Don't invest your emergency fund
(BLOOMBERG) – A couple of years ago, the high-yield savings market was hot – at least to millennials. Internet-only banks entered the market and drove up annual percentage yields to above 2 per cent at their peak.
This could help you grow your money far faster than the typical 0.01 per cent of most banks’ savings products.
Two per cent was a huge score. It made it much easier for people like myself to tout the glories of keeping your emergency savings in cash as opposed to in the stock market.
Just put it in a high-yield savings account, and you could, depending on the year, minimise the impact of inflation on your cash.
Well, gone are those days – at least for now. With interest rates and yields dropping on savings accounts, most recently to 0.6 per cent, it is going to be even more tempting for people to funnel their money into investments in order to hedge against inflation and generally keep building wealth.
That is fine for money you have to spare or want to grow for future use. But that definitely should not include your emergency fund. You want to keep that as cash, in a savings or current account.
For starters, cash is king. It is an idiom for a reason. The point of an emergency fund is to have easily accessible cash in a pinch.
This operates as a household safety net against job loss, medical emergencies (an emergency fund ideally would have enough to cover your healthcare deductible too) and home or car repairs.
Being able to cover the costs of the unexpected without incurring a debt cycle helps keep the foundation of your financial house strong.
Typically, the rebuttal against leaving your emergency fund in cash is that you are losing out on much higher returns you could get from investing in the market, as well as losing out to inflation as the purchasing power of that cash goes down.
Let us put some numbers to this. According to an analysis by Goldman Sachs, the S&P 500 Index returned 13.6 per cent annually since its 2012 report with a forecast of an 8 per cent return. (For the record, the bank is forecasting an annualised return of 6 per cent in the coming decade.)
Let us expand that out to a decade. If you invested US$5,000 (S$6,675) in 2010, even if you did not contribute another cent, your total would be just shy of US$18,000 last year.
Had you left that US$5,000 in a traditional savings account at a bank, where it earned the common 0.01 per cent, you would have earned five whole dollars over that same period.
Even if you had opted for a high-yield savings account with a 2 per cent rate, you would have only around US$6,100 over the same stretch. That would have kept you on pace to protect purchasing power, but it would not have earned nearly what it would have had you invested it.
So I empathise with the argument against keeping funds in cash. However, this logic really works only when you are looking at ideal market conditions. What if you were furloughed or laid off just as the stock market dropped significantly?
We saw this happen last March. Had you needed to sell investments to have cash, it could have meant taking a loss, or at least not being able to take advantage of the market’s bounce back.
Yes, money not increasing to keep pace with inflation is a bummer, but so is selling in a down market or, worse, not having cash when you need it most.
How much should you have sitting idle in cash?
The rule of thumb for emergency savings is often three to six months’ worth of living expenses.
That advice comes from a pre-pandemic world, however. So, depending on your industry, there is a chance your current experience has made you crave more like a year’s worth of cash stability.
Whether you are aiming for three months’, six months’ or a year’s worth of emergency funds, it is important to remember that it can be your bare essential budget. This does not have to be the amount you need for your ideal lifestyle – it is how much you need to have the basics.
That alone could help reduce how much you truly need in an emergency fund, plus your healthcare deductible, and the difference can be redirected towards investing.
Ultimately, the right amount comes down to your risk tolerance. Despite the bold headline on this article, this is not a black-and-white decision.
You can certainly allow for shades of grey, particularly if you want at least a year’s worth of expenses in emergency savings but feel ill at the idea of it all just sitting on the bench doing nothing to build your wealth. Consider how much you truly need in cash for your peace of mind – perhaps three months – and then invest the rest in a portfolio with a modest risk allocation.
Remember: Your emergency fund is not designed to be a wealth builder. It is more of a personal insurance policy for you and your family.
• The writer is the author of the Broke Millennial series of financial books.
Join ST’s Telegram channel here and get the latest breaking news delivered to you.
Source: Read Full Article
