Should You Invest Your Emergency Fund?
You want to have cash on hand when the going gets rough. But what's the best way to store it so you'll know what's there for a real emergency fund?
The entire purpose of an emergency fund is to have cash on hand when you need it. Yet money sitting in a savings account can feel like it’s doing nothing, particularly if the interest you’re earning is failing to keep pace with inflation.
Meanwhile, stocks have proven to be excellent long-term wealth builders, vastly outperforming the return you can expect to get at the bank.
So, it’s fair to ask: Why not invest your emergency savings in a stock market index fund and be done?
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You could do that. And chances are good that things would work out just fine if you did. But what if they didn’t?
Stock returns may be excellent over time. But market volatility means they don’t move in a straight line. And there's no guarantee the market will be up when an emergency rears its ugly head.
So, before you drop your entire emergency fund into the market, let’s do a deeper dive.
What an emergency fund is actually for
Remember, an emergency fund isn’t an investment. It’s insurance. Its function is to cover a job loss, an unexpected medical bill, a car repair or a broken air conditioner without pushing you into debt or into a rushed decision.
The rule of thumb is to keep the equivalent of three to six months of essential expenses in cash.
If you live in a dual-income household with two stable jobs, you might need less than that. For those with less stable incomes, such as freelancers or business owners, it might make sense to aim higher.
Whatever the number, the money has to pass three tests: it must be safe, easy to reach and worth a known amount on the day you need it.
A high-yield savings account passes all three. Deposits at FDIC-insured banks are protected up to $250,000 per depositor, per bank, per ownership category.
You can usually move the money to checking within a day or two. And $10,000 today is still $10,000 next month.
The case for investing it
It comes down to opportunity cost.
Over long stretches, a diversified stock portfolio has beaten cash by a wide margin. Savings rates often trail inflation after taxes, so idle cash can slowly lose buying power. And many emergencies never happen.
If you hold $30,000 in savings for a decade and rarely touch it, you’ve given up years of potential growth. Properly invested, it might have grown to $60,000, even $100,000 in a raging bull market.
Of course, there’s a catch. The events most likely to drain an emergency fund tend to show up at the same time stocks fall, or during a bear market.
Recessions cause layoffs. Layoffs cause emergencies. And recessions are when stock prices often drop the hardest.
During the 2007-09 financial crisis, the S&P 500 fell about 57% from its peak, and U.S. unemployment climbed to about 10%. In early 2020, stocks dropped about a third in roughly five weeks as millions of people lost their jobs.
Imagine this scenario. You put your $20,000 “emergency fund” in an S&P 500 ETF. You get laid off in a downturn, and the account is now worth $10,000.
To pay rent, you sell shares near the bottom. That locks in the loss and leaves less money to recover when the market bounces back.
Even in the absence of a market crash, investing your emergency fund can bring unwanted problems. In a regular brokerage account, selling shares that have gained value can trigger capital gains tax, so an emergency can come with an unplanned tax bill.
So, investing your emergency fund in stocks is a great idea… so long as you never actually have an emergency!
Splitting the difference
No one says you have to choose all or nothing. You can always split the difference, keeping a core first layer of one to three months of expenses in a high-yield savings account or money market fund. This is your instant-access money.
You could have a second layer on top of that in Treasury bills, short-term CDs or a short-term bond fund. Your risk here is modest. In a true emergency, you probably won’t mind paying a penalty of a couple of percent for cashing in a CD early.
Anything beyond these two layers can be invested for growth in stocks or stock funds. If an emergency outlasts the first two layers, you sell from here, ideally after the market has had time to recover.
There's no "right" size for an emergency fund. Every family is going to be different depending on their job security, number of earners, overall wealth and income, health needs, insurance coverage and a host of other factors.
A tenured college professor in a two-income home needs less cash on hand than a self-employed entrepreneur with a stay-at-home spouse and a mortgage.
Use your best judgment to figure out the best level for yourself. Just keep in mind that for an emergency fund to be effective, you have to be confident that it will actually be there when you need it most.
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