interesting paper on emergency funds

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interesting paper on emergency funds

Postby sometimesinvestor » Sun Sep 01, 2013 1:42 pm

its a little long but basically suggests that particularly younger investors should consider having some riskier assets in their emergency funds.

http://www.fpanet.org/journal/IsanAllCa ... propriate/
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Re: interesting paper on emergency funds

Postby stan1 » Sun Sep 01, 2013 1:48 pm

An "important note" in the limitation section:

It is important to note that the analyses presented in the paper do not apply to all households, but rather to more affluent clients of financial planners.


Wealthy people have more ability to take risk. Nothing new. Many people on this board have long considered their taxable investing accounts as assets that would be sold in the event of job loss or other financial hardship. Willingness is a different question.
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Re: interesting paper on emergency funds

Postby Best of Both Worlds » Sun Sep 01, 2013 1:56 pm

An EF to me has always meant having enough in reserves in the event of a job loss. I am willing to give up slightly higher returns for that comfort. I realize that in the long run, the funds earmarked for emergencies will increase enough where an investor can begin investing in equities. Until that time, the money should be invested as conservatively as possible.
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Re: interesting paper on emergency funds

Postby nisiprius » Sun Sep 01, 2013 2:22 pm

Where's the data on the emergencies themselves? Everyone collects ultraprecise data on the performance of financial assets...

"Data from Shiller (2013) was used to measure stock (S&P 500) returns,
while Ibbotson Associates (2011) data, obtained from Morningstar, were used for the bond returns (long-term Treasuries)..."

...and then shrugs and uses anecdotes and handwaving guesses about the contingencies those assets are supposed to meet.

As nearly as I can tell, unemployment is the only specific income shock they collected data on, and they don't use data on expense shocks at all.

It is true that "Rising unemployment necessitates having an emergency fund in place (Bureau of Labor Statistics 2011)" and yet unemployment is one of the few expense shocks against which many workers are automatically insured. Other income and expense shocks may be less common, but also be exactly the ones for which an emergency reserve is needed.

"Unemployment data was also obtained from the U.S. Bureau of Labor statistics (2011).
The time period for the return measures was 1926 through 2011,
whereas unemployment data ranged from 1948 through 2011."

Well, what's wrong with this picture?

"Emergencies may not happen as frequently as imagined....

...Well, yeah, if you assume that 1929-1940 was a figment of the imagination, than unemployment emergencies may not happen as frequently as "imagined."

It's not like this data is impossible to find, you know:
Image
And it's Wikipedia, and it cites its sources. (What's particularly odd is that Wikipedia says it was able to find BLS data back to 1940, yet Scott & al. see fit to go back only to 1948).

"...which means there may be an opportunity cost associated with holding too much cash."

Shouldn't the consequences of not being able to meet an emergency be assessed? Where in this paper do we see the consequences being assessed? I see "consequences of unqualified withdrawals from tax-advantaged accounts," I see "consequences of asset location for all goals," I don't see "consequences of not being able to meet an emergency."

"A noted problem with relying on borrowing in times of financial distress is that even previously established and collateralized credit lines may be called in times of broad economic uncertainty." The thing that really happened becomes a hypothetical. Why do they say "may" when it was a "were?"

"There may be an opportunity cost associated with holding too much cash." Of course. But so what? There is a cost in building the Brooklyn Bridge with cables six times strong as needed, but Roebling was glad he had when he discovered that a dishonest contractor had supplied cables that were weaker than they were supposed to be. There is a cost to building an airliner whose wings can bend this far without breaking. There is always a cost to safety, and you can always pocket more if you cut out the safety.

Image
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Re: interesting paper on emergency funds

Postby grabiner » Sun Sep 01, 2013 4:07 pm

stan1 wrote:An "important note" in the limitation section:

It is important to note that the analyses presented in the paper do not apply to all households, but rather to more affluent clients of financial planners.


Wealthy people have more ability to take risk. Nothing new. Many people on this board have long considered their taxable investing accounts as assets that would be sold in the event of job loss or other financial hardship. Willingness is a different question.


In particular, investors with only tax-deferred retirement savings should have an emergency fund outside the retirement accounts; yes, this gives up some tax benefit, but it reduces the risk of having to pay an IRS penalty to replace a roof.

In theory, it would be reasonable to place an emergency fund in long-term municipal bonds as long as it is slightly larger than necessary; yes, municipal bonds can lose money, but the risk of losses in the bond market is essentially independent of the risk of a need for emergency cash. And long-term municipal bonds are close to being part of an efficient portfolio for investors with both taxable and tax-deferred accounts. (It may be slightly better to hold bonds in a retirement account and stocks in taxable, but there isn't much loss, and munis in taxable may even be better with some tax situations and 401(k) options.)

But in practice, I wouldn't recommend this because of psychological issues; you need to have money which is indepenent from your retirement funds so that you can save for retirement with the confidence that you won't need to touch that money (and thus not worry about the risks).
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Re: interesting paper on emergency funds

Postby nedsaid » Sun Sep 01, 2013 4:59 pm

Good old fashioned money in the bank is good for all households. FDIC insurance means that the funds up to the insured limits are safe. The main reason people might chafe at having 3-6 months of expenses in the bank is the fact that interest rates on bank deposits are lower than inflation. Still people need access to cash in an emergency. The alternatives to bank deposits carry more risk.

I hate to see articles encouraging people to put their emergency reserves into riskier assets. Murphy's law pretty much guarantees that emergencies will strike when asset values are depressed. In my book, it takes a lot of cash to have "too much cash." Particularly if you are a homeowner raising children, it is hard for me to see how one could have too much cash. Cars and Houses need expensive repair and maintenance and kids (and us adults too) have a habit of breaking things. For example, replacing a roof can be thousands of dollars. Car repairs are often several hundred dollars.

So emergency funds need to be safe and they need to be liquid. One could make a case that emergency funds over six months could be in a bit riskier assets.

In practice, I tapped my emergency cash only once. I took funds out for a trip to Japan but I had it all repaid in less than six months. I have treated these funds almost as something sacred. If something breaks that needs to be fixed, I have either tapped my credit line or paid out of cash flow. I see those funds like the fire alarm behind the glass. "Break glass only in emergency." A true emergency would be needing the funds for shelter, food, and utility bills. Or maybe an extraordinary situation that would require legal or medical bills to be paid.

My emergency funds are money in the bank, a money market fund, and savings bonds. These are to me what Linus' security blanket is to him. It is a feeling of security that allows me to be more aggressive in my retirement investing. It is a good feeling that it is unlikely that I would incur tax penalties for accessing my retirement accounts early.

Too many people live right on the edge financially and seem to have a cavalier attitude towards money. I see the careless attitude often among those who are economically disadvantaged and most need to watch and manage their limited resources. (That was a huge surprise to me). Too many TV commercials that keep us dissatified with what we have. We have a culture of spending and not of thrift. We all need a cushion in our finances but that runs across the grain of our spendthrift and "need it now" culture. People often hate the discipline that it takes.

So I have a pretty careful attitude when it comes to emergency cash. You may not agree, but that is just me.
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Re: interesting paper on emergency funds

Postby freebeer » Sun Sep 01, 2013 7:45 pm

nedsaid wrote:...if you are a homeowner raising children, it is hard for me to see how one could have too much cash. Cars and Houses need expensive repair and maintenance and kids (and us adults too) have a habit of breaking things. For example, replacing a roof can be thousands of dollars. Car repairs are often several hundred dollars....


I really don't understand what people think is magical about parking money in round-to-zero return bank accounts vs. holding in taxable brokerage accounts at someplace such as VG. Neither is literally "cash". And, FDIC guarantee isn't an "emergency access" liquidity consideration, it's insurance against loss. It's true that there's a couple days delay between selling a VG fund and when it appears in my bank account but it's a rare expense for which that delay has been an issue, and to me getting paid interest is worth the hypothetical inconveninece: I have never had to replace a roof on 24 hours notice, and car repairs are paid for after completion. DW does like to keep more in our checking account than I think is wise - but it's not because of any kind of "emergency" considerations, it's simply the "convenience" of being able to pay even large bills without bothering to check the balance first.
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Re: interesting paper on emergency funds

Postby nedsaid » Sun Sep 01, 2013 8:56 pm

There is nothing "magical" about money in the bank other than it is easily withdrawn and insured from bank insolvency by the FDIC. Other investments do not have that protection.

Using Vanguard to stash emergency cash is just fine. Short term bond funds would work just as well though the principal fluctuates a little bit. I have part of my emergency funds at a mutual fund money market.

I have addressed best I can the problem of low interest rates by using US Savings Bonds as part of my emergency funds. I have been buying I Bonds since 2008. I do realize that money in the bank makes almost nothing.

I am not sure there is much if any disagreement. You would rather have your emergency stash at Vanguard than in a bank. That is just fine and works for you. Best wishes.
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Re: interesting paper on emergency funds

Postby IlliniDave » Mon Sep 02, 2013 5:35 am

I have mine sort of tiered. I keep a year's worth of survival expenses (about 80% of my "normal" expenses) total, with a little over 3 month's worth in a bank savings account, and 9 months' worth in short-term bonds at Vanguard.

I've been thinking about Dr. Bernstein's recommendations in the "Shallow and Deep Risk" thread. http://www.bogleheads.org/forum/viewtopic.php?f=10&t=120512

I fall well short of the cash hoard sanity threshold he proposes (minimum of 5 years living expenses or 25% of portfolio in cash/short-term bonds). All of my "investment" bonds are intermediate-term.
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Re: interesting paper on emergency funds

Postby freebeer » Mon Sep 02, 2013 12:41 pm

nedsaid wrote:...
Using Vanguard to stash emergency cash is just fine. Short term bond funds would work just as well though the principal fluctuates a little bit. I have part of my emergency funds at a mutual fund money market.


Got it, I just misunderstood what you meant by "cash" (I don't necessarily think of short term bond funds or other assets at VG as "cash" and so thought you were arguing for keeping money just in regular bank accounts).
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Re: interesting paper on emergency funds

Postby stemikger » Mon Sep 02, 2013 12:44 pm

There is another thread started by Justus that is almost identical. Here it is below.

justus wrote:I recently came across this entry on betterment's site. What do you think? Should you invest your emergency fund in 40% stocks?

https://www.betterment.com/blog/2013/08 ... -is-wrong/
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Re: interesting paper on emergency funds

Postby Rick Ferri » Mon Sep 02, 2013 1:14 pm

My view on emergency money parallels the way a corporate finance department would look at it (I used to teach corporate finance at a local college). I see the need to divide emergency funds into two parts: "immediate" liquid assets that are held in cash like investments and "permanent" liquid assets that can be invested more aggressively.

There are times I've dipped into my emergency savings, but I never depleted them, and always brought the total back up to my 12-month living expense target. I realized that I rarely dipped into our emergency money, and if I held only half of this money in very liquid cash assets that is was probably enough.

Starting about 5-years ago, I split the permanent liquid asset half of my emergency fund into an intermediate-term municipal bond fund and total stock market index fund. My idea was to be more aggressive with these permanent liquid assets so that my total emergency fund would have the chance to outperform inflation and taxes. That has happened.

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Re: interesting paper on emergency funds

Postby FL_TrailRunner » Sat Feb 01, 2014 7:21 pm

Rick Ferri wrote:
Starting about 5-years ago, I split the permanent liquid asset half of my emergency fund into an intermediate-term municipal bond fund and total stock market index fund. My idea was to be more aggressive with these permanent liquid assets so that my total emergency fund would have the chance to outperform inflation and taxes. That has happened.

Rick Ferri


Mr. Ferri,
I read and followed your Asset Allocation book about 4 years ago, and received some helpful suggestions when I posted here:
viewtopic.php?p=954763
I followed the Early Saver model and rebalanced annually. Before re-balancing last week, I re-read parts of your book and some forum posts on areas where I needed clarification.

I also discovered the 2010 NYT article where you shared your portfolio's asset allocation:
viewtopic.php?f=10&t=58709
It was cool to see the explanations from you in that article and how they lined up with the AA book.... as well as your input here in this post. I had never considered structuring Emergency Funds like this.

If you have a chance, I just wanted to get some clarification for myself and others about the selection of fund(s) in the “immediate” and “permanent" portions of Emergency Funds. In the 2010 article, you mentioned using the Short-Term Bond Index ETF for general "emergency funds", and here, in 2013, you mention putting the "permanent" half in an Intermediate-Term Muni Bond fund and half in TSM.

Would it be correct to say that you use the Short-Term Bond Index ETF for the “immediate” liquid assets? And, the other two funds for the “permanent” half?

Currently, all my emergency funds are held in online savings account earning .75%.

If I made a change, the funds would be held in a taxable account at Vanguard.

Even if you don't have a chance to respond, thank you for all of your contributions to the Bogleheads!
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Re: interesting paper on emergency funds

Postby Rick Ferri » Mon Feb 03, 2014 11:37 am

Would it be correct to say that you use the Short-Term Bond Index ETF for the “immediate” liquid assets? And, the other two funds for the “permanent” half?


My goal in posting was to point out that emergency money doesn't ALL need to be in a money market fund. I believe the level of risk that each person is willing to take matters. I'm fine with a short-term bond fund for immediate liquidity while others may prefer a money market fund. With the permanent half, I am willing to take more risk while others may opt for only and intermediate-term bond fund.

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Re: interesting paper on emergency funds

Postby EmergDoc » Mon Feb 03, 2014 12:19 pm

People with a big fat taxable account don't necessarily need a traditional emergency fund. It's like retirees- the whole kit and caboodle is the emergency fund.

A traditional emergency fund is $1000 in the bank (a la Dave Ramsey) or 3 months worth of expenses (perhaps $10K for a typical family). Nobody is suggesting any of that ought to be invested in stocks, or even bonds.

Now, if you're some nutty Boglehead with a 12 month or 6 figure emergency fund, then sure, put some of it into a more reasonable portfolio. But kind of like how Crossfitters say "your workout is my warmup", Bogleheads might say "Your portfolio is my emergency fund."

Personally, I've never really had a true 3 month emergency fund. It just seemed silly to miss out on a Roth IRA contribution for the year in order to put some cash in a bank account to do nothing. The question is- "How long could you live without an income?" That is now measured in years for me, perhaps decades if I were really frugal. How much of that needs to be accessible within a couple of days? Not nearly as much as is accessible. I'd love to be paid to give up some of my current liquidity.
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