This isn't investment advice because I am not an investment advisor; it's to be used for educational purposes only.
Should I invest my emergency fund? This is one of the most common questions I hear. Folks who do all the hard work of saving six months (or more!) of their expenses into an emergency fund are often offended at how little interest they earn to amass a small fortune.
I understand the feeling and the urge to invest your emergency fund money. The long-held wisdom has been that one should never invest their emergency fund. The reasoning behind this is that you're opting for liquidity (having your cash available when you need it) over any returns you'd get investing.
But given historically low interest rates, the second school of thought is beginning to emerge. That it's wise to invest your emergency because inflation eats away at the value of your cash year after year.
How does one decide to invest or not invest their emergency fund? That's what we'll unpack and explore in this article.
It's Personal
Your emergency fund and your personal finances, in general, are exactly that, personal. For example, most financial experts recommend saving between three and six months' worth of expenses. Some folks might choose three months, while others might feel more comfortable with nine months or even a year saved up. The amount you ultimately decide to accumulate is a personal choice.
When deciding whether or not you want to invest your emergency fund, you have to examine something else that's personal: your risk tolerance. If you're the type of person that can't tolerate seeing their emergency fund cash dwindle when the market falls slightly, you're probably averse to risk. However, if you're like me, a small business owner married to another small business owner, you might feel quite comfortable taking on financial risks.
It's Financial; Weigh the Real Risks
Although the stock market is not the economy, the market is often an indicator of how the economy is doing at the moment. So if the economy impacts your job and your emergency fund is invested in the market, that's a lot of real risk you're exposed to. While you may have a high tolerance for risk, that doesn't mean you should be taking it.
I went to the chiropractor recently, and while he was putting pressure on my shoulders to get feedback from me for what needed adjusting, he mentioned that it seemed like I had a high threshold for pain. "But it can be a double-edged sword," he said, "because it makes it easy for you to ignore things you need to address." When you have a high tolerance for risk, be careful not to ignore real risks that need to be addressed.
Right Size the Risk
Your emergency fund is simply not the place for taking on a lot of risk. A good strategy for taking on some risk is to right-size the risk. If you're worried about your cash losing value to inflation, remember that inflation is roughly one to three percent a year. And remember that risk and return have a positive correlation: the greater risk you take, the higher your potential returns. Lower risk is also associated with lower returns. That's why the cash you have sitting in a money market savings account has such a shitty return; it's practically riskless.
Suppose you find yourself deeply compelled to take on risk in your emergency fund, right-size the risk. You can do this in two ways. The first way is only to invest a portion of your emergency fund while holding the lion's share of it in a high-yield money market savings account. What's the perfect amount to put into the market? It's personal, but try to err on the conservative side with something like a quarter of your fund.
The other way to right-size the risk is to invest in things that aren't very risky. So don't buy an NFTs or Crypto. If you're simply trying to keep up with inflation at one to two percent, you might consider an allocation heavily weighted with bond ETFs.
The Takeaway
No return that you get should come at the cost of your well-being or peace of mind. It would be best to determine what level of risk you are comfortable with and then build your emergency fund.
Investing is risky, especially for your emergency fund; however, using the compromise mentioned above, where you split your emergency fund between savings and investing, could be the perfect alternative for those worried about inflation.
Taking time to consider your options is the best way to make an informed decision. While it's savvy not to underestimate the power of inflation and the benefits of investing, it's also important to mind your risk exposure.