A fully-funded emergency savings is critical to your financial health. Having accessible cash prevents you from having to rely on credit cards to cover large, unexpected expenses while freeing up your monthly cash flow to save for big-picture goals like retirement and kids’ education. However, if your savings account is rather large, having too much cash in a bank account can mean losing out on the opportunity to build additional wealth.
The key to an emergency fund
The key to an emergency fund is that the money is accessible. If all your wealth is in an inaccessible asset like real estate, for example, trying to get cash out of it would take weeks or months as you either sell the house or get a loan on its equity. A bank account meets the accessibility standard—money can be withdrawn instantaneously to cover an unexpected expense. But are you sacrificing in other ways for the sake of accessibility?
The problem with bank accounts is that interest rates are extremely low. Traditional bank savings and money market accounts have rates near zero, while some online banks top out around 1%. Why is this important? Your real return—the amount you earn after inflation—is almost certain to be negative. If you have a large chunk of money sitting in a savings account year after year, the purchasing power of that money will slowly be eroded.
An alternative way to save—invest!
We believe there is another way! Rather than keep all your savings in the bank, consider investing some of it in a conservative or moderate-risk portfolio. This way, your reserve cash will have the chance to work for you!
Here are some three benefits to this approach:
Contrary to popular belief, you aren’t locking up your money by investing. Fortunately, technology allows the investment experience to be much different than twenty years ago. Money can be transferred from your investment account to your bank account in 4 or 5 business days.
2. Long-term growth potential
Let’s revisit our earlier point about bank interest rates. Because inflation is higher than your interest rate, your savings account is guaranteed to lose purchasing power every year. You won’t see any losses on your statement, but your savings account is not risk-free. It is prone to “inflation risk.” Investing tries to combat this risk by giving your funds opportunity to grow! But we don’t want to see your $40,000 turn to $20,000 because the stock market tanked. Therefore, we suggest investing your emergency funds in conservative or moderate-risk portfolio—anywhere from 30% to 60% stocks. This allows growth but reduces volatility.
3. Out of sight—out of mind?
To reiterate my earlier point, your funds are still accessible. However, having funds outside of your normal bank account might keep the temptation to spend this money at bay.
If you have a large amount in your savings account, consider investing part of it. Having too much money in the bank will expose you to inflation risk—having your money lose purchasing power in the long-term. Since investing is prone to fluctuations, we recommend keeping your stock allocation from 30% to 60% of the portfolio. This way, you can experience long-term growth with greater short-term stability.
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Want to know more about how to properly set up your emergency fund? Schedule an appointment with one of our Financial Advisors below.