In a past blog post, we pointed out that a $0.00 emergency fund is most useful for us. Lots of visitor traffic came from both Physician of FIRE and Rockstar Finance (thanks for featuring us!!!) and most comments were very supportive. Good to know that others follow a similar approach. To make the case more complete we should also look at some of the standard arguments people normally use in favor of keeping a large stash of cash for emergencies.
That’s because in addition to some of the complaints we got in the comments section, someone we quoted in our post, Scott Alan Turner, is a blogger and podcaster and he dedicated almost an entire 28 minute podcast (transcript included if you don’t want to spend 28 minutes) to our theory and why he thinks we’re wrong. We respectfully disagree!
For full disclosure: I really like Scott’s blog and podcasts in general. I mean no disrespect and like to invite everybody to check out his material. I agree with most of what he has to say, just not the advice on emergency funds! Enjoy!
So, let’s look at some of the arguments in favor of an emergency fund and debunk them. It took us a while to put this together, but better late than never!
1: The Certified Financial Planner® (CFP) manual recommends 3-6 months worth of expenses in an emergency fund
“What do the not-so-called planners have to say, professional financial planners? Oh, how about Certified Financial Planners, the people who go and have to do three-year internships, go to school thousands of hours of study, be cream of the crop? Well, I should know because I’m enrolled in the master’s program and I have the textbook right in front of me. […] A good rule of thumb is that the client should have the equivalent of three to six months of fixed and variable expenses in liquid accounts for emergencies.” From Scott Alan Turner
Oh, well, where do we start? Just because a book used by financial planners recommends this doesn’t mean that it’s universally right. I might be preaching to the choir here since we’re all DIY-type folks when it comes to our finances. The CFP manual probably also recommends that we should all hire a CFP to help us with our personal finances at the cost of 1% p.a., which is another piece of advice from that CFP manual that we can all very safely ignore.
But back to the 3-6 month number: where does this number come from? Is this the result of a careful asset allocation optimal portfolio exercise? Likely not. Some financial analyst calculated how much money you should have for emergencies (job loss, home pairs, car repairs, etc.) and we would probably agree with the total amount. What we don’t agree with is that this all has to be held in cash with a close to zero nominal yield and less than zero inflation-adjusted yields. Again, we don’t have a problem with the if just with the how we go about saving for emergencies. Nobody can time recessions and stock market meltdowns. Since stock returns are higher than cash returns we find a $0.00 emergency cash portion in large financial asset portfolio much more attractive.
2: A $0.00 emergency fund only works for very high net worth, high-income households. All others should have an emergency fund
“Remember this person has a seven-figure net worth. […] I am happy that you guys have a plan that works for you. However, you’re in a very small minority, and you’re trying to apply your plan that’s specific to your situation to the majority of people who, A, have no savings, B, are living paycheck to paycheck, and C, have $15,000, on average, in credit card debt. The average person has no savings.” From Scott Alan Turner
This one almost convinced us. But thinking about it more carefully, it’s actually the other way around. Poor people are hurt more by this bad advice. Here’s why: Thanks to our personal net worth we would be able to afford to throw away the earnings potential of $10,000 or even $50,000. If that cash stash had the potential to give us better sleep at night, so be it. But we’re sleeping just fine knowing that a large army of little green soldiers works hard for us instead of languishing in a money market account. It also wouldn’t take us very long to accumulate a sizable emergency fund. At our current 60% savings rate it would take just 2 months worth of savings to accumulate 3 months worth of emergency fund savings. Not a large impediment to our retirement planning.
A very different story emerges for the less affluent and the less aggressive savers. If channeling money into your money market account means you neglect to save in productive assets, you could be delaying your financial freedom by years. Imagine you save only 10% of your take-home pay and consume 90%. To accumulate 3 months worth of spending you’d need 0.90*3/12/0.1=2.25 years worth of after-tax savings. 4.5 years to hit 6 months worth of spending and a full 6 years (!) to follow Suze Orman’s bat-$&!t crazy recommendation of 8 months of emergency fund savings. You’re throwing away years of earnings potential in the stock market.
Thus, the same financial advisers that tell everybody how important it is to start saving for retirement early, thanks to compound interest (chapter 3 in the CFP manual?), also tell you to effectively sit on your hands for several years trying to save for emergencies. And if, lo and behold, a few emergencies actually hit your finances, before you know it you might spend your entire adult life trying to replenish that emergency fund to the elusive 3, 6 or 8 months level. You never get to enjoy the power of compounding!
3: If you have an emergency during a recession you want the liquidity of cash
“If I have $100,000 in stocks, in 2008 and 2009 the market dropped 50 percent. If I’m about to replace my roof and it’s going to cost me $10,000 … like I have to right now … it’s an emergency. I have hail damage. I need a new roof. If I had to pull it from my equity portfolio in 2009, my $100,000, which became $50,000, is now $40,000. A 50 percent drop, sell $10,000 to cover the roof, that’s $10,000 that is not going to grow anymore, or recover or compound.” From Scott Alan Turner
Wow, now our prospective financial planner understands the concept of opportunity cost. Great! When you sell equities before a large rally, you miss out. That’s opportunity cost. We completely agree. But there is also the opportunity cost of having cash sitting around during expansions when the stock market rocks. Recall, that expansions are significantly (about 5 times) longer than recessions, see NBER data here. There’s also the opportunity cost for all those who didn’t have any emergency spending during the recession (a vast majority of households!) who then missed out on the stock market gain since March 2009. There is also the issue of when during the recession do you need a roof repair? If it’s right at the beginning of the global financial crisis, the market hadn’t dropped by much. Liquidating some of your equity holdings during that time saved you the agony of going through March 2009.
The entire emergency fund rationale thus depends on the crazy assumption that the large cash stash sitting around would have been optimal under very specific and unlikely circumstances, namely your car breaking down or you losing your job exactly at the bottom of the stock market. To us, this is the textbook definition of Hindsight Bias. Keeping too much money in an emergency fund is an irrational behavioral bias. Daniel Kahneman won a Nobel Prize in Economics for his work studying these biases. Rational people would weigh the pros and cons of the emergency fund over all possible outcomes. And just to be sure, you can and should value the liquidity of an emergency fund at the bottom of the crisis more than the opportunity cost of the emergency fund during normal times to account for risk aversion. But unless you are crazy, crazy risk-averse, the emergency fund is still not worth it!
4: Emergency funds cannot be invested in anything risky
“Funding a medical emergency, a loss of income, with your investments in a down market? Too risky.” From Scott Alan Turner
The whole emergency cash arithmetic has the strong smell of another well-known behavioral bias: mental accounting. One of the symptoms of this irrational bias is that investors have different degrees of risk aversion in different pots of money. Imagine you have a million dollar portfolio: $970,000 is invested in stocks and $30,000 is your emergency fund, which you keep in a money market account for fear of losing money. If you are so afraid of losing $15,000 in your emergency fund and have to keep that money in cash, shouldn’t you be more worried about losing $485,000 in your brokerage account? Remember: Money is fungible! The fact that you have such crazy risk-aversion inside your emergency fund, but are oblivious to risk in your overall portfolio is a serious behavioral bias and leads to sub-optimal decisions. We have pointed out this Mental Accounting fallacy before. Also, in our post here (also see chart below) we show why risk mitigation in a portfolio is usually not performed through holding more cash but by moving along the efficient frontier.
5: The stock market is correlated with job cuts
“If the economy tanks your investment accounts may go down, lose your job, and get your HELOC pulled. The three are not diversified and thus they are risky to depend on. Storing cash is a hedge and many are willing to pay the opportunity cost to diversify.” From the comments section
True. There is a positive correlation between job losses and both the business cycle and stock returns. But the correlation is quite weak. Only 17% of unemployment claims occur during recession periods, 83% during expansions since the government started measuring those in 1967 (Weekly Unemployment Claims). 17% is higher than the recession probability since 1967 (13%), hence the positive correlation, but you are still five times more likely to claim unemployment benefits during an expansion than during a recession. Unless you are an economics and finance wizard and you can time recessions vs. expansions, keeping that money sitting around in cash seems like a major waste of money.