tl;dr

• This is a follow up to my previous emergency fund post, based on feedback from my coworkers.
• I think emergency funds are good and should be the default option for most people, but I think they create an avoidable opportunity cost for me (and potentially some of my target audience). Even if emergency funds are suboptimal for you, there are still plenty of great reasons to have one, like peace of mind or removing pressure to take a bad job.
• There were many suggestions and criticisms on my previous post, covering dealing with market crashes and employment loss concurrently, which assets to sell, current interest rates, compounding losses, and plenty more. If something in my previous post felt off to you, see if it’s addressed in the “Criticisms” section below.

Introduction

I recently shared a copy of my previous emergency fund post with some coworkers, and it led to a lot of discussion. This post (and Part 3 where I model out a number of scenarios), is my attempt to address some of the points that came up. While it’s not strictly required to read the first post to understand this one, I would recommend it to have the full context.

More Reasons to Have an Emergency Fund

In my original post I said:

Emergency funds are a commonly recommended financial tool, and they’re generally a good idea for most people

Hopefully it’s clear that I’m not anti-emergency fund. I don’t have one, but I think they make a lot of sense for a lot of people. I heard some additional compelling reasons to have an emergency fund in the discussion on my previous post. I think these reasons are compelling even if my previous post was applicable to you (if that post wasn’t applicable to you, I hope it’s already clear I think you should have an emergency fund):

• Peace of Mind: Life isn’t just a game of min-maxing dollars. For most of us, money and finances are a tool to allow us to enjoy life, not an end in and of itself. Having an emergency fund can give you day-to-day peace of mind. If the worst happens and you do need to use it, it can also provide a ton of in-the-moment peace of mind when dealing with super stressful situations like the loss of employment. I can’t value peace of mind, but I think it’s worth a lot. If not having an emergency fund will affect your peace of mind, you should probably have one.
  • The way I have day-to-day peace of mind without am emergency fund is by having done the math to convince myself that it’s an acceptable choice for me (check out Part 3 for some of the scenarios I’ve run). I can’t know for sure if it will affect my peace of mind during an emergency, but I hope having a clear plan for what I’d do in an emergency (ie. what I described in the prior post) will give me peace of mind if an emergency does happen.
• Not Having to Take the First Available Job: Someone who is laid off without an emergency fund might feel pressure to take the first job offer they get. Taking that offer might mean they are settling for a less optimal job (pay, work-life balance, or something else) than they could have found if they had searched for longer. Emergency funds could give some the confidence they need to spend longer on a job hunt vs if they didn’t have an emergency fund, resulting in a better job. I have a ton of sympathy for engineering one’s own finances to force oneself into making a better decision. For example, I don’t use an HSA (a great financial investment tool) because I don’t what to create incentives for myself to save money by not getting healthcare¹.
  • Luckily, I have confidence that lacking an emergency fund wouldn’t pressure me to take a pay cut just to get another job quickly. I actually took a package from my employer in Spring of 2023, and turned down a number of sub-optimal options before finally accepting a new offer.
• Mitigating Being Bad with Money: Not everyone is great at managing their personal finances. Some people might not be able to juggle all the balls needed to access money during an emergency without making a costly mistake. If that’s you, you should probably just have an emergency fund.

Criticisms

In this section, I’ll address a few common criticisms of my plan that came up repeatedly.

“When it Rains, it Pours;” the market will crash, you’ll lose your Pledged Asset Line (PAL), and you’ll be laid off

The single biggest complaint from readers was:

There have been times like the Global Financial Crisis (GFC) where the S&P 500 has tanked 56%, banks cut lending (including closing PALs and other revolving credit lines), and millions of people lost their jobs. All of that could happen to you, at the same time.

The GFC shows how what seems like three separate events (market crash, PAL closure, and job loss) can be correlated and thus must be considered as a real possibility in one’s plans. If this happened to me, my only option would be to sell stock at a market low to cover my emergency expenses.

I have one major and one medium concern about this scenario, and some answers to them:

1. Would this bankrupt me? To avoid being bankrupted in our GFC-like scenario, the value of my sellable assets would need to be greater than my expenses during my period of unemployment. And this needs to be true after the market has dropped. Given that 56% is the largest drop the S&P 500 has ever seen, let’s assume my assets dropped by that much. That assumption means I would need $2.27 of pre-drop stock for each $1.00 I wanted to be able to access in an emergency. I have enough stock in my taxable accounts to cover a few years of emergency expenses, even without dipping into retirement accounts, so I’m not worried about going bankrupt.
   
   Technically if my unemployment went on for years, it is possible that I could eventually be bankrupted. An emergency fund wouldn’t save me in that scenario, however, because they typically only cover a few months worth of expenses, not years.
2. Would this scenario turn the Expected Value (EV) of my plans negative? Even if this confluence of events wouldn’t bankrupt me, I’d almost certainly still end up with less money than if I’d had an emergency fund (I confirm this guess with hard numbers in Part 3). So the key question is: is the loss in this scenario big enough that it outweighs the gains in the scenarios where things don’t go as bad? The reality is that the likelihood of each scenario is impossible to predict, so I am making a gamble and assuming that the EV remains positive. Risk and reward are generally correlated in investing, and this is a risk I’m willing to take. It makes complete sense if you don’t want to take this risk though!

The Bond Portion of Your Portfolio is an Emergency Fund

Yes! If you do something like a Bogleheads 3 Fund Portfolio, you probably have some bonds in your portfolio that won’t likely be as hard hit during a market crash (though they could be). Odds are that if you’re forced to sell investments during an emergency that coincides with a market crash, selling those bond funds would result in a lot lower losses. Check out Part 3 where I model this exact scenario.

Current 5% Interest Rates Make Emergency Funds Make Sense

I absolutely would prefer to be making 5% on my emergency fund than the near-zero rates we saw until recently. But it’s still not enough to change my mind:

1. 5% is still less than 9.9%: The 5% I can earn in interest is still less than I expect to earn investing in stocks (eg. the S&P has historically returned 9.9% annually). Higher interest rates absolutely do lower the opportunity costs of having an emergency fund, but they don’t eliminate it unless they surpass stock returns.
2. 5% might not be here to stay: My plans here are on the scale of decades, and while we’re seeing 5% rates now, I’m not going to bank on them lasting for the long term. There is already plenty of speculation that the Fed will be cutting rates soon, which would drive down safe returns nearly everywhere.

Check out Part 3 where I provide a spreadsheet you can use to model the impact of different interest rates and stock returns on emergency fund opportunity costs.

Selling at a Market Low Means You’ll Lock in Losses and Miss the Rally

Yes, if I had to sell stocks to cover an emergency, and I did so after a market crash, I would miss out on any rebound that was likely to happen.

It’s hard to put a dollar value on that missed investment. Using the 9.9% average return of the S&P 500², having $1,000 less invested today means you would have $1,099 less next year or $12,582,566 less in 100 years. Even putting everything in terms of today’s dollars, the loss is unbounded and only grows with time (assuming you accept that stocks have returns that are higher than inflation over the long run). Note that this logic applies to any time you’re out of the market, not just at the bottom of a crash. Any time you miss out on some stock growth, that opportunity cost compounds over time.

The same logic, however, also applies to the profits from not having an emergency fund. So my perhaps unsatisfying conclusion here is: If you think the EV of not having an emergency fund is positive, that profit will compound. If you think it’s negative, that loss will compound. Obviously only do this if you expect a profit.

An important note here is that while having an emergency fund lets you keep your money in the market while it’s at a low, reconstituting it after the emergency prevents you from investing more money at that market low. If the market stayed at the same low point long enough for you to save enough to reconstitute your emergency fund / stock investments, you’d actually break even (ignoring some deviation due to dividends on your stock vs interest on your emergency fund). While markets don’t usually stay at the exact same value for that long, they can be slow to recover after a crash. For example, after the Global Financial Crisis the S&P didn’t return to it’s 2007 highs until 2013.

Debt Compounds, so You’ll End Up with Huge Losses when Relying on a PAL

Over long periods of time, and high interest rates, this is a real risk. But the income I earn, relative to my expenses, mean I could pretty quickly pay down any debt I took on once I got a new job. Right now I’d expect to pay around 9.47% to take money out of my PAL³. So even if I relied on my PAL for a whole year, my debt would only increase 9.47%. If interest rates were dramatically higher, or if my new job was a massive pay cut, it is possible debt might lead to higher losses. I show how much PAL interest I’d have to pay in different scenarios in Part 3.

“The Juice isn’t Worth the Squeeze”

Many commenters thought that my plans were a lot of work, and amounted to a micro-optimization that wasn’t worthwhile. For context, here is the work required:

1. Setting up a PAL: I did this anyway when buying my apartment, so it was no additional work. But if you don’t already have one, you can set one up with your existing brokerage in an hour or so. I’d recommend having one (or something similar like a HELOC) regardless of whether you have an emergency fund; there are many scenarios where being able to access cash without selling stocks is helpful.
2. Doing the Math: I have spent probably two dozen hours on this series of posts. But that’s mostly post-writing and spreadsheet making. When originally deciding to not have an emergency fund, I probably spent an hour or so doing the back of the envelope math to convince myself.
3. Coordinating Spend During an Emergency: Taking money out of a PAL is just as easy as taking money out of a checking account. But the more complex approach I laid out in my previous post (using checking account + credit cards + PAL) definitely does take a bit of accounting. I’d guess it’d be on the order of half an hour / week just checking in on my finances and moving money around.

So we’re looking at potentially a few hours of work, for thousands of dollars in returns (continuing for as long as I don’t have an emergency fund). To me, this is worthwhile. But personal finance is also a hobby for me; I enjoy micro-optimizing. If it’s like pulling teeth for you, it’s OK to opt out. This isn’t a big make-or-break financial move you have to do to be able to retire. It is a micro-optimization.

This is Like Not Having Health Insurance

I use insurance to take unlimited potential losses (ie. those that could bankrupt me) and put an upper bound on them. I don’t get medical insurance to save me a few hundred bucks on an annual checkup, I get it to cover the millions of dollars I might have to pay for treatment if I had cancer. Emergency funds, however, are almost the exact opposite. They prevent some initial losses, but additional losses are entirely unbounded after the fund runs out. So I’d say at most this is more like picking a health plan with a higher deductible and lower premiums, gambling that I won’t need much healthcare and will save overall.

I Know Somebody Who Was / Would Have Been Ruined by not Having an Emergency Fund

I’m sorry to hear that. I hope it’s clear that I support emergency funds in most cases. If you are in a case where not having an emergency fund would leave you ruined after an emergency, you absolutely should have an emergency fund. Emergency funds should be the default, not having one should only be done after doing the analysis to make sure you’ll be OK without one.

Emergency Funds can be “Dry Powder” to Invest During a Market Downturn

I have two issues with this idea:

1. This violates the purpose of emergency funds: Emergency funds are for emergencies, not investment opportunities. If you need your emergency fund for emergencies, you shouldn’t be risking it in the market. What if you used it for dry powder today, the market dropped 50% tomorrow, and then you had an emergency? If you’re in good enough shape financially that you’d be fine in that scenario, see point two…
2. This requires market timing: Generally, time in the market beats timing the market. If you have money you can invest, you are probably better off investing it now rather than holding onto it for some indeterminate date in the future when you think it’ll be a better investment opportunity. Remember that the whole time you’re holding your emergency fund as “dry powder,” you’re paying an opportunity cost.

If the Market is Up, Selling Stocks Beats Paying Interest on a PAL

There are a few reasons I’d like to avoid selling my assets:

1. Market Returns are Uneven: Missing the 10 best days in the market would halve your returns over 30 years. I’d rather keep my money invested and not risk pulling it out on the wrong day.
2. Taxes: If I need money at a time when the market is up, I’d have to pay capital gains on the stocks that I sold.

These reasons, combined with the fact that the PAL interest doesn’t add up to that much (I show exact numbers for this in Part 3) over the time span I want to access it, makes me prefer using my PAL over selling stocks.

Part 3: Modeling the Scenarios

I referenced Part 3 throughout this post. It models out a mix of scenarios (small emergencies where I can rely on credit instruments like a PAL or HELOC to get me through, and bigger emergencies where everything goes wrong), along with a mix of investments (S&P 500, Bogleheads 3 Fund Portfolio). It really compliments this post (they were originally one post, before it got too big), so I’d encourage you to read it next.

1. The problem with having an HSA + HDHP is it creates an incentive to delay or avoid seeking out health care. Yes, my employer’s contributions to my HSA would cover my deductible if I go to the doctor, but I get to keep those contributions whether or not I go to the doctor. So I make money by not going to the doctor, and lose money by going. I know myself, and I don’t want that kind of financial incentive to avoid getting the care I may need. ↩︎
2. Note that this is a bit of an under estimate because the rate of return post-crash would be higher than the overall average rate of return. It doesn’t really matter for this example, however, because the point is just that the opportunity cost of a loss is effectively unbounded. ↩︎
3. Many banks set their rates relative to a Safe Overnight Financing Rate (SOFR), which is 5.34% as of 2024-07-11. For example, for small loans Schwab sets their rate at SOFR + 4.4%. This gives us the 9.47% number. ↩︎