According to a recently published paper in the Journal of Financial Planning, the costs of holding large amounts of emergency cash outweigh the benefits over the long-run.[1] There’s no disputing the peace of mind provided by having cash on hand for a leaky roof or car repair. However, holding large sums of cash can adversely impact one’s long-term standard of living. The low return on savings accounts, money market funds and other cash equivalents makes it difficult to outpace the ravages of inflation.
The foregone wealth resulting from overestimating emergency cash needs can be substantial over time. For example, a $50,000 investment in cash equivalents would likely be worth $150,000 after 30 years (and will have lost purchasing power). Based on historical averages, that same amount invested in a diversified, balanced portfolio of cash, bonds, and stocks could be worth $500,000. What could you do with an extra $350,000?
Many investors rarely, if ever, tap their emergency funds. Furthermore, there are several alternative sources for ready cash should a need arise:
• Selling investments
• Tapping a home equity line of credit (HELOC)
• Borrowing against investments via a margin loan or pledged asset line
• Using credit cards on a short-term basis
• Accessing the cash value of a life insurance policy
When it comes to planning for emergencies, what is the optimal cash reserve? Unfortunately, there is no single formula which works for everyone. The answer depends on many variables, including: stage in life, risk aversion, work income volatility, amount of disability insurance, etc. An objective advisor can help evaluate these variables to determine the appropriate amount and composition of your emergency fund.
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[1] Scott, Janine et al. “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” Journal of Financial Planning. September 2013.