You Don’t Need an Emergency Fund

Conventional financial wisdom says that it’s critical to maintain an emergency fund, a bucket of cash separate from your investment portfolio that can cover expenses in hard times. I’ve been told that living without an emergency fund is the financial equivalent of skydiving without a parachute, that it’s only a matter of time before you reach a dire ending.

In this case, conventional wisdom is wrong. Many investors are better off without an emergency fund, instead investing all extra cash according to their typical asset allocation. Assuming a large enough portfolio, this strategy can mitigate the downside risk by selling investments to cover expenses in case of emergency. But the real differentiator is that it also maximizes the upside. By having more money invested, you will end up with a greater net worth over time.

Of course, this strategy is only viable if you have a portfolio that can take a hit and still cover your expenses in an emergency. If you haven’t yet reached that point, saving in a more traditional emergency fund is beneficial. But if you’ve started to accumulate some wealth, read on to see why you’re better off without an emergency fund.

What is an Emergency Fund?

The general purpose of an emergency fund or a “rainy day fund” is to ensure you can cover expenses in an unexpected financial emergency, such as job loss or large medical bills. The exact definition of an emergency fund is a bit murky, but there are two generally agreed-upon traits:

  • Held in cash or highly liquid vehicle such as a checking account, saving account, or money market fund
  • Able to cover 6-12 months of expenses

Holding a traditional emergency fund like this is one way to mitigate financial downside, but it is not optimal. To determine what is optimal, we need to assess the ultimate goal of an emergency fund. Breaking it down, the goals are:

  1. Have enough cash in hand to cover immediate expenses
  2. Be able to withstand a period of up to a year with no income

The first goal should be met through the standard operating cash that you have available, without requiring an emergency fund. For example, I keep two months of expenses in my checking account for rent, food, etc. The second goal can then be accomplished with financial vehicles that can take a few days to get cash in hand. This opens many possible solutions, including cash under a mattress, gold buried in your backyard, money in a saving account, or a sizable investment portfolio.

Is this your emergency fund?

Since all of these could meet the goals of an emergency fund, how can we choose which is optimal? We need another goal.

What an Emergency Fund Should Be – Mitigate Risk and Maximize Net Worth

The two previously mentioned goals of an emergency fund relate to reducing downside risk. But what about the upside? We shouldn’t mitigate risk without thinking about how it can impact our ability to accumulate more wealth. So, let’s add a third goal:

  1. Have enough cash in hand to cover immediate expenses
  2. Be able to withstand a period of up to a year with no income
  3. After the above two goals are met, maximize net worth over time

If your portfolio is large enough to withstand a significant drop and still cover a year’s expenses, these three goals are best met without a traditional emergency fund. The first goal is met by your operating cash, the second by selling investments, and the third by adding as much money to your investment portfolio as possible.

This is intuitive: having more money invested and less in cash will come out ahead over time. But some argue that being forced to sell stocks at a low price after a market downturn will offset the higher average returns from the additional investment. To analyze that counterpoint, let’s look at history.

History Shows that No Emergency Fund Performs Better

We’ll analyze two investors over the period from 2000 through 2019, which includes two major market downturns. Both investors started with annual income of $65,000 and expenses of $40,000 that increased with inflation each year. Both kept sufficient operating expenses in a checking account to meet liquid cash need. One investor (EF) saved an additional year of expenses in an emergency fund, with returns that equal inflation. The other (no-EF) invested in a 100% equity portfolio of the Vanguard Total Stock Market Fund (VTSMX or VTI).

The two investors are compared across two scenarios: the worst-case scenario and the best-case scenario. In the worst-case scenario, both investors lost their jobs and had zero income in both 2002 and 2008. The EF investor covered expenses from his emergency fund, and the no-EF investor sold stocks to cover expenses. In the best-case scenario, both investors maintained their jobs throughout the 20-year period. Here is how they fared:

In both scenarios, the No-EF investor comes out ahead. Surprisingly, the difference between the two investors is more pronounced in the worst-case scenario when they lose their jobs. In this case:

The No-EF investor ends up with a net worth $100,000 (6%) higher.

While it is true the No-EF investor is forced to sell stocks low, he also buys back in low, shortly after the crash. The EF investor, on the other hand, misses out on this buying opportunity because he spends the next year-and-a-half building back his emergency fund before buying more stock. This causes the EF investor to miss the significant market gains after the crashes.

Unsurprisingly, the No-EF investor also wins in the best-case scenario, though the net worth difference is less pronounced at only 3%.

Portfolio Size Needed to Forgo an Emergency Fund

Based on this analysis, it is clear that an investor with a large enough portfolio should forgo an emergency fund. The question, then, becomes: how large of a portfolio is “large enough”?

The portfolio needs to be able to cover a year’s expenses even after a sharp drop. The largest one-year decline of the S&P 500 was 43.3% in 1931. To be extra conservative, let’s assume that a market drop of 75% is possible. To withstand that drop, your available portfolio would need to be 4 times your annual expenses. For example, a portfolio of $200,000 could fall 75% and still cover $50,000 in expenses if sold. If the market drops more than 75%, you likely have bigger societal problems that wouldn’t be solved by any emergency fund.

This amount must be available for you to withdraw without penalty. This includes regular taxable investments and Roth IRA and 401k contributions (after 5 years), but it does not include traditional 401k contributions.

The Bottom Line

If you have built a sizable portfolio, you don’t need a separate stash of cash as your emergency fund. Instead, you can invest all funds according to your asset allocation and sell in case of emergency. This strategy will effectively mitigate your financial downside while also maximizing your net worth over time. This is true in both a worst-case scenario when you lose your income and a best-case scenario when you retain it.

This Post Has 6 Comments

  1. MikeX

    All your math makes sense, so I have to agree that not holding an emergency fund seems right from a purely financial standpoint. My portfolio is in the range you mentioned to safely be able to sell investments in a downturn, but I don’t think I’ll be able to bring myself to get rid of my emergency fund from a mental standpoint.

    What if I am unable to sell stocks on my brokerage? What if the government halts trading for an extended period of time? I know these scenarios are unlikely, but these are what I think about.

    Either way, appreciate the analysis.

    1. Blake

      There is definitely a big psychological aspect. If holding an emergency fund prevents someone from panic-selling at the first sign of a market downturn, then it’s worthwhile to hold an EF. But I feel that can be better handled by setting an appropriate asset allocation in the first place.

  2. Mark

    Nice article!

    Are you suggesting that no matter what the market is doing or what one’s asset allocstion is, no matter what, if you need cash you just sell assets in proportion to your AA? If your AA is 50/50 and you need $40,000 you just sell $20,000 of each stocks and bonds? Selling low may burn you, but more often than not the expected return over time is greater with this method due to no cash drag. Another benefit is your AA is always in balance regardless of when your emergency starts and ends. No depleting bonds and then needing to replenish for a year or two after you start saving again.

    Is everything I’ve said accurate?

    1. Blake

      Mark, you’re spot-on. If you need cash, sell investments so that you maintain your target portfolio asset allocation.

      In the scenarios I used, job loss occurred during two big market downturns, so it’s likely a 50/50 investor would need to sell more bonds than stocks to rebalance to 50/50. When he’s able to start contributing to the portfolio again, he would pick right back off where he left off according to his target AA.

      1. Mark

        Blake, thanks. So incredibly simple and logical. Assuming access to money to cover the emergency (i.e. a taxable portfolio that can withstand a large market decline and still have enough to cover the emergency), it completely breaks down the argument of ever needing to hold an emergency fund or any amount of cash other than operating expenses of perhaps a month or so. The best part is that the portfolio is never out of balance. The desired risk level is always maintained, regardless of market conditions, employment, timing of other emergencies or cash needs, etc. There is no more “saving” for a car, a new roof, vacations – you simply always, always, always invest per your AA, and spend cash as you need to.

        Right??!!

        1. Blake

          I think you just summed it up better than I did! It’s simple, mitigates downside risk, and optimizes returns. Holding money outside your portfolio with your desired asset allocation is just mental accounting.

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