More on Emergency Funds …

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Recently I wrote a couple of posts on Emergency Funds; my goal was to blow a hole in the standard “save a 6 month Emergency Fund” myth … that’s right: myth!

Most of the comments (and, they were really good) related to my suggested use of HELOCs as a possible replacement for 6 month’s cash slowly wasting away in a CD – and, I have just posted a follow-up to address this.

But, Meg comments from a slightly different angle that I think addresses the core of my original post:

I hate having loads of cash sitting around earning less than the rate of inflation. And I consider 3 months of expenses for me to be loads of cash. Plus I have tons of liquidity in the form of a total stock market index fund. This is from where I have drawn money when I totaled my car unexpectedly (ins only covered half the value of a comparable newer car), when I needed a down payment for real estate purchases, etc.

That has worked great over the last 5+ years of a bull market. But 2 weeks ago I was presented with an unexpected real estate investing opportunity, which I jumped on. I was of course going to put 20% down (to minimize the rate, avoid PMI, be conservative, etc). Then the market began its tumble. I was AGONIZING over the loss (it would still technically be a gain to sell, but still it sucks to sell at a market cycle low).

Then Meg, found a fortuitous solution:

Luckily for me I have a wealthy and generous grandfather who volunteered completely unprovoked to lend me the money for the down payment rather than have me sell stocks at a cycle low. He has plenty of money sitting in bonds and cash that he doesn’t have any better use for, I suppose, than to thrill a granddaughter with a 2.5% loan.

Lucky for Meg, indeed. But, an anti-climax for those of us who are not so fortunate!

So what would you do? Rich relatives aside, I see three choices:

1.  Put 6 Month’s cash into CD’s as an emergency fund

2. Put 6 month’s cash into an Index Fund and let it sit

3. Put 6 month’s cash into an Index Fund, sell at a 20% ‘loss’ to buy the real-estate

Now, these aren’t exactly comparable choices (we really need a table: do/don’t buy the property across the top, and CD’s/Index Funds down the side … and to be really fancy, we’d need a cube adding emergency/no emergency along the edge), but we can at least illustrate some key thoughts by examining them mathematically.

And, I will consider a 30 year investing horizon, because that allows me to guarantee an 8% return for the Index Fund (it will probably do better, maybe even 12%, but then there could be fees and commissions to consider).

Put 6 Month’s cash into CD’s as an emergency fund

If Meg is on $100,000 and paying 25% tax, she would need to sock away $37,500 to provide a 6 month after-tax salary emergency fund.

This might take some time, so let’s pick up at the point where she achieves this monumental milestone: over the ensuing 30 years, her salary will increase, hopefully at least in line with inflation (let’s average that to 4%) so she will need to keep topping up her Emergency Fund such that it reaches $117,000 by the end of the 30 year period (I didn’t increase her tax rate to 35% … I guess I should have).

Assuming that her CD’s keep pace with inflation – and, she doesn’t need to draw down on the fund at all during the 30 year period – she will have $247,000 at the end of the 30 year period.

Before you sing Ode to Joy on this, remember that the CD’s are just keeping up with inflation, so the $247,000 is ‘worth’ no more and no less than the money that Meg actually put away … there is NO investment here at all.

Now, CD’s actually bounce around between 3.5% (actually for a bank deposit with WaMu) and 5.5% in the current market (and, who knows what they will average over the next 30 years?), so Meg could technically get a point to a point-and-a-half above inflation, but we are only talking $90,000 ‘gain’ over 30 years, if she gets the max.

Put the 6 month’s cash into an Index Fund and let it sit

OK, now that we have the cash ‘baseline’ set, let’s see what happens if we ‘amp up’ the savings rate a little by putting our Emergency Fund into an Index Fund instead:

Assuming the 30 year ‘guaranteed’ return for the ‘large cap’ stock market of 8%, Meg will ‘gain’ $335,000, after her inflation adjusted deposits are factored out … or, nearly a quarter of a million more than the $90k gain that she made by putting her money into pretty much the highest-performing major bank CD’s out there!

So, that was the premise of the original post: is the ‘peace of mind’ of having 6 month’s cash put aside for emergencies ‘worth’ $250,000 to you … put another way, would you pay a $8,333 a year (that’s $250,000 divided by 30) to ‘insure’ yourself against an emergency – on top of the insurances that you already do pay?!

Now, the stock market has actually averaged 12% over all but two 30 year periods in 75 years of history so what would ANOTHER $900,000 do to your decision-making process?!

That’s why you find another way … any other way … to dealing with an emergency rather than wasting the earning power of 6 month’s salary!

Put 6 month’s cash into an Index Fund, sell at a 20% ‘loss’ to buy property

Now, so here’s where it gets tricky: would you sell down your stock holdings, at a potential 20% ‘loss’ to move to another form of investment?

Basically what we are saying is this: you don’t know when an emergency will crop up, so while a CD will at least keep it’s value – year in, year out – an Index Fund may return more now, but at some stage (Murphy’s Law says in EXACTLY the year that you need the money for some emergency!?) the stock market will drop 10% or even 20%.

OK, let’s see …

Let’s assume that we have been rocking along nicely, still working on our 8% returns then at Year 10, this opportunity comes up just as the market tanks to the tune of 20% … what would you do?

Well, firstly, we are going to assume that the market eventually recovers and we get back to our long-term 30 year average of 8% for the Index Fund (after all, there have been NO 30 year periods when this hasn’t occurred, hence my suggestion to use 8% rather than the oft-quoted long term ‘average’ of 12% for the market … this higher ‘average return’ just isn’t guaranteed). So, we are still talking $250,000.

But, if we divert our funds to the real-estate option after 10 years (and, let’s assume that we use all of it as a deposit after taking that one-off 20% ‘hit’), we would have a $1.2 Million net gain by suffering the loss and acquiring the property (assuming that we find one that averages only a 6% capital gain, plus some rental income).

Why the huge advantage to real estate?

It is the only leveraged investment that we have considered (for example, try running a margin loan on your Index Fund and see what that can do).

Also, keep in mind that we don’t stop ‘topping up’ our emergency fund after the 10 year mark when we bought the real-estate, we simply keep putting our salary increases aside after year 10, so we could afford another, smaller, property (say, a $350k condo) at year 20 that would boost the 30 year returns markedly, again.

But, if it’s now in the real-estate, how do we handle an emergency? Simple: with a HELOC or refinance or sell the investment if a real emergency arises and the bank calls your HELOC in.

And, if you think that’s all-too-risky, then keep your money in the Index Fund and forget about the real-estate idea …

Here’s what Meg would do:

I would never have counted on such generosity and would have still sold my funds for this RE investment.

So would I, Meg, so would I … now, what about the rest of you?