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 and inflation.
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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 during relatively “normal” economic environments. With inflation at around 2% annually on average historically, 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.
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 (and likely the expected return) 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%. Keep in mind future drawdowns may be worse than the worst ones shown in the past on a backtest.
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 short-term bonds instead of long-term bonds.
Below are some ETF portfolios to consider for investing your emergency fund that check these boxes.
“What's the Best ETF for an Emergency Fund?”
I get a lot of questions asking what the “best ETF for an emergency fund” would be. Well, I'd argue that's sort of the wrong way to think about it.
In my opinion, there's no single fund that can adequately serve that purpose. Remember, for an emergency fund, we want to minimize volatility (the swinging movement of the portfolio) and risk (permanent loss of capital, in this case), because the money has to be there when we need it. To do that, we want to diversify broadly across different assets. And in order to do that, we need multiple ETFs; there's really no getting around it, at least with the current availability of financial products.
I've also heard the phrase “emergency fund in bonds” thrown around a fair amount. First, that phrase is too reductive. There are quite a few different types of bonds and different durations out there to choose from. Here we want to primarily make use of short-term treasury bonds. Secondly, while I'd argue we do still want mostly bonds here, bonds alone still don't get the job done. Bonds mitigate the risk of stocks, but stocks also mitigate the risk of bonds. Again, diversification.
I designed a pretty low-risk portfolio to invest one's emergency fund. Past iterations of this idea got a little more granular (and thus more complicated) with more funds. Einstein suggested to “make everything as simple as possible, but not simpler.” I've tried to do that here. It looks like this:
10% Total World Stock Market
45% Short-Term U.S. Treasury Bonds
40% Short-Term TIPS
This is sort of an “all weather” approach to a low-risk, low-return portfolio, with roughly half the fixed income allocation in inflation-linked bonds.
Some will notice that I've written elsewhere that gold has not been a reliable inflation hedge historically, has a long-term expected real return of about zero, and is tax-inefficient. However, I've also noted that gold tends to be uncorrelated to both stocks and bonds and is a decent hedge for uncertainty. Periods of “uncertainty” are a great time to have an emergency fund. To combat the tax problem, I've selected a gold fund below that is classified as a PFIC (Passive Foreign Investment Company) so that it is taxed at the capital gains rate (15% or 20%) and not as a collectible (28%).
Below is a backtest for the period 1998 through March 2021 comparing it to the Permanent Portfolio (a less conservative but still well-diversified portfolio) and “cash,” which is really T Bills:
Notice the much lower volatility, smaller max drawdown, and higher risk-adjusted return of mine compared to the Permanent Portfolio. Also notice how with T Bills, you're losing money after accounting for inflation.
Using mostly low-cost Vanguard funds, my low-risk emergency fund portfolio can be constructed using the following ETFs:
VT – 10%
VGSH – 45%
STIP – 40%
PHYS – 5%
To add this custom low-risk emergency fund portfolio to your M1 Finance account, click this link.
As an aside, 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.
Again, after your emergency fund grows and you can sustain a larger drawdown, you can explore riskier but still-well-diversified options like the All Weather Portfolio. This is essentially sliding further down the scale of risk and expected return. Earlier I said there's no single “best” ETF for an emergency fund. If I had to pick one, it would just be a plain ol' low-cost short-term treasury bond fund like VGSH from Vanguard. It's about as far down on the safe end of that aforementioned scale as you can get.
But that's obviously the boring answer that people aren't really looking for. And I'd argue that's appropriate, as emergency funds are supposed to be pretty boring out of necessity. But I'll oblige. So again, later on, provided the account value is sufficiently large, one could get away with something a bit more exotic like SWAN, which was designed primarily to protect the downside with treasury bonds while still allowing for upside participation in stocks. Toss in some gold like I noted on that page to sleep a little easier at night.
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, taxable brokerage accounts, high-yield savings, and more. 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. M1 Plus is a paid membership that confers benefits for products and services offered by M1 Finance LLC, M1 Spend LLC and M1 Digital LLC, each a separate, affiliated, and wholly-owned operating subsidiary of M1 Holdings Inc. “M1” refers to M1 Holdings Inc., and its affiliates.
M1 Finance currently has an account transfer promotion to earn up to $15,000 as outlined below:
M1 also currently has a promotion for up to $500 when initially funding an investment account:
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, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment 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. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. I mention M1 Finance a lot around here. M1 does not provide investment advice, and this is not an offer or solicitation of an offer, or advice to buy or sell any security, and you are encouraged to consult your personal investment, legal, and tax advisors. All examples above are hypothetical, do not reflect any specific investments, are for informational purposes only, and should not be considered an offer to buy or sell any products. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.
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