In a lot of basic financial advice that I read, there is usually the mention of the concept of an “emergency fund”, which is a cash stash that can be deployed in the event of unforeseen emergencies (e.g. losing your job, medical emergency, etc.).
Maintaining a cash reserve to survive many months (ideally a year) in theory is good practice. It is very difficult to run a completely leveraged lifestyle (typically known as “paycheque-by-paycheque”) because it does not take many external circumstances to impact your financial situation. However, if you have cash-like assets that can be liquidated at a moment’s notice, then it makes the concept of an emergency fund highly redundant. You can be impairing your returns by having capital deployed in low-return products.
The question is a matter of resource utilization – keeping the cash literally stored as pieces of paper (hundred dollar bills) underneath your mattress surrenders any ability to gain interest, and present a security risk if you are robbed, or if your house goes on fire. So keeping the cash in a risk-free savings account (e.g. Ally offering 2%) is the next best alternative. For most people, this is probably the best option for the “emergency fund” since their decision-making abilities to invest the proceeds might incur negative expected value.
For most financially sophisticated people, seeing the cash stored at a fully-taxable 2% might be a bit unbearable, especially when one considers that it will be a below-inflation return. Where else could you put your emergency stash? You could move into short-term corporate bonds of stable companies, but in this low interest rate environment, would be unlikely to yield more than 2%. The next step up would be preferred shares, but that entails the risk of principal loss in the event of an untimely liquidation.
Finally, this leaves longer-term maturity corporate/government debt or even low-risk equities (e.g. utility companies with stable yields). You can see why “chasing yield” becomes dangerous – as long as bond/share prices remain stable and keep pumping out the coupon payments or dividends, you feel “safe” (a very dangerous feeling in finance if you are expecting a high reward for your “safe” risk). But it only takes a 2008-type event before everything gets flushed in the marketplace. Still, there were quite a few securities out there that were relatively unaffected by the financial crisis, and you can assume they will be an acceptable risk for emergency fund capital.
Giving a numerical example, let’s say your lifestyle requires you to save $25,000 to maintain a one-year operating cash cushion without drawing any subsequent income. If you had invested the money in a short-term savings account, and had your cash-requiring emergency at the same time as the 2008 financial crisis, you still would have $25,000 in principal to draw. A few button-clicks and you will magically have $25,000 at your fingertips.
However, let’s assume you wanted to reach for yield and invested the $25,000 in a TSX index fund at the beginning of 2008. The peak-to-trough amount the TSX dropped in 2008 was 42%. So had you been forced to withdraw proceeds at the bottom of the market, you would have had $14,500 left.
This would suggest that an emergency fund, if invested in a broad-based index of equities, should be about 1/(1-0.42) = 1.73 times larger than the amount you actually need to operate. So your $25,000 emergency fund, if you want to invest them in equities, should be around $43,000 if you want to be able to have a large degree of confidence of being able to withdraw $25,000 even in the middle of a 2008-style financial crisis.
This type of math suggests that people with about 1.73x the assets required to maintain their lifestyle in the event of an emergency should really have no emergency fund at all.
If your remaining assets are in safer securities, such as secured corporate debt, the impact of a 2008-type financial crisis is significantly less; there were plenty of corporate debt issues which barely budgeted during the crisis. As an example, the debentures of a company like Penn West Energy Trust (where their ability to pay out principal is never really in doubt) fell about 10% during the financial crisis. If you could structure a portfolio around such securities, then your ratio would be about 1.12x – or about $28,000 of the “emergency fund” invested in corporate debt.