Emergency Fund: How to Systematically Increase your Cash Return
“Cash is king”
As the old saying goes - but in the world of investments:
Cash is trash.
Adjusted for inflation, cash has a negative rate of return.
But this isn’t to say you shouldn’t keep cash on the sideline in the case of an emergency.
In the event of an emergency, I’d argue your excess cash has a positive psychological and risk-adjusted return (not to mention peace of mind).
Meaning:
Planning isn’t always about maximizing return, rather, minimizing risk.
If life throws expenses that amount to 10% of your gross income in one month or you lose your job, could you foot the bill?
If you couldn’t cover it, where would you go to cover the expense?
Investment accounts? Credit cards? Personal loan?
None of the above options are as good as pulling from you cash reserves.
It’s easy to want to spend (or invest) all your money, it’s hard to tame desire and keep cash on the sidelines for what may come.
How much cash should you keep on hand?
While I tend to be stubborn about accepting the norm, I think general financial planning principles got this one right:
3 months of living expenses for dual income, multi-member households or single individuals
6 months of living expenses for single income multi-member households
But as with most rules, they’re not law, so if you want a little more or less, that’s what makes personal finance, personal.
If you find yourself doubling these rules of thumb, you’re likely losing purchasing power on your dollars long term & hurting your financial situation (if not a part of some larger financial goal - like buying a house).
So where do you hold your cash for the best return?
Odd question because you’d imagine the expected return on cash is low.
And, you’re correct - it is.
But that doesn’t mean there isn’t any additional return to be had from placing your cash in the best spot for the highest expected cash return.
If you’re a dual household with $15k/mo in living expenses, this would place your emergency fund need at $45,000.
So where do you put this $45,000?
I like to recommend the following system:
1 month of emergency fund in your checking account
Remainder in a money market account
I prefer a money market over a Certificate of Deposit (CD) due to the liquidity of the money market (& there isn’t a penalty of interest if redeemed early).
But this shouldn’t just be any money market account - you want to make sure the rate you’re receiving on your money market is competitive.
By competitive, I mean within ~10% of the 30-day Treasury Bill Return (HERE).
Today, 30-day Treasury Bills are yielding 5.51%, so this tells me I should be generating ~4.96% on my market account.
I personally like Vanguard’s list of money market funds, they remain very competitive.
Looks like VMRXX is offering the highest rate of return is 5.29% - not bad (as of 9/3/2023).
Keeping cash in a money market that isn’t paying much interest is one mistake I see made frequently.
Not all money markets are created equal.
Your bank likely offers a money market deposit account, which may be marginally more appealing than a checking or savings account but that rate of return is likely far less attractive than a money market available on the open market.
Money market funds are the plumbing of the financial system but are frequently not talked about enough.
Money market returns are generated from the very short-term debt of financial assets - many times this is commercial paper, treasuries, corporate bonds, or repurchase agreements through collateralized borrowing/lending (mortgage backed securities).
Money market fund managers try to keep their fund NAV or net asset value at $1 (NAV is the company’s total assets minus total liabilities) using special pricing and valuations conventions.
If you’re invested in your bank’s market market deposit account, you’re gaining access to FDIC insurance but it’s not traded like a fund - it’s just held in a deposit account at the bank.
Bank money market account yields are generated the same way as your checking and savings account interest rate is generated (lending out your cash to credit worthy borrowers).
Publicly traded money market accounts are backed by the underlying financial assets that they’re made up of and interest is generated from the owned financial assets.
So if your bank can offer a competitive return on their money market deposit account - great!
If not, look to the open market to get a better return.
In the case of having $45,000 of emergency funding, placing $30k inside a money market account is expected to generate $1,500/yr.
I’ve come across individuals who hold over $1,000,000 in cash that is sitting in a checking account - this presents an easy way to generate $50,000 in value through placing cash in the right place.
This system works like a conveyor belt:
When your emergency fund grows above what’s recommended, you’re in a position to increase your systematic savings to other accounts (or increasing spending can be an option if it fits within your plan).
While placing your cash in the right account at the right time isn’t a retirement planning strategy I would rely on - it is a way to generate a couple extra thousand dollars per year which can add up over your lifetime.
If you never placed your money in a money market over your 70 year lifetime and you lost out on an average of 2% in cash return per year on $45,000 of cash, this is $134,000+ of interest income lost.
If you’re planning to be a centenarian, like myself, then this means you’re lifetime interest lost would be $281,000+.
Is a little additional work worth hundreds of thousands of dollars in lifetime value for you?