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Why Traditional Advice About Rainy Day Funds is Wrong

Why Traditional Advice About Safety Net Funds is Wrong :: Mint.com/blog

Conventional wisdom says that safety net funds (aka: rainy day funds) should be held in a savings account or similarly risk-free asset.

But is this really the wisest way to manage your rainy day fund?

Our analysis finds that you can do far better by investing your safety net fund in a diversified portfolio.

First, let’s get one myth out of the way: Cash savings accounts are not risk free.

Why?

Because after accounting for inflation there is about a one in three chance you won’t get back the money you put in, in real terms.

Today, with nominal cash interest rates hovering far beneath 1 percent, it’s almost guaranteed that you’ll make a negative real return over the next few years.

This means your safety net fund will need topping up year after year to maintain its real value. It also means that you’ll have a significant amount of wealth that is not growing, potentially for a long period of time.

Intelligent investing is safe, even for your safety money

The better solution is to have a safety net fund and grow it too.

For those with a fully funded safety net fund, we recommend investing in a moderate risk portfolio with allocation set between 30 percent and 50 percent stocks.

Betterment’s default advice for a safety net goal suggests a 40 percent allocation.

While this flies in the face of traditional advice, our analysis below shows that it stands up to critical examination.

Let’s  work through an example to explain our advice. First, everyone  should consider having some kind of safety net fund based on his or her monthly expenditures.

(Read our blog post about how to calculate your own safety net target amount.)

If you have not fully funded your safety net yet, we recommend saving regularly to get there.

For a worker earning around $110,000 in annual salary, a safety net target might be $18,000 (assuming minimum expenses of $4,500 per month for four months).

This saver has two options: put this money into a savings account or invest it. We think investing is the smarter choice.

However, to be smart investors we want to also protect ourselves against potential losses. This is why we recommend adding a buffer of 30 percent¹ to your original target amount.

For example, to maintain a $18,000 safety net we recommend starting with $23,377.

On the chart below we’ve plotted the actual returns for every five-year period since 1955 for a $23,377 safety net fund with a 40 percent stock allocation.

As you can see, the returns — like those of any investment — can vary on both the upside and downside.

However, over any five-year period it is rare to find the value of the safety net fund dip below $18,000.

On the other hand, for the saver who keeps a safety net in cash, inflation is likely to chip away at that amount in real terms.

Invested safety net fund over every five-year period, starting 1955

SOURCES: Betterment analysis of S&P500: Yahoo Finance; Federal Reserve Economic Database; Bureau of Labor Statistics

Reinvesting gains in your safety net fund

The benefit of investing a slightly larger amount than you need is the opportunity to earn returns.

If the original investment of $23,377 grows at around 5 percent per year (an approximate long-term annual return for a Betterment account with a 40 percent stock allocation), it will be getting bigger than necessary on a regular basis.

This is a good problem to have.

To prevent your safety net from getting too big, we advise transferring the excess to another goal in order to bring it back down to the correct level every time it gets to be 20 percent bigger than it needs to be.

That excess growth not only makes up for the original buffer you invested, but it can now be transferred to help along other goals like IRAs, retirement, or a vacation around the world.

In fact, the best scenario is that you will never need your safety net fund at all. Even the poorest returns on investing will still handily beat cash over 50 years.

In other words, cash is a very poor long-term investing — or safety net fund — strategy.

We do not have a crystal ball and do not know exactly what markets will do in the future. But what we can see in recent history is that the downside of taking some risk is not terrible — but the upside is very powerful.

¹ Increasing your target amount by 30 percent will allow the investment to absorb a 23 percent decline while preserving the target amount. We are using 23 percent because it represents the greatest peak-to-trough percentage drop a Betterment 40 percent stock portfolio would have experienced since 2004 (the drop took place between July 2008 and March 2009). Prior to 2004, insufficient data is available to test the Betterment portfolio’s performance with confidence. However, to demonstrate a longer historical view, the graph above uses performance of a portfolio consisting of 40 percent S&P500/60 percent 5-year Treasury Bills, going back to 1955. There is no guarantee that a future drop would not be steeper, but we feel it is useful to demonstrate the impact of historically exceptional volatility on a buffered safety net fund.  Please see our full disclosure of our methodology for model historical returns.

Why Traditional Advice About Safety Net Funds is Wrong” was provided by Betterment.com.