Why Investing Your Emergency Fund Isn’t a Good Idea

December 12, 2013

emergency fundOne of the major disadvantages in a long-running bull market in stocks is that people start to get a little bit greedy. They want to invest any money they have in an effort to make more money in a market that seems like a sure thing. That can include retirement money, borrowed money, money in the cookie jar – and even the family emergency fund.

On the surface this can seem like a prudent step. You’re attempting the use any money that you have to make more of it. But while it’s perfectly alright to maximize returns, you still have to have some money that is not invested in risky assets of any kind. An emergency fund is the perfect example.

1. An emergency fund isn’t an emergency fund if it’s invested.

It’s one thing to seek a higher interest rate on your emergency fund, but quite another to invest it in equities. Once you do, an emergency fund ceases to be an emergency fund, and becomes a general investment account. That defeats the entire purpose of having it in the first place.

While investing an emergency fund in stocks or mutual funds can seem brilliant when stock prices are rising, it will look downright foolish if the market turns down and the emergency fund is largely depleted without ever having provided for a single emergency.

2. An emergency fund is your last line of financial defense.

A lot of investors are not at all comfortable having money that isn’t earning much more than 1%, especially when the stock market can turn double-digit returns. But an emergency fund isn’t like other accounts. It’s your last line of defense against financial disaster or a career crisis.

An emergency fund is doing its job just sitting in the bank, earning a very low rate of return, and being available just in case. It doesn’t need to do anything more than that in order to serve its purpose. If an investment contains any form of risk whatsoever, it does not belong in your emergency fund.

3. Jobs tend to disappear at the same time investments fall – in a major way.

There’s a more tangible reason to avoid investing your emergency fund in risk-type assets like stocks and mutual funds. Declining stock markets and deteriorating economies usually go hand-in-hand. And when the economy falls, it takes the job market down with it.

Imagine your emergency fund declines by more than 50% – because you had it invested entirely in mutual funds you thought were completely safe – and then finding out that you’re about to be laid off. The thought of that possibility should end any ideas about investing your emergency fund in anything more risky than certificates of deposit or money market funds.

4. At least some of your money must be in completely risk-free vehicles.

No matter how well the stock market is doing, at least some of your money should be in completely risk-free investments. This includes a certain percentage of your actual investment portfolio. You should have at least a small percentage of your portfolio in cash or cash equivalents if for no other reason than the fact that it enables you to buy bargain stocks when the opportunity presents itself.

But you should also hold certain positions outside of your portfolio in cash as well. Proper diversification requires that at least some of your money – even if it is a minority percentage – be invested in mutually exclusive assets. While it is isn’t possible to invest money in assets that will rise when stocks are falling, you can keep money in vehicles that will remain stable when the market drops.

Your emergency fund should be part of that cash-based investment scheme. And it’s not so that can be a source of capital for future investment in stocks, but for the possibility that you may slip on a financial banana peel and need the cash to survive.

5. You’ll make better investment decisions keeping your emergency fund separate from investments.

One of the advantages to a well-stocked emergency fund that is often forgotten in prolonged bull markets is that having it can actually make you a better investor.

An emergency fund provides you with a cash cushion that separates your survival from your investments. If you do run into a problem with either income or a rash of unexpected expenses, your ability to tap your emergency fund will prevent you from liquidating investment assets at inopportune times.

In addition, simply having money sitting in the bank to cover any short-term emergencies will eliminate the panic factor that could cause you to make irrational investment decisions.

Start seeing your emergency fund as a strategic part of your overall investing strategy. It’s the part of your portfolio that you keep fully sheltered from risk, so that you are free to pursue risk-type investing elsewhere in your portfolio.

Have you been tempted to invest your emergency fund? Where do you currently keep your emergency fund? Leave a comment!

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Kevin

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Kevin
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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2 Responses to Why Investing Your Emergency Fund Isn’t a Good Idea

  • JoeTaxpayer

    Agreed. Every point is well presented.

    Say your retirement account needs are covered by your 401(k). And you weren’t planning on a Roth IRA. The Roth account can be a great place to hold the emergency fund money. Not ‘invested,’ just parked there in a money market fund or CD. Same as you’d keep emergency money elsewhere. The benefit of the Roth is the tax free growth if it’s not used.
    Best of all, the money remains accessible for the true emergency, but feels like it’s tougher to grab, not just sitting in checking. As the account grows beyond the amount needed for emergencies, just open a second account to fund with ‘investments’.

    What confuses people with this idea is they hesitate at ‘using a retirement account for emergencies.’ Understood. This suggestion is only for those who have no Roth in the first place.

    • Kevin Mercadante

      I agree Joe. A Roth IRA is an excellent place to park an emergency fund. You can withdraw the amount contributed without concern for income taxes, but the earnings will grow on a tax-free basis. If you never pull the money out for an emergency, you’ll also have a nice supplemental retirement plan.

      You’d still want to have the money invested in non-risk type vehicles, at least the portion allocated to your emergency fund.

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