What is the first piece of advice legendary investor Peter Lynch gave in his best-selling book One Up On Wall Street? It wasn’t about how to spot great companies, or P/E ratios, or earnings growth. It was to pay off your house completely before investing in the stock market.
I wouldn’t go so far as paying off my house before investing, but the idea behind his advice is so true. The whole point of his advice is that every investor should be absolutely sure that they can take care of their basic needs before playing in the stock market. The best way to do this is to build up an emergency fund.
What is an emergency fund?
An emergency fund is money that you can easily access in order to pay for basic living expenses such as:
- Shelter (mortgage, homeowner’s taxes, rent)
- Utilities (electric, gas, water)
- Reliable transportation (gas, car insurance, Uber)
- Communication (internet, cell phone)
Does not mix with your investments portfolios.
Speaking from experience, an emergency fund should be kept separate from any money used for investing. It shouldn’t be mixed in your brokerage accounts. It should be sitting in a good old-fashioned bank savings account or short-term CD. It is basically any place in which you can withdraw the money easily and penalty free.
Why Emergency Fund Is Essential for Investors
Buy Low Sell High is the simplest way to explain to someone how a value investor makes money in stocks. Yet many investors do the exact opposite. One reason I believe this is true is that they don’t have a big enough emergency fund to weather the storm of a bear market. In boom times, it’s easy to look at a stock chart of the S&P 500 and say you’ll dump a bunch of money into it the next bear market and sell during all-time highs. In reality, when the market is down 30% from all-time highs we’re probably in or close to a recession. And in a recession, our mindset shifts from making money in stocks to making sure we have a plan in case we get laid off from our jobs.
Investors with big emergency funds can get aggressive when there is “blood in the streets”. This is value investing at its finest and many fortunes have been made using this strategy. I’ve personally experienced this in the last major downturn from 2007 to 2009 (The Great Recession). My net worth definitely increased by staying invested in stock mutual funds through the March 2009 lows. However, I wasn’t as aggressive as I should have been and definitely left some money on the table. One of the biggest reasons was that I didn’t have a big enough emergency fund.
It’s all about the mental game! A big enough emergency fund gives investors the mental confidence to buy great stocks at bargain prices. This is a
How Much Do I Need for an Emergency Fund?
If you do a Google search for this question, you’re likely to get “3 to 6 months of living expenses” as an answer. Having experienced the dotcom bubble and Great Recession as an investor, I actually think that 1 year’s worth would be even better for most people. Keep in mind that 3 months or 6 months or 1 year are just rules of thumb and may not apply to your specific situation. The question I like to ask myself is:
If I were to lose my job during a recession, how long would it take me to find another one that pays comparably well?
Your answer may be different depending on if you’re 30 years old or 50 years old, in a high-demand position or not, willing to move or not, willing to accept a lower paying job or not. And the list goes on. I intentionally included “during a recession” because it will likely
take twice as long in a recession to find a job as it would during boom times. I personally know of a few people who took nearly 2 years to find a job after the Great Recession!
How to Build Up an Emergency Fund – The 80/20 Method
First, determine how much you need for your emergency fund. I’ve included a free sample Google worksheet here to help you with that. It gives estimates for 6 months, 12 months, and 18 months.
Second, use what I call the 80/20 method. What is the 80/20 method? It’s simple. Let’s say every month you have $1000 left over that can be used for investing or your emergency fund. If you haven’t reached your emergency fund goal yet, then put 80% towards your emergency fund and 20% towards investing. So $800 would go towards the emergency fund and $200 for investing. Once you’ve reached your goal, then switch it – 80% towards investing and 20% towards the emergency fund.
Why continue putting money in the emergency fund after reaching your goal? Because it’s better to be safe than sorry. I always remember Peter Lynch’s advice about paying off your house before even beginning to invest in stocks. That is some ultra-conservative advice from someone who had a reputation for being an ultra-aggressive stock picker.
Is there an upper limit when I don’t need to allocate 20% to the emergency fund? There probably is a theoretical upper limit, but I don’t think that any of us will get there using the 80/20 method. Life happens and that’s what the emergency fund is for. Most of us will dip into that emergency fund on occasion to pay for unexpected events. And that means we’ll have to build it up again if we dip below are minimum.
Where to Store Your Emergency Fund
The simplest place (and what I recommend) is to store your emergency fund is in
What about T-Bills? T-Bills are guaranteed by the full faith and credit of the U.S. government. They generally pay higher than savings account rates and are exempt from state income taxes – which is great if you live in a state that collects income tax (like California)! You can buy T-Bills that mature in as little as 4-week cycles. Go to the government’s Treasury Direct website for more information. It’s very easy and convenient to invest in T-Bills, so I highly recommend them for your emergency fund.
What about CD’s (Certificate of Deposit)? CD’s pay about the same as T-Bills but don’t have the added benefit of being exempt from state taxes. If you live in a state that doesn’t collect income taxes, then you only need to decide if CD’s pay higher interest than the equivalent T-Bill.
Where Not to Store Your Emergency Fund
After graduating from college and getting my first “real” career job in my 20’s, I was excited to open a 401k. The only choices in my 401k at the time were about 15 mutual funds. One of those funds was called a Stable Value Fund. I came to learn that almost all 401k plans have something called a Stable Value Fund. It acts very much like a savings account in that it has steady, safe, low returns. “Great!”, I thought to myself. I could just use this fund as my emergency fund since it acts almost exactly like my savings account. Boy was I wrong! Read on and learn why I think using a Stable Value Fund as an emergency fund is a bad idea.
3 Reasons Not to use a Stable Value Fund for Your Emergency Fund
Reason #1: Penalties for early distributions
As I mentioned above, emergency funds are to be used for unexpected events such as losing a job. Let’s say you have a $100,000 401k portfolio and $30,000 of that is in a Stable Value Fund. You lose your job and decide to withdraw from your 401k to support yourself until you find another job. In most cases, you’ll owe a 10% penalty if you’re under the age of 59 and 1/2. There are some exceptions. For example, you may be able to avoid the 10% penalty if you’re over 55 and lost your job. Consult with your 401k plan administrator and your tax adviser for the most up-to-date information on how to avoid the 10% penalty. Bottom line, if you’re like most people and would be required to pay the 10% penalty, then keeping your emergency funds in a high-yield savings account outside of your 401k is a much better option.
Reason #2: Your plan may force you to withdraw from your other funds along with your Stable Value Fund
Going back to the previous example, let’s say you lost your job and have $30,000 of your 401k in a Stable Value Fund and $70,000 in other funds. You’re over 55 and your plan allows you to withdraw penalty free. You would like to withdraw the $30,000 and leave the other funds alone. There’s a good chance your plan administrator won’t let you do that. Typically, when you request a withdrawal, your plan administrator will cash out pieces of all your funds and then send you a check for the amount you requested. That means you’ll be forced to sell your other funds. Not cool! Of course, check with your own plan administrator on how they handle withdrawals.
Reason #3: It’s difficult to track your investment performance
Even if for some reason your able to get around the 10% penalty and able to isolate just your Stable Value Fund for withdrawals, I still don’t think it’s a good idea to use mix your emergency funds with your 401k.
The final reason why mixing your emergency funds with your 401k is that it’s difficult to track your performance. You may be a great investor, investing in the best mutual funds year after year. But by keeping a good portion of your 401k in the Stable Value Fund, you may be under performing against the S&P 500. By keeping your 401k laser focused on your long-term financial goals, you’ll be better able to manage it and measure its performance.