax effective savings accounts, like a cash ISA if based in the UK. Don't think of an emergency money as just sitting there, you have options just makes sure the options fit the requirements.

UPDATE

Given feedback I appreciate there are levels of emergency fund, the above details things which might be about 1-2 month salary in cost, car repairs, leaks, boiler repairs.

Now I have another fund which is in P2P funds which is higher risk than a deposit account but then gives me a better return and is less subject to market fluctuations and it would be the place I go to for loss of job level emergencies say 6 months of salary, this takes a bit longer to access but given I have the above emergency fund I have given myself time to get the money from the P2P account.

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    Long ago, when there was actually interest paid on 1 yr cds, I observed that given the choice between a pretty low money market rate, and a 3% CD, the .75% (3mo) penalty on the CD shouldn't scare people off. There are certainly different levels of liquidity, and even with responsible emergency funds, risk/reward still exists. – JoeTaxpayer Aug 7 '17 at 16:42
  • @JoeTaxpayer understood, normally in the UK the penalty is the interest that you would have gained in the penalty period, so you never get back less than what you put in, but yes we all have different levels of risk and reward. I'll change it so that it's my opinion about the no cost aspect. – JamesD Aug 8 '17 at 7:27
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It all depends on the liquidity of your investments some examples:

  • If you own 100 houses it would take at least couple of weeks to get some funds in your hands from the sale. Unless we are in 2007 where the DOM(day on market) for a house was about 6 months.
  • If you own some investments in the stock market, you can get you money in about three days, on a happy day, however during a market crash, it would be hard to liquidate you position.

You can mitigate only the risk that you can control. It is always good to have:

  1. Cash at home: always available, always tradeable to cover about 6 weeks worth of food.
  2. Checking account: High liquidity unless there are natural disasters, war, etc,bank unsolvency.
  3. Long term investments stocks, real estate.

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