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Time to Invest the Emergency Savings?; Short-term bonds seen as one alternative
For years, advisers have been suggesting to their affluent investors that the best way to guard against emergencies is by stashing cash in reserve.
Now, with interest rates still low, such a common investing rule-of-thumb is being challenged.
When inflation starts to creep up, cash will look even worse as a source for emergency funding, according to Jonathan Krasney, president of Krasney Financial in Mendham, N.J., with $350 million in assets.
“Over time, cash has proved to be a wasted asset to protect against emergencies,” he says.
The so-called “opportunity cost” of holding cash for long periods in low-returning money–market or savings accounts is particularly troublesome, says Duncan Williams, professor of financial planning at William Paterson University in Wayne, N.J.
During a hypothetical 40-year period, someone maintaining six months’ worth of cash savings at all times could earn as much as 20% less than a person who put everything into one account with an allocation of 60% stocks and 40% bonds, according to a recent study he co-authored published in the Journal of Financial Planning.
“Instead of accumulating cash in a separate account, investors can simply sell securities from their investment portfolios, which hold greater potential to take advantage of market appreciation over time,” Mr. Williams says.
Of course, during steep market declines, that could lead someone to sell low and buy high later–a basic “no-no” for investors, he points out.
The study tried to take such factors into account. It compared results of an investor who sold under some of the most adverse conditions over the past several decades and restocked their emergency portfolios first with cash–as opposed to those who started to replenish their entire investment portfolio at once.
Over longer periods, a portfolio with 60% in stocks could gain 0.76% more a year than someone splitting their savings between a cash emergency fund and a separate investment account, researchers found. Investors who held more in stocks–anywhere from 80% to 100%–and didn’t split accounts could wind up with as much as a full percentage point more in their coffers each year over several market cycles.
In fact, during periods of extreme market stress and high unemployment, Mr. Duncan found that holding separate emergency and investment accounts actually tended to raise the chances of exhausting savings.
“The basic common thread of our findings is that whether you look over shorter periods or longer ones, following a single one-account strategy almost certainly will leave you with more money when an emergency actually takes place,” he says.
But it’s a strategy that won’t appeal to all types of investors, notes Harold Evensky, president of Evensky & Katz Wealth Management of Coral Gables, Fla., with $900 million in assets.
“It might not make as much difference for investors with smaller portfolios,” he says. “Still, this is a debate that needs to take place on a more frequent basis. Too many people take for granted that cash is the best way to plan for emergencies.”
Persuading someone to buy more risky assets for their rainy day reserves is a tough sell, observes Michael Smith, a portfolio manager at Philadelphia-based RTD Financial Advisors, with $800 million in assets.
In his practice, clients preferring to stick with a traditional approach outnumber those who feel comfortable with taking a more contrarian strategy by more than 2-1, according to Mr. Smith.
“In theory, it makes a lot of sense,” he says. “But for most investors, saving cash for emergencies is like adding a nice warm blanket in the winter. It lets them sleep better at night.”
To help soothe nerves, adviser Mr. Krasney suggests that investors consider the need to diversify their portfolios. He tells stock investors that they should hold at least some bonds, including those with shorter maturities.
While more volatile than money–market funds and cash, short-term bonds “lend themselves quite well to doubling as emergency savings” since they’re expected to generate greater returns over full market cycles, Mr. Krasney says.
At the same time, short-term bonds typically don’t return as much as longer-term bonds and stocks over time.
“By its very nature, we find the shorter end of a bond portfolio as a good place to sell to cover emergency expenses, particularly when stocks are falling,” Mr. Krasney says.