Should You Invest Your Emergency Fund?

My pal Cullen and I have chatted a bit recently about the rise of so-called “robo-advisors” such as Betterment and Wealthfront. While the total value of these services might be called into question, they are at least spurring an important conversation in my industry about fees and investment philosophy. The best thing that could come out of the rise of firms like these is to wash out a lot of commissionable brokers hawking loaded, expensive, actively managed mutual funds on an unsuspecting, uninformed public.

Last year I read a piece on the Betterment Blog about emergency funds titled “Safety Net Funds: Why Traditional Advice is Wrong.” In it, Betterment lays out an argument for why individuals should not keep an emergency reserve in cash, but instead should invest it (with them!). The core of their argument was that a balanced portfolio of stocks and bonds is much more likely to make money over any five year period than it is to lose money, which of course is true. If you needed money in five years, there is a reasonable probability that you would do better than a cash savings account by investing in a balanced portfolio.

But needing money in five years isn’t the purpose of an emergency reserve.  The emergency reserve needs to be there tomorrow, next week, next month, in a year, etc.  It needs to be liquid and readily available. And there is absolutely no guarantee at any given short time period that you won’t have a loss on a balanced portfolio.  Betterment’s argument is that their balanced portfolio only lost 23% in the market wreck of 2008-2009.  So, they say people should just over-fund the emergency reserve by 30% to account for the possible decline.

Here’s the issue with that.  Let’s say it’s 2006 and you start funding your emergency reserve in a balanced portfolio, and for a few years the portfolio ticks up nicely and you’re feeling pretty good about being able to contribute to your savings.  Then in 2008 things start to slip and the value declines some.  You get nervous, but it’s ok because you were over-funded. Then in late 2008 the economy really hits the brakes and your spouse loses his/her job.  And for six months you start to draw down your emergency reserve to make up for the loss of household income until he/she finds work again. By the time your spouse finds work, it’s early 2009, the market is down about 50% and you have fully depleted your emergency fund.  Sure, you got to spend the “normal” emergency fund because you over funded it.  But what you really did was lock in a permanent loss of your investment. You successfully bought high during 2006-2007 and sold low during 2008-2009. If you hadn’t needed your emergency fund, it would have recovered in a few years.  But waiting around for the market to recover is not the role of an emergency reserve.

It’s worth pointing out that Betterment has an incentive for you to invest your emergency fund: they get to earn an asset-based fee if you do, and don’t earn any revenue if you keep your reserve in cash or CDs. Investing your emergency fund is ultimately a great way to buy high and sell low when an event arises that requires you to tap your savings. Perhaps the robo-advisors should stick to asset allocation and simple investment strategies and leave real financial planning to more thoughtful professionals.

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