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Emergency Funds Revisted: Real World Simulations

Posted by on 22 March 2019 in Investing & Asset Allocation

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?

There are 8 comments on this article

  1. Avatar for Dan Montgomery

    James D.

    As with most things in life, there’s no one size fits all answer.

    If you’re ruthlessly trying to maximise returns, putting it all in the market is the choice of higher expected value. But there is some value in being able to rest easy knowing you’ve got easy access to some emergency funds.

    It’s like insurance. By definition, buying insurance is negative expected value (insurance companies need to make profit), but people are happy to purchase insurance for the ease of mind.

    But I am also of the opinion that most people are a little too risk averse, and most people realistically do not need a particularly large emergency fund.

    • Avatar for Dan Montgomery

      Dan Montgomery

      I tend to agree mate. If we didn’t have offset accounts, I’d probably advocate leaving funds in the market. But we can get near-market returns with zero risk in an offset account. We’re very fortunate in this respect.

      Everybody has their own risk tolerance though!

      • Avatar for Dan Montgomery

        Parth

        Related question in my mind: what’s the best strategy for people who don’t have access to an offset account (because no mortgage)?

        I’ve historically just kept the emergency funds in high interest savings account. The income from this is taxed at your marginal tax rate. I wonder if it makes sense to do this or put the money instead in the market. Have you done similar risk vs return percentage numbers for this scenario by chance?

  2. Avatar for Dan Montgomery

    Mateo

    Both seem like good options to store an emergency fund! I’m leaning towards the offset though, imagine needing 30k for some sort of emergency health operation and you’re checking the market first to see if it’s a good time to pull out your dosh. Not ideal!

  3. Avatar for Dan Montgomery

    tdambra

    I am not sure if my approach to your informative work is sound, but to what extent are your work generally applicable to the retirement phase?

    To a certain extent I take your number crunching as sound as I am not sufficiently qualified to make an assessment of your assumptions.

    As a recent retiree I have my assets spread over an investment property, a cash emergency fund, and the rest in the balanced option of a superannuation fund. I have no debt and tax is not an issue as earnings are largely tax-free when split with my spouse.

    My plan is to withdraw 3-4% a year and maintain an emergency cash fund of three years income to cover unforeseen expenses and dips in the share market.

    As I see it the worst case in your accumulation scenario is putting the emergency funds in the share market and finding you need to withdraw during a serious dip in the market.

    As I see it this is unacceptable risk in the retirement phase.

    What I think should be addressed in your accumulation scenario is that the risk profile changes the closer you are to retirement.

    • Avatar for Dan Montgomery

      Dan Montgomery

      You make a great point. My general approach is to run the calculations, explain the implications, then leave people to make their own decisions.

      As you say, for those in the retirement phase it may not make sense to keep an emergency fund in the market. At this stage of life, it may not make sense to take such a significant risk. This is especially true if you have a fairly stable source of income that covers your retirement expenses, and have no desire for any income above that 🙂

  4. Avatar for Dan Montgomery

    FMT

    For me, I couldn’t think of anything worse then to put my emergency fund into the stock market!

    It’s not a Investment, it’s a emergency fund.

    I want 100% of my emergency fund there ready and waiting, risk free.

    But everyone risk tolerance is different.

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