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I’ll be damned if Chinese Proverbs haven’t cornered the market on inspirational sayings. My personal favorite is: “The best time to plant a tree is twenty years ago; the second best time is today.” I have a hunch that whoever first put this saying on paper didn’t intend for it to be adopted by financial planners and investment gurus. But it has been for good reason.
The proverb as applied in this instance would essentially say: “The best time to start saving was twenty years ago. The second best time is now.”
There is little debate among financial experts you should have a stash of emergency savings. Indeed, nothing can send you into a financial tailspin quite like unexpected expenses or job loss. What financial experts disagree on, however, is how much should you have in an emergency fund and where you should put it.
How Much Should Be In Your Emergency Fund
Most folks put the ideal benchmark for an emergency savings at three-to-six months of living expenses. If you spend $4,000 a month on necessities for you and your family, you should have $12–24,000 sitting in an emergency savings account.
Why three-to-six months you ask?
The three-to-six-month mark reflects the average amount of time it takes for laid-off Americans to find a new job. But you should decide for yourself whether that yardstick applies to your situation. If you have been practicing for years and your income prospects are very stable, then six months of emergency savings may be overkill. If you just opened a firm, or if you are in a volatile sector and could lose your main source of income any minute, then three months is likely the absolute minimum. What your emergency amount should be is going to depend on risk tolerance, job stability, health of your family members, and whether or not your household has dual incomes, among other considerations.
The following axiom, however, applies regardless of your situation: if that money is sitting in a standard savings account, you are losing money every year.
Where You Should Put Your Money Instead of Savings
Advocates for housing your emergency fund in a vanilla savings account would be horrified with the idea of exposing your emergency fund to any kind of market risk. Savings account apologists will cite that when you need to tap into your savings, it is often because of a downturn in the economy. And if there has been a downturn in the economy, we all know what happens to markets — and potentially your emergency fund — in that environment.
Further, emergency funds need to be liquid. An emergency fund cannot bail you out if is tied up in real estate or a five-year bond. These are all incredibly valid points that strongly support the argument you should have some amount of money readily available when the waters get choppy. But this is where the “six months of expenses” crowd loses me. As much as they are concerned with minimizing risk, they tend to ignore the following: the inflation rate in the U.S. from five years ago to today sits at 9.48%. This means that your large emergency fund has lost a significant amount of its buying power precisely because it is just sitting there. That doesn’t even meet the conditions of risk; it is just a guaranteed loss.
Thankfully, we have options besides the standard savings account. There are a good number of “FinTech” companies, which are automated financial services available for savers and investors. Call FinTech what you like: an unholy alliance between Wall Street and Silicon Valley, the once percent’s newest attempt to screw the middle class out of your money, or just a lazy marketing-centaur buzzword. But I will tell you this much, it beats the mattress approach. And while it is true that folks need to approach the management of their emergency savings with an abundance of caution, there is a middle ground between losing six months of expenses to inflation every year and exposing every penny you own in small-cap Greek biotech firms.
The Robo Advisors
In recent years, the FinTech movement has given rise to so-called “Robo Advisors,” which have grown significantly in popularity among investors. They offer a combination of intuitive user interface and simple investment strategy with relatively low fees. They generally use a combination of Exchange-Traded Funds (ETFs) and Bond indexes, the exact combination of which is basically dependent upon individual risk tolerance. For example, a young, risk-tolerant investor can invest her holdings in an account with a mixture of 90% stocks and 10% bonds. Whereas a more risk-averse person (who might be looking at this as the main component of his emergency fund) could have a combination of 10% stocks, 90% bonds.
The most popular stand-alone Robo-Advisor companies out there — Betterment, Wealthfront, and Wisebanyan — have fairly competitive fees, anywhere from 0.15% to 0.35% depending upon asset levels. Though, it is worth noting that Wisebanyan advertises no annual fee at all. I am only familiar with Betterment, but the reviews of Wealthfront and Wisebanyan seem to bear out the following: the user interfaces do a fantastic job of making you actually excited to save money.
Each FinTech company allows you to come up with a figure you should have in your emergency savings, and it shows you what you will need to contribute to meet that goal. The graphs also show you what your initial investment combined with monthly contributions will look like under horrible market conditions vs. fantastic market conditions.
If you will recall, I mentioned inflation has devalued the dollar roughly 9.5% over the last five years. In that same timeframe, a standard U.S. total stock market index fund has increased roughly 16% annually. Now, those five years contain a historically significant bull market, so the comparison might be unfair. And the next five years will certainly contain a different set of percentages. But, regardless of which timeframe we cherry pick, history has shown that cash is one of the worst long-term investments possible
So how quickly can you access the money you have invested Betterment or the like? You can withdraw any amounts contributed in your taxable account and get your money in five business days. This puts these investments much more toward the “mattress” end of the liquidity spectrum than most investments, which should make it liquid enough for any pressing expenses.
So What’s the Catch?
The new FinTech options are not perfect. Their fees are higher than other forms of index-based investing, such as mutual funds, Exchange Traded Funds through Vanguard, iShares, and the like. Betterment, Wealthfront, and Wisebanyan also haven’t been around very long. No one would blame you of being skeptical of the new shiny thing in investing. It would be a good idea for you to do some research on where to put some of your bloated emergency savings. And when you do decide on the best firm to work with, take it slow.
Stick Your Toe In
I am not an investment professional, nor do I pretend to be. But I do know when my money isn’t worth what it once was.
Whether you change up how you manage your emergency fund, or you slide all of your emergency reserves over to a Robo Advisor, there is plenty of middle ground between an all-cash emergency fund and a pure stock investment account. Decide for yourself how many months worth of expenses you want to keep in cash and how much you would like to invest. And If you move over to a Robo Advisor, know that you still have control over what you are willing to risk.
Featured image: “Young businessman depositing money in piggy bank” from Shutterstock.