The concept of an emergency fund is simple. Ideally, we should all have 6 months of expenses put aside in a savings account, just for emergencies. There are generally two objections to this school of thought.
Objection 1: Inflation risk and opportunity cost
From an investment perspective, emergency funds held in cash represent significant opportunity cost. In fact, some experts will tell you that six months’ of expenses is way too much to subject to the inflation risk and opportunity cost of a traditional savings account. In certain circumstances, I would agree with that. As with most things financial, the answer comes down to an individual’s personal situation.
Cash is king when it comes to emergency funds for two reasons: first, it is liquid, and liquidity needs should always be an investor’s first consideration. Second, it is virtually free of investment risk. However, depending on how much emergency cash you have and your own level of risk tolerance, you might want to consider an alternative to a traditional savings account.
Solution 1: Increase yield with a short-term bond mutual fund
Short-term bond funds invest in investment grade bonds with short maturities, typically 3 years or less. As such, they are generally lower-yielding investments than longer bonds. Short-term bond funds are less sensitive to interest rates than longer bonds, making them a more conservative investment. As a trade off for slightly higher yield, however, these funds do carry a bit more risk. Look for a fund with low expenses and shorter duration to preserve your principal.
If you need a good company to purchase a bond fund through, I suggest either Betterment or Personal Capital. Betterment and Personal Capital are both part of an industry shift towards low cost wealth management and have recently been gaining a lot of clients.
Objection 2: Six months’ expenses is a lot of money
It’s true – half a year’s expenses represents a daunting figure for many of us. A family whose expenses are $3,000 per month would be looking at $18,000, just for emergencies. And that doesn’t include funding other goals, such as college or retirement.
One way to meet this need is to reduce the amount needed by drafting an emergency plan. The idea is that in a true emergency, expenses would be ranked in order of need, and only the most necessary would remain. A second, even complementary strategy is to combine emergency savings with another goal.
Solution 2: Combine emergency and retirement saving in a Roth IRA
If you can’t afford to max out your Roth IRA and put money aside for emergencies, consider having your Roth pull double duty. Roth IRA contributions are made with after-tax dollars, and can always be taken out without penalty. Consider bulking up your Roth contribution by combining it with your emergency savings. That way, you don’t have to feel like you’re missing out on retirement savings to save for emergencies. Any money you don’t use will be available to you as retirement income. Also, once you reach your goal for your emergency fund, you can direct your entire contribution toward your more risky retirement investments.
I’d like to point out two considerations here. It is rare that I advocate earmarking retirement money for another purpose. This solution only applies if you are unable to max out your retirement contribution and save for emergencies at the same time. Second, money that is designated for emergencies should be in a separate, low-risk investment. (like a short-term bond fund, for instance) within your Roth IRA account.
Beyond the numbers
My personal viewpoint is that emergency saving is best thought of as insurance, rather than investing. In putting aside a pool of money for emergencies, we are self-insuring against job loss, medical expenses, or unforeseen catastrophe. While there is nothing wrong with maximizing your level of protection, doing so at the risk of not being covered is counterproductive. And prioritizing other goals at the expense of emergency funding puts everything at risk.