We write a lot about retirement planning in this space, but today let’s take a break for some important “right-now” planning. One crucial item for everyone, regardless of age, is an emergency fund—savings you can tap in a pinch, if needed, to cover a few months’ worth of expenses. Traditionally, people park these reserves in savings accounts, money market funds or other cash vehicles, but a recent CNBC article included “advice” urging investors to move their stash from cash to a mix of stocks and bonds.
Folks, this is dangerous advice.
We can see the temptation to seek higher returns for these savings. Savings accounts and money market funds pay next to nothing right now, and seeing your savings idle for years with no compound growth can be frustrating. Some might worry they can’t keep up with inflation. But this is the wrong way to think about this. It ignores two of the most crucial factors, time horizon and volatility.
Typically, emergency funds are meant to see you through a short-run pinch in the event of a job loss or other big, unforeseen event like an illness or home repair. Since you likely won’t have much (if any) advance warning for any of these, the time horizon for your emergency funds is, by definition, “now.” Even if everything is hunky dory today, anything could happen tomorrow.
Time horizon is a crucial determinant of asset allocation. There is a tradeoff between risk and return, and higher-returning investments come with more risk and a greater likelihood of short-term declines. When the time horizon for a certain bucket of assets is short, it is wise to minimize the risk of loss and maximize liquidity—in other words, hold cash. Otherwise, you run the risk that market declines erode your savings just when you need it most.
Consider a job loss. Layoffs usually come late in a recession, and big stock market declines usually precede a recession. If you are laid off, you could be forced to tap your emergency fund near the bottom of a bear market, by which time stocks have fallen 20% or more. That puts you in a much tighter spot. If you have half your original savings in stocks, and stocks fall 50%, you’ve lost a quarter of your cushion. That is a difficult and wholly unnecessary predicament.
When figuring out how to allocate your money, consider segmenting your funds according to their purpose. You might have your retirement planning bucket, money earmarked for a down payment, your children’s college fund, and your emergency savings. Each bucket has a different goal and unique time horizon. Identify these, figure out how much volatility each can withstand, and then figure out which blend of stocks, bonds, cash or other securities best matches that that risk/return profile. The sooner you might need that money, the less risk you should take.
A professional can help you figure this out, too, but we’d urge you to be a bit skeptical and ask questions about the rationale for certain recommendations. Don’t take anything at face value.
As Financial Planning columnist Jonathan Clements recently noted, some of the wisest financial advice an investment professional can give might result in them managing less money for you, emergency funds being just one example. Someone who is forthright enough to say “You know what, since you might need this money next month, you should keep it in cash, not under my care” probably has your best interests in mind. Same goes for an adviser who might encourage you to pay down higher-interest rate debt instead of before embarking on a retirement planning strategy. The opposite might be someone putting you at risk for the sake of their fee revenue or commissions.
To add value for you over the longer term, an adviser has to consider your needs before their own bottom line. At Fisher Investments, we pride ourselves in putting our clients first.