When the S&P 500 was up nearly 27% in 2021, it was easy to feel like the broad market would go up in a straight line forever. Cash reserves were yielding under 1% for the year. Why would an emergency fund be necessary if you can just sell some shares to cover expenses?
The wake-up call of 2022 has been nothing short of harrowing for some investors. The S&P has fallen 17%, while some of the big tech names are down as much as 90%. If you end up in a position to need extra cash when the market falls into a tailspin, you’ll be forced to sell your shares at a discount (potentially a very steep one) and, consequently, to hinder the long-term growth of your portfolio.
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Here, we’ll discuss how financial psychology and basic math work together to make a cash emergency fund a smart choice.
The purpose of a cash reserve fund
One of the main arguments against a cash emergency fund is that most “high-yield” savings accounts only pay 1% in annual interest. Why accept such a low return if you can invest the money in index funds and see double-digit performance?
This strategy works perfectly well when a market or stock is steadily rising, but truly fails when markets are flat or falling. So why do we have emergency funds in the first place? The answer is simple: To provide psychological comfort and practical insurance in the event that we enter a bear market and stay there for an extended period.
The purpose behind a cash emergency fund, again, is not to provide maximum return. First, cash provides security in the event of an unexpected job loss or an unforeseen expense. Second, an emergency fund eliminates the need to sell stocks when your portfolio falls in value. This protects “current you” and puts “future you” in a position to retire securely.
Borrowing from Murphy’s Law, it certainly feels like the moment you need money from your stock portfolio is the moment it will fall by 20%. Things have a tendency to happen this way, and you’ve simply worked too hard to lose a large portion of your financial capital — especially if it’s avoidable.
What does a good emergency fund look like?
Most financial planners will recommend an emergency fund in the neighborhood of three to six months’ worth of living expenses. This is a useful rule of thumb, but if you decided to keep 12 months’ worth, you’d probably feel better if the market fell by 50%.
Some of the concrete attributes of a good emergency fund include:
- Accessibility. This might seem obvious, but choose an account you can access immediately.
- Insurance. FDIC regulations insure deposits up to $250,000 per account owner, per financial institution.
- Fully liquid. The fund should be held in cash.
- Pays a competitive rate of interest. It won’t be much in our current market environment, but it should be competitive.
- Not tied to the stock market. Money invested in stock funds is not sufficient, given their volatile nature.
Furthermore, you should separate your emergency fund from the rest of your portfolio, and even exclude it from your asset allocation. This is not considered at-risk money, and it shouldn’t be treated as such. It does, however, play an extremely integral part in your financial plan and will likely play a larger psychological role than you’d ever expect it would.
You’ll be happy you have one
In a bull market, people will naturally question the need for a stable emergency fund. This is common investor psychology in this scenario, as it feels like market outperformance will continue forever. The reality is quite the opposite.
A bull market should prompt you to confirm that you have enough cash available in the event of a sudden downturn. After the market falls, the opportunity is lost. If you do have an emergency fund available during a bear market, you’ll feel like the smartest person in the room.
Remember: Long-term investing is meant to generate solid returns over many years. Your cash reserve holds a different purpose and should be treated as a separate part of your finances. Be sure to know the difference as you construct and refine your plan.
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