An analysis: how to optimise the traditional emergency fund

If you’ve read any of my investing focused posts before you may notice that I have a penchant towards optimisation. The core of my own investing philosophy treads down the path of the optimal, continually addressing questions such as: Am I maximising my returns for my level of desired risk? Am I currently saving the most I can be on fees? Is my current asset allocation still ideal for my situation?

In this post I’d like to look again at the ever divisive topic of the emergency fund. My previous post about emergency funds touched on my personal view that we should have less of a simple pot of cash but more of a plan in place to access funds when they are required. With that said, I’ve noticed the emergency fund topic cropping up more and more across messaging boards of late, so I think it’s prime time to revisit this.

Faced with disaster, what would you do?

I think this consideration sums up the reason most of us have, or hope to have, some semblance of an emergency fund in place. ‘Disaster’ in this sense can take on many forms, be it from a broken down boiler to sudden job loss. The recent and ongoing fallout from the COVID-19 pandemic has definitely brought this fear into focus. Anecdotally, I have heard of people that have essentially lost their income overnight or taken such a significant cut that their usual cash flow now cannot pay the monthly bills in full.

Whilst the government in the UK is taking significant steps to protect households by paying 80% (up to £2,500) of salaries to furloughed workers, this scheme will not last forever and will be coming to an end in October under current plans. For someone that is furloughed and working in a sector that is far from stable at the moment, such as travel and tourism, this can definitely be a scary time. I’d also argue that this is definitely worthy of being called an emergency when you look at the timeline.

How quickly can the world fall apart?

If, by chance, you were an individual that decided “You know what, it’s time to sort my finances out” the day before COVID-19 was declared a global pandemic on March 11th, you’d have had just 10 days to get your act together before the entire country shut down on March 20th. I don’t know about you, but in those 10 days there is not a chance that I’d have been able to put even an additional penny aside as my pay day doesn’t come until the end of the month. To expect a nation to prepare for crisis at breakneck speed was an impossibility.

Nobody predicted this in such concrete terms, so to be in that situation described above is very unfortunate indeed. Nonetheless it goes to show that these black swan events really can blind side us and the case for some kind of emergency cushion certainly looks smart. Arguably yes, COVID-19 had its warning signs, but as always in life that’s ever so easy to say in retrospect yet nigh impossible to say as the situation is unfolding.

Emergency funds are more for the good times than the bad.

I’ve gone into what exactly an emergency fund is before, but to summarise, an emergency fund does more or less what it says on the tin: it is a fund for emergencies. Ironically, an established emergency fund will actually be present through more good times in your life than bad times – this is where the need to optimise starts to burn into the very soul of many investors such as myself.

Consider someone following the standard protocol of saving 6 months’ worth of expenses into a savings account and calling this an emergency fund. As noted, this would be something in the region of £12,600. That takes a long time to accrue even for the most diligent savers and it can be an even longer time before it is actually required, if at all. COVID-19 notwithstanding, when was your last real emergency that you needed to pull savings to pay for? Beyond that, how much did you actually spend? Unless you had a real disaster, it is unlikely you had to blow five figures in one go and need the full whack available in 10 minutes via instant bank transfer.

And so the optimisers begin to wonder…

When the global economy is chugging along just fine and our lives are rosy, it can be really tough to see that £12,000 languishing in a cash account. It will likely be earning something in the region of 1% or less, yet if this was to be invested entirely in the global stock market you could reasonably expect up to 5x more than this on average. Even a single year of this performance difference can be tempting enough. A 1% return on £12,000 is £120, whereas a 5% return would give you a cool £600.

In the shoes of an optimiser, this can be really hard to stomach. As the years tick by and the sun is shining, the difference becomes even more drastic ode to compounding returns.

If you’re lucky enough to dodge the need to draw on your emergency fund for a full 5 years, the nominal spread is stark. Your 1% cash balance would have grown to about £12,600. Meanwhile a £12,000 investment returning that 5% would come out closer to £15,300.

It’s not hard to begin to consider the hypotheticals when looking at these kind of numbers.

If at the end of year 5 you needed to replace your boiler at a cost of £2,000, how much would you have left? Well if you’d have stuck with the traditional cash cushion, you’d now be down to £10,600. If you’d have gone for the investment, you’d be left with £13,300!

Sadly, the stock market doesn’t always do what we expect.

As fun as averages might be to model and as easy as it is to stare at some numbers to fool ourselves, the fact is the global stock market is not a beast to be toyed with in the near-term.

Cherry picking perfect scenarios, as we have just done, can seemingly allow us to justify taking significant risk without any of the downside. Perhaps it would be wise to also model downside risk, then?

The draw to cash is that it is consistent and highly liquid. You know your £12,000 in a 0% savings account will always be £12,000. Monetary inflation will of course erode the purchasing power of this over the years, but the nominal value will always read £12,000. As long as your problem costs less than £12,000 you will always have the ability to pay it off.

The draw to investment is also clear, liquidity and consistency is sacrificed for the possibility of greater returns. It can take up to a week in normal market conditions to settle a trade and get cash transferred from a brokerage to your bank account. The volatility of investments means that the daily, weekly and yearly value will fluctuate and the swings can be dramatic.

Taking our scenario once again of a global stock market investment vs a savings account, we can model a few different hypotheticals, assuming no withdrawals or additions.

For the cash account it is simple, on a 1% yielding account we have a starting balance of £12,000 and an ending balance of £12,600 after 5 years, no matter what the stock market or economy does.

For the investment, things can go drastically differently, so much so that it is practically impossible to conceive every reality. Consider that every single day the global stock market can go up, down or rarely stay exactly flat. Then consider that the stock market can rise or fall by any number of percentage points. Even if we gave an arbitrary ceiling and floor of +/-20% and round to two decimal places, there are an almost limitless number of things that could happen. The market could rise 1.23%, fall 4.34%, rise 8.34% or maybe fall 3.21%. For 5 years’ worth of daily calculations.

The only reasonable way to model this then is to use past returns to give us an idea of what happened historically and to remember this may not happen in the future.

Using Vanguard’s cheat sheet we can get a quick idea of some numbers:

  • The worst yearly performance the US stock market has ever seen was -43.1%.
  • The best yearly performance the US stock market has ever seen was +54.2%.
  • The average yearly performance for the US stock market over 90ish years was +10.1%.

I’ve spoken about the global stock market as that is my investment of choice and the US makes up about 50% of that at the moment so is a solid starting point.

Armed with some numbers, we can now consider some hypotheticals and decide how reasonable they are. The worst returns are not always isolated incidents. In 1987 the US market fell by 11% on 19th of October, another 9% the next day on the 20th of October and another 9% still on the 26th of October.

Similarly the best gains are not isolated events. 2020 has seen three of the historically largest gains in quick succession, a 9% gain on 13th of March, an 11% gain on 24th of March and a 7.7% gain on the 6th of April.

Using these data to model thousands of scenarios sounds incredibly tedious, but thankfully the work has already been done for us. Portfolio visualiser has a built in Monte Carlo simulation tool that will crunch the numbers for us. Setting the simulation so that no withdrawals are made, inflation is ignored and our portfolio is 50% US Stock Market and 50% Global ex-US Stock market we can get some real, historical numbers and a fancy graph. These data are of course in dollars, but this is all an estimation game anyway, so I wouldn’t dwell too much on that.

Year10th Percentile25th Percentile50th Percentile75th Percentile90th Percentile
Monte Carlo results for year end balances on an investment of 100% equity.
Monte Carlo simulation results for a portfolio consisting of 50% Global-ex US equity and 50% US equity.

What does this tell us? It looks like good news for the investing approach at first glance, that’s for sure. Each percentile corresponds to the value below which that % of the observations are found. So the 10th percentile shows the values you’d expect 10% of the time, the 50th percentile is what you’d expect 50% of the time and the 90th percentile contains all the results you’d expect 90% of the time not that this has a 90% chance of occurring.

In simple terms, historically speaking there is a 10% chance that your portfolio will be worth £11,000 or less on average after 5 years. In the table above I’ve listed what I believe to be the key years to consider, the first year, second year and final year. Let’s be real here, if you’re going to have an emergency, it’s going to end up being right at the start when it’s most inconvenient or you’re going to have no issues at all and sail right on through.

All is not as it seems. Don’t be wooed by the averages.

Using historical, averaged data does indeed paint a rosy picture for investment, so let’s sprinkle a dose of reality onto these numbers and get away from this average nonsense. We observed that the worst ever drop the US market saw was -43%. The US makes up about 50% of the numbers we generated, so a single day drop of 43% would be halved in its effect to just about 22%.

N.B This is assuming that only the US market drops and the rest of the world happens to stay flat. The saying “when the US sneezes the rest of the world catches a cold” tends to ring true, but again this is all estimated hypotheticals so we will continue with the assumption that the drop will be 22% overall.

We are talking about an emergency fund after all and when do we usually need to access our emergency funds? When bad luck strikes. Ode to Murphy’s law I think it is only reasonable to bring these numbers into focus by shaving off the potential 22% loss at each point to see what situation we would be in.

The biggest fear people tend to have when investing their emergency fund is that they’ll need to withdraw from it when the markets are down, so we should plan for this eventuality.

Year10th Percentile25th Percentile50th Percentile75th Percentile90th Percentile
Monte Carlo results for year end balances on an investment of 100% equity, with a 22% decline of each balance.

After crunching the numbers we come out with a pretty mixed bag.

If we need access to our invested emergency fund at the end of year one and the markets are down, in 90% of circumstances we will already be operating at a loss.

If we need to access our invested emergency fund at the end of year two and the markets are down, 50% of the time we will have less than £12,000 available for withdrawal.

Of course as we get into year 5 the averages do start to work in our favour, but citing Murphy’s Law once again imagine how utterly deflated you’d feel to have had a disaster occur and log into your account and see the balance at a paltry £8,500 when you could have had just about £4,000 more if you’d have just left it alone in a savings account rather than bothering with investing at all.

Mental accounting vs the optimisers, a war of attrition.

I’ve addressed mental accounting at length in the past, the phenomenon whereby we humans tend to bucket our finances to the possible detriment of our entire portfolio. But for some people, dividing their emergency fund and the rest of the portfolio is vital to their individual success. This non-optimal approach can therefore, rather oddly, be more optimal if it increases individual comfort and happiness. After all, how much value do we put on the ability to sleep soundly at night? It’s a hard value to define for sure.

Bucketing as a tactic is also very simple. At its core, an individual using the bucketing approach can carve their assets into two buckets: a specific emergency fund and an investment portfolio. The individual chooses a value for their emergency fund using whatever metric they please and once that value is attained, they drive all new capital into the investment portfolio.

Keep it simple, stupid.

To follow this approach through, we could therefore use a blend of equity and fixed income as our emergency fund bucket, choosing a product that keeps things simple. One such product series that I have covered before is the LifeStrategy series of funds. I think these make fantastic investment vehicles for a variety of reasons and LifeStrategy 20, or any 20% Equity fund, might just be the ideal choice for someone that likes the bucketing approach.

LifeStrategy 20, or LS20, invests 80% of its funds in fixed income and cash with a 20% stock market exposure. Running a Monte Carlo simulation against this product is very difficult to accurately portray as the composition is complex and UK based, but we can approximate this with the following inputs:

  • 10% Global Stock Market
  • 10% US Stock Market
  • 80% Global Bonds Hedged

This historically yielded:

Year10th Percentile25th Percentile50th Percentile75th Percentile90th Percentile
Monte Carlo results for year end balances on an investment of 20% equity, 80% global bonds.
Monte Carlo simulation results for a portfolio consisting of 10% Global-ex US equity, 10% US equity and 80% global bonds.

This time when the stock market falls our LS20 fund will only see a 5% decline as it has far less stock weight. Readjusting our numbers gives us the following:

Year10th Percentile25th Percentile50th Percentile75th Percentile90th Percentile
Monte Carlo results for year end balances on an investment of 20% equity, 80% global bonds, with a 5% decline of each balance.

Now that definitely looks a lot more reliable compared with the 100% equity investment option.

The emergency fund only falls below £12,000 in very few scenarios. In the worst case we are £700 down opposed to the £4,000 noted in the previous example. But by taking on a small equity risk premium, we also have a good chance at netting some very nice returns. Remember that we said by year 5 we would expect cash only to have returned £12,600? The 5 year values here are very promising, with the 50th percentile being over £1,000 up compared to this.

Digesting it all.

There is certainly a lot to think about, but if you’re the type of person that feels the need to bucket your finances, bucketing in this fashion could prove a very lucrative tactic. It’s simple, very easy to implement and the math demonstrates that there is significantly more upside than down.

As humans we have pesky emotions and feelings. For some people seeing two separate pots in their ISA is vital to their well-being and allows them to take the step into the world of investing. If you’re that type of person, better you take this approach than never begin your journey at all.

5 thoughts on “An analysis: how to optimise the traditional emergency fund

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