Investors: the stock market is not your emergency fund

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When the S&P500 was up nearly 27% in 2021, it was easy to think the vast market would rise in a straight line forever. Cash reserves were reporting less than 1% for the year. Why would an emergency fund be necessary if you can just sell a few stocks to cover expenses?

The 2022 awakening has been nothing short of heartbreaking for some investors. The S&P fell 17%, while some of the big tech names fell 90%. If you end up needing extra cash when the market crashes, you’ll be forced to sell your stocks at a (potentially very high) discount and therefore hamper the long-term growth of your portfolio.

Here, we’ll discuss how financial psychology and basic math work together to make an emergency cash fund a smart choice.

The purpose of a cash reserve fund

One of the main arguments versus an emergency cash fund is that most “high yield” savings accounts only pay 1% annual interest. Why accept such a low return if you can invest the money in index funds and see double-digit performance?

This strategy works perfectly well when a market or stock is steadily rising, but really fails when the markets are flat or falling. So why do we have emergency funds in the first place? The answer is simple: to provide psychological comfort and practical insurance in case we enter a bear market and stay there for an extended period.

The purpose of an emergency cash fund, again, is not to provide maximum performance. First, cash provides security in case of unexpected job loss or unexpected expense. Second, an emergency fund eliminates the need to sell stocks when the value of your portfolio declines. This protects the “current you” and puts the “future you” in a position to retire safely.

Borrowing from Murphy’s Law, it certainly sounds like the time you need money from your stock portfolio is when it will drop 20%. Things tend to work out that way, and you’ve simply worked too hard to lose much of your financial capital, especially if it’s preventable.

Image source: Getty Images.

What does a good emergency fund look like?

Most financial planners will recommend an emergency fund in the range of three to six months of living expenses. This is a useful rule of thumb, but if you decided to hold the 12-month value, you’d probably feel better if the market fell 50%.

Some of the tangible attributes of a good emergency fund include:

  • Accessibility. It may seem obvious, but choose an account that you can access immediately.
  • Insurance. FDIC regulations guarantee deposits up to $250,000 per account holder, per financial institution.
  • Fully liquid. The fund must be held in cash.
  • Pays a competitive interest rate. It won’t be much in our current market environment, but it should be competitive.
  • Not tied to stock market. Money invested in equity funds is not enough, given their volatile nature.

Additionally, you should separate your emergency fund from the rest of your portfolio, or even exclude it from your asset allocation. It is not considered money at risk and should not be treated as such. However, it plays an extremely important role in your financial plan and will likely play a bigger psychological role than you ever imagined.

You will be happy to have one

In a bull market, people will naturally question the need for a stable emergency fund. This is common investor psychology in this scenario, as it looks like the market outperformance will continue forever. The reality is quite the opposite.

A bull market should prompt you to confirm that you have enough liquidity in the event of a sudden downturn. After the market falls, the opportunity is lost. If you have an emergency fund during a bear market, you’ll feel like the smartest person in the room.

Remember: long-term investing aims to generate solid returns over many years. Your cash reserve has a different purpose and should be treated as a separate part of your finances. Make sure you know the difference as you build and refine your plan.

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