Top 10 reasons for having an emergency fund – debunked (Part 1)

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.

EffFront with Emergency Fund
Efficient Frontier and why the Emergency Fund shouldn’t be in a money market account

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.

Continue to Part 2



66 thoughts on “Top 10 reasons for having an emergency fund – debunked (Part 1)

  1. Great read as always ERN!!

    Regarding point #3:

    To be fair, after the crash of Sept 09, it took another 19 MONTHS (I use VTSAX data since many investors understand that one) to claw back to a similar level. So it’s not an issue of urgent need for cash at a very specific point in time. If you are selling equities at any point in the long claw back phase, isn’t it a bad time to do that in ANY month of that 19-month period?

    1. Thanks for stopping by!
      Yes, absolutely. The peak before the GFC was in October 2007. Had you raised cash around that time you would have looked much better with cash through the recession. Whether you had an emergency or not.
      But: imagine you had no emergency. Even relative to to the old 2007 peak the S&P returned 40% price return, 70% with dividends reinvested. Not stellar, but much better than a money market account.
      Imagine you had experienced an emergency. When do you replenish the fund that’s now below the 3-6 month target? If you do it immediately you would miss out on the big stock rally since 2009 (over 250% since the bottom in March 2009, dividends reinvested). If you don’t replenish the fund right away, why not? Are we now in the business of actively timing the stock market? Are emergencies suddenly less likely? The emergency fund strategy, if applied literally, just opens up too much of a can of worms.

  2. You’ve given some sound arguments, ERN. Looking forward to the next five!

    I’m cool with a minimal emergency fund while working. What do you say to the retirees who plan to keep two to three years worth of living expenses in cash or fixed income to ride out big market drops without having to sell low. Is that strategy any different than having a ginormous emergency fund?

    1. Thanks, PoF!
      I’ve been thinking about that exact issue myself and it’s profound enough to warrant its own blog post. Here are my notes so far:
      Keeping multiple years worth of expenses all in a money market account seems excessive. Three years would mean 9-12% cash in the portfolio, which would be a major performance drag.
      If we were to keep as cash only the incremental cash flow needs above the dividend yield, the need for a cash cushion to avoid selling equities at the bottom is much less.
      Say, at 3% withdrawal rate, 2% dividend yield, but account for a bit of a drop of dividend payments during a recession then we’d need only around 1.25% p.a.
      I should be fine with 5% cash or investment grade corporate bonds and 95% equities and sustain four years of drawdown without touching principal.
      But I think even that is quite conservative. I hope to have higher yield than the regular equity index, both from holding higher yielding dividend stocks and having some real estate investments with rental income (through private equity funds).

      1. This math works for me. I have no arguments with this at all. It is a logical argument for a lower cash position when we hit FIRE than I originally thought.

        Hope to see Mr Turner weigh in with opinion on your post…..

      2. Good post ERN. You know where I stand on this matter. Besides, even assuming a worse case portfolio level dividend cut of 30% during the next deep recession, my dividends will be sufficient to scrape by for couple of years before market picks ups again. The main thing to avoid is selling stocks when they are down but God forbid, you have an emergency then. Dividends to the rescue!

        1. Thanks!!! Yes, exactly. Dividends never drop as much as the index. Dividend yield and maybe some supplemental rental income should certainly sustain the average FIRE planner through a garden variety recession without touching the principal. A repeat of 2008 (or 1929) would be a bit harder but I don’t see that coming any time soon.

          1. I have too much cash–about 15% of my investments.

            Emotionally, I’ve been unable to go all in on the “overpriced” stock market and hesitant to go into bonds when rates are rising. Instead, I’ve been accumulating cash for the last year or so rather than invest.

            More thoughtfully, I have two demands for cash:
            – living expenses during early retirement in case the economy goes bad
            – continue to pay for my child’s college expenses after hearing enough “we lost it” stories over the years

            I’m not worried so much about short-lived moderate dividend declines during a normal unpleasantness (2001 or 2009). Those last 1 or 2 years and the dividend declines seem muted.

            I’m more worried about something like a repeat of the 70s hitting just after I retire, where real dividends declined for almost two decades as inflation ate them up in a really bad economy.

            I’m really hoping you get around to the “living expenses fund” analysis for early retirees : )

            BTW, when my dad was in his 70s, he fired his financial advisor and went 100% into VTIAX. He said “my time frame is now infinite. stocks perform better in the long run”. I find it amusing that the young and the old have essentially the same planning horizon!

            1. I hear you! There have been long drought periods for dividends in the past, especially when dividend yields were much higher. In 2000, the Dividend yield was below 2% and approaching 1%. No wonder that dividends stayed relatively stable during that episode. But the yield was too low to support a retirement. Catch-22!

  3. Thx for the arguments.

    The argument for where you worry about the 485 000 loss is harder to accept. That would be a paper loss.
    When my emergency would require me to sell, I then realise the loss.
    Moving along the efficient frontier to achieve less risk ignores for me the fact that this does not exclude having to sell at bargain prices. That frontier highlights the risk for a given degree of certitude…

    1. Thanks ATL!
      I worry about all losses. Paper loss or realized loss, the difference is mainly in the accounting realm. As an economist I see no distinction. In fact, the one and only distinction I would make is that a realized loss is something I can use to my advantage for tax purposes, but that is a different topic.
      Not worrying much about losses as long as they are paper losses, to me, again has the smell of two behavioral biases: mental accounting and loss aversion.
      Regarding the efficient frontier, yes, this doesn’t help you much if the market tanks. That’s because the efficient frontier is an ex ante concept working with expected returns not realized. But that’s the reality of investing: I have to make investment decisions before the market returns are known. But I would still argue that the cash holding is inefficient. Risk mitigation through bonds would have diversified the equity portfolio. If you had invested only 5-10% in Treasury bonds, selling off those holdings and the dividend yield from equities would have avoided selling any equities during the crisis and you would have earned more yield than with a money market account.

  4. I use windfall income to save for an emergency and don’t replenish it until it gets below a threshold I am not comfortable with. Also I think it’s prudent to save for at least 2 months for an emergency (aggressively) then do instalments savings to get you to the rest of the months while you save for retirement. Although high income earners can quickly save for an emergency fund, statistically rarely of them do. Your 60% savings rate is spectacular but definitely not the norm. However I do agree that once you get to a certain net worth that you are comfortable with, especially if your net worth is bringing you a sizable passive income each year an emergency fund becomes less important

    1. Thanks for sharing your thoughts.
      Yes, as long as you don’t go overboard with the emergency fund you should be fine. Two months is fine when aggressively saving in other accounts. Eight months as recommended by some (Suze Orman) seems really excessive.
      Best of luck!

  5. Really nice job, ERN.

    I agree with your economics wholeheartedly. They’re right, after all… 🙂

    I’d suggest two lines of argumentation that could reasonably be invoked in support of some meaningful supply of on-hand cash (though not necessarily a so-called “emergency fund”):

    1. It’s convenient to keep slush cash on-hand for the normal flow of life expenses. Say, a month’s worth of on-hand checking account cash seems to help cut down on the administrative costs of paying bills, etc., and so the forgone investment gains from those funds could be arguably fairly compensated by saved administrative and transaction efforts. On-hand cash of this type can also reduce the risk of missed payment fees, etc. that us simple humans are prone to suffering from lack of mental bandwidth. (“Simple Lazy Human Argument”)

    2. Your treatment of behavioral biases and their costs is right on. The problem, though, is overcoming them. If our lizard brains can’t handle the notion of volatility affecting all our assets, we might be inclined to sub-optimally allocate our overall portfolio into less risky holdings, thus driving total portfolio returns down below what they’d be in a portfolio with, say, 3 months of cash that is otherwise efficiently allocated. Yes, yes, lots of “ifs” in this argument. But the risk-aversion bias might be more costly overall without some on-hand cash to act as a salve. (“Weak Knees Argument”)

    Taken together, the Simple Lazy Human Argument and Weak Knees Argument suggest that maybe, for some reasonable and prudent (human) investors, having up to 3 months of on-hand cash isn’t completely inefficient. Anything more is probably indefensible because of those pesky opportunity costs.

    Anyway, we agree on the underlying economics. These thoughts are just offered up for the sake of discussion. Now, if only we didn’t have to carry around these weak and simple lizard brains in our hairy cabesas, we could maybe all do the economically efficient stuff all the time!

    1. Thanks, FL! As always a very smart and thought-provoking comment!
      Yes, absolutely, everybody needs a certain cushion to prevent bouncing checks and for peace of mind. That’s money we don’t even put into a money market account. That’s zero interest in the checking account giving a free loan to Wells Fargo. You are welcome, Wells Fargo! We have calibrated our finances to keep a minimum of $500-$1,000 at all times. If we have more, we pay down the HELOC or if it’s permanently available money we move it to the investment account.
      Your second point is quite intriguing. If I understand you correctly, the behaviorally inclined investor doesn’t want to mix all of his/her investments into one single bucket because then he/she would become overly risk averse. So, in a sense, mental accounting becomes efficient (under the circumstances) because you put all your irrational risk-aversion into the emergency fund and let the investment account run at efficiently high risk (who cares about paper losses, out of sight out of mind!!!). That’s a very smart way of putting it. Really neat. Good point! Of course, it’s still best to not be impacted by either excessive risk aversion or mental accounting. Have to think about this some more! 🙂

  6. I’m with you 100% ERN. We use the HELOC as our emergency fund and to smooth out cash flow issues throughout the year. If we were in a different financial situation and we didn’t have so much equity in the house, I would probably hold a little bit of cash though. Luckily, I don’t have to worry about that!

  7. Love the post ERN and agree completely. As you may know, I recently wrote a post about why I’m comfortable with only a few thousand in cash and debunked the common reasons an emergency fund is useful. I love the points you lay out and I think the best argument is the opportunity cost of just leaving so much cash idle. Thanks and I look forward too three next post!

  8. I could not agree more! I keep 1.5 to 2 months’ worth of expenses in our cash accounts – anything over and above that gets channeled into whatever “financial project” I am working on at the time. For example at the moment I have set a goal to pay off our mortgage so I make accelerated payments as soon as our salaries hit our account. No point leaving the money idle, best to use it to earn more cash, or in my case at the moment, to save me interest.
    If anything out of the ordinary happens, I whip out my credit card.

    1. Hi Mrs. SF! Thanks for stopping by again. That will be our plan exactly: keep only the minimum cash reserve.
      If everything goes well we should be mortgage-free upon reaching early retirement by moving to a much cheaper locale and buying a modest home with cash only.

  9. ERN you put together some very strong arguments that I found myself nodding with. I think one of the assumptions for an emergency fund is that those that are most at risk choose not to invest the money but instead spend it instead causing them to live paycheck to paycheck. If there was a way to ensure that they invested these funds and made available when needed I would be in total agreement with your post.

    1. Thanks!
      Agree! The only thing worse than neglecting investments in favor of an emergency fund is no savings at all. I like the idea of automatic investing. That’s not just for the 401(k) but even taxable investments. Out of sight, out of mind.

  10. I LOVE emergency funds. I have 100% invested in equities but something that helps me sleep better at night is the fact that I’m protected as a result of my emergency fund. I have about 2 years worth of expenses racked up if I were to lose my job tomorrow as a result of the economy tanking.

    If the economy tanks and my portfolio takes a huge hit, no problem! I can easily bounce back. Emergency funds are a great risk management tool!

    1. Thanks!
      Can’t argue with that. If it makes you sleep better, you should keep the cash reserve.
      One question I have for folks who are fans of the cash cushion in retirement: what are your rules for drawing down your cash cushion? That’s because if you ALWAYS keep the 2 year reserve, then there is no significant use of the cash cushion: you consume out of cash but then you have to sell equities to replenish the cash holdings. Robbing Peter to pay Paul.
      So, how far would equities have to drop before you consume only out of cash and you draw down your cash? And how far would equities have to recover before you start replenishing your cash fund to 2y worth of expenses?

  11. I’m actually in favor of keeping an emergency fund largely for the correlation you outline in 5. However some of this is tied to the industry I work in which is more related to governments and other large organizations tightening their belts. That being said I don’t believe that an emergency fund is necessarily held in cash. I saw one person in the comments mentioned a Helloc. Another option I’ve seen used is a Roth IRA bond allocation. I personally view my emergency fund as part of my bond allocation of my overall account. I invest some portion of my money in I bonds and CDs with higher rates and relatively minimum withdrawal penalties. The impact is I have minimum or no risk on the money (not in relation to my emergency fund but rather in the context of my entire portfolio), I don’t really impact my opportunity cost on my entire portfolio as I would be invested this way anyway for my asset allocation, and I can tap it in emergencies.

  12. Betterment has interesting article arguing against ZIRP savings for emergencies. Instead, use a low volatility stock/bond combo (around 35/65 as I recall) that would provide much better returns with low risk. Vanguard’s Wellesley Income Fund does exactly this, and serves as my cash fund. Its 15 year performance has been surprisingly good.

    1. Great point! That 35/65 or 40/60 portfolio has a very nice return/risk ratio. It’s likely the (or close to the) tangency point (best Sharpe Ratio) along the efficient frontier. But the return is likely also low and may require leverage to scale up the expected return as we pointed out here:
      But without leverage it looks like a good allocation for a low risk/low return portion of the portfolio.

      But: careful, don’t fall into the mental accounting trap with different pots of money having different risk aversion:


  13. I’ve got about 18k out, but I use 15k to do savings account bonuses. If my networth was 6 figures, I might not hassle with it. As is, I get about 8% risk free from the bonuses.

    This does make me want to get off my butt and lose the Chase account though. I can’t drop below 1500 without triggering fees. At 5% assumed return, I’m missing about $75/yr. I can find a bank nearly as convenient I think for the $75, and drop the e-Fund by 1500.

    Thanks though, I’ve always felt along these lines, and been told otherwise by my elders, etc. Good to hear it written out so thoughtfully, I will use this!

  14. This is absolutely fascinating. I love being confronted with logic, and this blog is changing my thought process on allocation. I am probably far too conservative (which is ironically risky). I do have one thought/question. I searched this blog for the term “life insurance” and didn’t find any hits. I ask because my wife passed away at 45 (five years ago). I am now 49. If we had retired early and my wife had been the option-selling guru, I would have been in a tough spot. I understand that life insurance (or any insurance) is for the loss averse – is this a scenario where you simply have decided to self insure?

    1. Sorry to hear about your loss. After reaching FI we could theoretically self-insure now. But even we still carry around some life insurance. And it’s both for me (the wife will probably take a less aggressive approach with lower expected returns) and even for her (she has great side hustle potential as an RN). So, life insurance might make sense for FI/FIRE folks. Thanks for pointing that out!

  15. Thanks for your comments. I found it to be immensely helpful in my situation. I think folks who haven’t experienced loss probably underestimate the emotional and financial impacts of losing a loved one. Who wants to think about that kind of thing? Best of luck to you. I don’t think you’ll really need luck, though! Your posts are inspiring. Please keep it up as long as you enjoy it!

    1. Haha, thanks for pointing that one out! You almost can’t make that up! Which basically means that lots of people who think they disagree with me actually agree without knowing it. 🙂

  16. #3 comes up all the time with this subject, and it drives me crazy. Even the first comment on this post by one of your readers. It’s such a narrow fixation: a timeline that starts at the top and ends at the bottom. The real timeline is your entire lifetime. Sure, that $10,000 “is not going to grow anymore”, but the *next* $10,000 will. This argument is essentially assuming that you invest at the worst possible time, sell, and then switch to cash going forward. If we’re comparing cash to investing as a *strategy*, we need to assume people actually stick to each strategy for the duration and look at the overall outcome, not the immediate outcome of a single event.

    #2 still makes some sense though, depending on how you define “high” net worth. It should probably be high relative to your emergency savings amount. If you have $15,000 of total liquid assets invested and it drops 40%, it won’t matter that it would theoretically recover if you need to spend $10,000 *now*. But that also depends on credit availability, and how long it will take to make up the shortfall. Seriously, even if you only have a 20% interest credit card, if it will take 6 months to turn things around, this is fine. That’s basically a 10% loss (less, because the first month or so was interest free) one-time, which is nothing compared to the ongoing opportunity cost of cash over decades.

  17. Regarding #2, it is advice that isn’t just given to those with lower income, but more importantly to people who are bad with their money. Ramsay’s trademarked steps include saving a small E-Fund of $1000, crushing all debts, then saving a larger E-Fund before considering much investing advice. You’re correct that mathematically it’s backwards advice, but it’s advice for people who up to this point never gave their expenses a first thought and desperately need to get out of high interest debt. Those of us who can do the math and are more comfortable with handling money are more likely to benefit from the equations you’ve been throwing out here.

  18. I think the US saying is “it’s a no brainer!”. In Australia we have a “equity mate!”. (think HELOC). Love the blog.

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