Financially reviewed by Patrick Flood, CFA.
The oft-cited advice is to put your emergency fund in a safe, high-liquidity savings account or money market fund, but there may be a better way if you’re willing to take on some additional risk. Here we explore how you can invest your emergency fund to beat a high-yield savings account.
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Introduction – Why Invest Your Emergency Fund?
An emergency fund is exactly what the name suggests – an amount of money, usually in a separate account, saved for a rainy day in case of emergencies in the form of unexpected expenses, e.g. car repairs, loss of job, medical bills, etc. Professionals recommend having 3-6 months’ expenses in an emergency fund. Even having one month of expenses saved up puts you ahead of most people in the world.
The advice usually heard is to put this emergency fund in a safe, low-risk, highly-liquid account like a savings account or money market fund, so that you can access it immediately when needed and not worry about it dropping in value. That is, safety and liquidity over returns. This is solid advice and obviously makes great sense. But there may be a better way.
High-yield savings accounts typically max out around 2% APY. With current interest rates at all-time lows, it’s rare now to find anything approaching 1% APY. With inflation at around 2% annually on average, you’re still losing to inflation with a high-yield savings account or money market account. This has caused many to begin rethinking the common advice of not investing one’s emergency fund in recent years as interest rates approach zero, with no sign of rising anytime soon.
Those willing to assume a marginal amount of extra risk can invest the emergency fund in a well-diversified portfolio that can be expected to grow over time instead of staying flat or diminishing due to inflation. This is obviously a highly personal situation. Those with a low tolerance for risk may very well be perfectly happy losing money to inflation and keeping their emergency fund in a safe savings account, and that’s totally fine. The emotional aspect of investing is very real. Peace of mind can absolutely be worth the expense of lost value to inflation and opportunity cost.
Similarly, if any of the following apply to you, investing your emergency fund is probably not a good idea:
- High-interest debt
- An unstable job
- Just starting an emergency fund
- Greater risk factors for emergencies (kids, commute, etc.)
But for others, investing your emergency fund can make sense in the right circumstances. Let’s assume you have an emergency fund of 6 months’ expenses saved and sitting in a savings account right now. Let’s also suppose this amount you need – the value of the account – is $10,000. Consider these facts:
- It’s unlikely that you’ll need the entire emergency fund – all $10,000 – on a single day all at once.
- In the modern era of credit cards, you can use a credit card to cover any emergency expenses and pay off the balance within 30 days without incurring interest charges, meaning immediate liquidity/availability of cash at the time of the expense is not supremely important.
- As mentioned above, any savings account is still going to be losing to inflation, meaning the account value is slowly dwindling over time in terms of real dollars and actual purchasing power. Diligent savers will need to continually top off the account for this reason.
- Time that passes without needing to access the emergency fund is an opportunity cost where that money could have been invested to achieve a compound growth rate that beats inflation, allowing the account to grow over time instead of shrink or stay flat.
- Significant market downturns and black swan events – are inherently rare. Diversifying the investment account mitigates volatility and the degree of drawdowns (risk).
- Traditional brick-and-mortar banks are unlikely to offer a competitive high-yield savings account, meaning you’d have to go with an online bank where transfer times to get liquid cash are likely similar to that of a brokerage account anyway.
Investing your emergency fund becomes particularly appropriate and attractive if you have:
- A large emergency fund saved, e.g. 6-12 months’ expenses.
- High-limit credit cards.
- More than one stream of income or more than one person earning in the household.
- A stable job.
- Good health insurance.
- An HSA.
Of course the main criticism of investing one’s emergency fund is the fact that a market correction can result in the account dropping in value at the precise time you need that money. Thankfully, there’s a way to mitigate or even eliminate that risk.
How To Invest Your Emergency Fund
There’s a simple yet beautiful way to ensure a market correction doesn’t affect your ability to use the money in your emergency fund: overfund the account.
Specifically, we want to attempt to estimate the maximum degree (value) by which the account can drop from the initial value and then simply overfund the account by that amount. For example, if we estimate the max drawdown of the investment portfolio to be 10% and we need $10,000 in the emergency fund for 6 months’ expenses, we would want to put an additional $1,000 in the emergency fund for a total of $11,000.
This maximum drawdown – and subsequently, the amount by which to overfund – correlates with the riskiness of the investment portfolio in which you place your emergency fund. If the portfolio is low-risk, we may estimate the max drawdown to be 10% as in the example above. A riskier portfolio may have an estimated potential drawdown of 30%, in which case you’d want to overfund by 30%.
This concept becomes less important as time passes without using the emergency fund. The longer you go without using it, the more time the investments have to grow, making drawdowns less impactful. For example, if your investments appreciate and the emergency fund grows from $10,000 to $15,000 after 5 years without needing to access it, a market downturn of 10% still leaves you with $13,500 in the account.
In terms of account type to invest your emergency fund, you can use a taxable brokerage account or a Roth IRA. For the former, depending on when you sell your investments, you’ll incur short- or long-term capital gains taxes. For the latter, you can withdraw contributions from a Roth IRA tax- and penalty-free anytime, but the paperwork may be a bit more cumbersome. Also keep in mind IRA’s have annual contribution limits which may be lower than the amount you need in your emergency fund.
Time Horizon and Asset Allocation
Consider the fact that the time horizon for your emergency fund is technically continuous and limitless, as unexpected emergencies are, by definition, unpredictable. You may never need to access your emergency fund, which would be a good problem to have. Conversely, you may need to access it within a year. As such, asset allocation must be set initially to be quite conservative and can later be made more risky as the account grows if you prefer.
For example, when starting out, we want a very conservative allocation with something like 10/90 stocks/bonds, but after 20 years, this may slide to 40/60 or even 60/40 stocks/bonds if you want.
Remember, in investing the emergency fund, we want to minimize volatility and risk, at least when starting out. This means maximizing diversification across uncorrelated asset types, as well as diversifying risk factor exposure. This also means using broader, less volatile asset classes and styles, such as index funds over stock picking, treasury bonds instead of corporate bonds, and mostly short-term bonds instead of long-term bonds.
Below are some ETF portfolios to consider for investing your emergency fund.
An extremely popular low-risk lazy portfolio that I’m suggesting to consider for investing your emergency fund is the Permanent Portfolio. It seeks to reduce portfolio volatility and risk by diversifying with assets so that the portfolio performs well in any market environment, similar to the famous All Weather Portfolio.
The Permanent Portfolio consists of 25% U.S. stocks, 25% gold, 25% long-term treasury bonds, and 25% cash. Below is a performance backtest of the Permanent Portfolio for the period 1978-2019:
Note the historical max drawdown of roughly 14%. While past performance doesn’t indicate future performance, we can use that as an estimate of the drawdown we may expect in the future, meaning we’d need to overfund the account by about 14%.
I would suggest using M1 Finance if you don’t already have an investment broker because it has zero transaction fees, automatic rebalancing for new deposits, and a user-friendly interface, among other things. I wrote a comprehensive review of M1 Finance here.
You can add this Permanent Portfolio pie to your portfolio on M1 Finance by clicking this link and then clicking “Add to Portfolio.” It uses mostly low-cost Vanguard ETFs.
Those wanting to be a little more conservative might consider an even lower-risk portfolio that I designed. It looks like this:
8% Total World Stock Market
2% U.S. Small Cap Value Stocks
60% Short-Term Treasury Bonds
20% Intermediate-Term Treasury Bonds
Below is a backtest for the period 1998 through March 2021 comparing it to the Permanent Portfolio and cash:
Notice the much lower volatility, smaller max drawdown, and higher risk-adjusted return of mine compared to the Permanent Portfolio. Also notice how with cash, you’re losing money after accounting for inflation.
To add this custom low-risk portfolio to your M1 Finance account, click this link. It uses mostly low-cost Vanguard ETFs.
Where To Invest Your Emergency Fund
Again, I think M1 Finance is an ideal platform to use to invest your emergency fund. The modern broker offers retirement accounts, a taxable brokerage account, and an integrable checking account with debit card. This allows you to house multiple accounts under one roof and seamlessly transfer between them. M1 features fractional shares, automatic rebalancing, a sleek mobile app, zero account fees, zero transaction fees, and some of the cheapest margin around.
M1 also has a premium account option called M1 Plus that gets you access to their new Smart Transfers, allowing users to set up chains of automatic transfers between accounts based on specified dollar amount thresholds, e.g. investing any excess cash above $1,000.
I fully support investing your emergency fund to avoid the opportunity cost of missed growth, provided it fits your personal situation and risk tolerance described above. But in doing so, make sure you’re investing it in a relatively low-risk, well-diversified portfolio, especially when initially accumulating your savings. Look at historical risk metrics and overfund your invested emergency fund accordingly.
If you’re still indecisive, you can always simply split the difference. Put 3 months’ expenses in a highly-liquid savings account, and the other 3 months’ expenses in an investment account. This allows you to cover short-term, immediate expenses with liquid cash while also allowing money in the investment account to grow, and allows you to potentially avoid capital gains taxes from selling investments to cash.
Do you invest your emergency fund? Do low interest rates have you rethinking the traditional advice of a plain ol’ savings account? Let me know in the comments.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.