In our last post on emergency funds, we looked at emergency funds at a very high level. We found that over the period 2003-2018 an emergency fund in the market returned more than an emergency fund in an offset account. But after tax, the offset account did better.
But a fair criticism of this type of analysis is that it looks at a single cohort. That is, one cohort that invested their funds at the beginning of 2003.
An improved approach would be to simulate how an emergency fund might work in the real world for a bunch of different cohorts. Then we can compare the performance of those cohorts and look for broad trends.
So in the post we take a closer look at emergency funds to understand when they’re better off in the market and when they’re better off in an offset account.
Emergency Fund Simulations
For these simulations, we assumed that we build up our emergency fund by depositing $1,000 every month. After 24 months, an emergency strikes and we need all $24,000 of our principle back.
To be consistent with the last post, we assumed that an emergency fund invested in the market would be allocated 50/50 to an Australian stocks ETF and U.S. stocks ETF. And an emergency fund left in an offset account would reflect the RBA’s average standard variable rate for owner-occupied loans.
We simulated each scenario (invested in the market vs left in an offset account) at monthly starting points from the beginning of 2006 until mid-2018. This resulted in 304 individual simulations.
The chart above shows the final balance of each scenario over the 12 year period until 2018.
As we would expect to see, there is significantly higher variability in the final balance of an emergency fund invested in the market. And, whilst the final balance of an emergency fund left in the offset account never falls below zero, there are periods of net negative returns for the market. Nothing surprising so far.
The table above outlines some key statistics:
- The average return for an emergency fund invested in the stock market is about $100 higher than the offset account in absolute terms. But this comes with significant additional risk, which is illustrated by a much, much higher standard deviation.
- In fact, in about 70% of cases we will be better off investing our money in the stock market. It will be a wild ride but the final balance (on average) is higher than leaving the emergency fund in an offset account.
- Investing our emergency fund in the stock market over a two year period will result in a net negative return in about 23% of cases. This implies there might be cases where we cannot afford a large emergency that requires our full emergency fund.
There is a very interesting dynamic to keep in mind when comparing the market and an offset account. For one, we need to distinguish between frequency of out-performance and magnitude of out-performance.
As we can see in the chart above, investing our emergency fund in the market out-performs the offset account in most cases (i.e. we can see more blue than pink). But when the market does underperform, it really underperforms (i.e., the pink troughs can be huge). This is due to the the market having higher average returns (more blue) but also higher standard deviation (larger pink troughs).
As we mentioned in our previous post on emergency funds, one of the big benefits of offset accounts is the tax benefit. Funds in an offset account are effectively taxed at 0%. This is because they don’t result in a gain as such, they result in the avoidance of a loss.
On the other hand, interest earned on deposits and stock market capital gains are taxed at our marginal tax rate, minus the capital gains discount if applicable. So these investments can be subject to some pretty hefty tax bills.
In the chart above, we’ve estimated the effect of tax on emergency funds invested in the market. To be consistent with our previous article, we assumed a 35% blended tax rate. As you can see, after taking tax into account, emergency funds are better off in the market in about 65% of cases.
You’ll also notice that tax reduces our upside but doesn’t reduce our downside. This is true in our example. But we need to keep in mind that we can use this loss to offset another capital gain in the same year or later years. As always, when it comes to tax, results will vary based on individual circumstances.
One thing to keep in mind is that tax has a larger influence over longer time periods. The longer you keep your funds in the market, the higher tax bill you’ll have. But offset accounts are taxed $0 no matter how long the funds sit there for.
How do we decide?
The question of whether we should invest our emergency fund in the stock market or in an offset account is essentially a question of risk vs reward. Are we willing to risk losing some of our emergency funds 25% of the time in order to make more money 65% of the time?
The problem here is whether we should be more concerned with averages or more concerned about tail events. Some other bloggers argue that averages are more important for emergency funds. If a true ‘tail event’ occurs and the market erodes 30% of our emergency fund right when we need to pay for an emergency, there are short-term solutions to get us over the line.
In any case, it’s fair to say that we now know enough to make an informed decision about whether to keep our emergency fund. What’s more important: maximising returns or minimising risk?