Why you should not be tempted to invest your emergency fund

Having cash on hand helps to cover unexpected costs without going into debt and keeps the foundations of your financial house strong

Business and financial concept
Powered by automated translation

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 .01 per cent offered by most banks’ savings products.

An annual percentage yield (APY) of 2 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 0.60 per cent APY, it’s going to be even more tempting for people to funnel their money into investments to hedge against inflation and generally keep building wealth.

That’s 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 checking account.

For starters, cash is king. It’s 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 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’re 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’s put some numbers to this. If you invested $5,000 in 2010, even if you didn’t contribute another penny, your total would be just shy of $18,000 in 2020. Had you left that $5,000 in a traditional savings account at a bank, where it earned the common 0.01 percent APY, you’d have earned five whole dollars over that same period. (And $5,000 in January of 2010 would have the same buying power as $5,952.62 in 2020, according to the US Bureau of Labour Statistics’ CPI Inflation Calculator.)

Your emergency fund isn't designed to be a wealth builder. It's more of a personal insurance policy for you and your family

Even had you opted for a high-yield savings account with a 2 per cent APY, you’d only have around $6,100 over the same stretch. That would’ve kept you on pace to protect purchasing power, but it wouldn’t have earned nearly what it would have had you invested.

So I empathise with the argument against keeping funds in cash. However, this logic really works only when you’re looking at ideal market conditions. What if you got furloughed or laid off just as the stock market dropped significantly? We saw this happen in 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’s a chance your current experience has made you crave more like a year’s worth of cash stability.

Consider how much you truly need in cash for your peace of mind and then invest the rest in a portfolio with a modest risk allocation. Remember: Your emergency fund isn’t designed to be a wealth builder. It’s more of a personal insurance policy for you and your family.

Erin Lowry is the author of Broke Millennial, Broke Millennial Takes On Investing and the forthcoming Broke Millennial Talks Money: Stories, Scripts and Advice to Navigate Awkward Financial Conversations.

  • Bloomberg