A few days ago, I came across this article from Betterment entitled Safety Net Funds: Why Traditional Advice Is Wrong. The article argues that the idea of having a cash emergency fund is a bad idea because a cash emergency fund earns a relatively poor annual rate of return. Here’s the crux of that argument (in italics):
First, let’s get one myth out of the way: Cash savings accounts are not risk free. Why? Because after accounting for inflation there is about a one in three chance you won’t get back the money you put in, in real terms.
Today, with nominal cash interest rates hovering far beneath 1 percent, it’s almost guaranteed that you’ll make a negative real return over the next few years. This means your safety net fund will need topping up year after year to maintain its real value. It also means that you’ll have a significant amount of wealth that is not growing, potentially for a long period of time.
That’s a very good argument for why a person shouldn’t use a savings account as an investment vehicle. The problem is that an emergency fund is not an investment vehicle.
The purpose of an emergency fund is not to earn a big return on that money. The purpose of an emergency fund is to have cash quickly and easily available to you when a life emergency occurs. It’s not pinned to availability of funds from your brokerage. It’s not tied to the ups and downs of whatever you have that money invested in.
Most of the rest of the article talks about historical rates of return over multi-year periods in the stock market, showing how most five year periods see the investment holding its value and many such investments doing much, much better than that.
Another problem: what do you do if you have big losses? Under this plan, it’s not good. Let’s say you went for this advice and bought 1,000 shares of an investment at $10 apiece for your $10,000 emergency fund. Over the next few months, the bottom drops out of the market and you lose 40% of the value (akin to what happened in 2008). Suddenly, each share is only worth $6. Then, you lose your job and need $5,000 in an emergency to survive for a month until your new job starts. To get that $5,000, you’re going to have to sell 833 shares of that stock at $6 apiece. This leaves you with only 166 shares worth $6 apiece for a total of $1,000 in value. Those shares are going to have to increase in value by 400% to even get you back to the starting line of a total value of $10,000 in your emergency fund (minus the $5,000 you withdrew).
There’s also a relatively minor issue with taxes:
To prevent your safety net from getting too big, we advise transferring the excess to another goal in order to bring it back down to the correct level every time it gets to be 20 percent bigger than it needs to be. That excess growth not only makes up for the original buffer you invested, but it can now be transferred to help along other goals like IRAs, retirement, or a vacation around the world.
The article spends much of its time arguing that a person should have their emergency fund held in a stock fund based on the S&P 500, but then they argue that whenever it gets too big, a person should transfer that excess to another investment.
The problem there is that this creates a taxable situation. Let’s say you sell $10,000 in stocks in an emergency that you originally bought many years ago for $5,000. You’re suddenly facing a $5,000 long term capital gains, which means a tax bill (depending on your tax bracket and the year) of somewhere around $750. If you haven’t held the investment for very long (less than six months or so), those gains are taxable as ordinary income, which could eat up as much as a third of those gains in just federal income taxes. This is a minor issue in the big scheme of things, but it’s still worth thinking about as it can create tax complications for the unprepared.
Taxes in investments aren’t really a problem when you prepare for them, but they do discourage buying and selling with any regularity. That’s why they make a poor choice when it comes to an emergency fund – part of the nature of an emergency fund is that you’re going to tap it when life hands you lemons. You’re going to make withdrawals on an unplanned schedule.
Overall, the advice from Betterment is not advice I would follow. To be sure, you can make a case for it that revolves around an eternal optimism about the stock market and about your personal life. However, the point of an emergency fund is that we don’t live charmed lives. An emergency fund isn’t an investment. It’s a tool for life success.
This brings me to a bigger problem I have with the article. If this article were written by an independent writer, I would mostly look at it as “investment advice for optimists,” because that’s what I see it as being. It makes sense only if you’re incredibly optimistic about life and about the future of your investments.
The problem is that it’s not written by an independent writer. This article shows up at Betterment, which is an investment service that makes money when their customers use them for investments. It is in the financial best interest of Betterment for their clients to put as much money as possible into Betterment’s funds. Betterment makes more money that way.
As I said, this article offers financial advice that, in my opinion, is only good advice if you believe in an extremely optimistic personal and economic future. At the same time, that advice makes more money for Betterment, the company giving the advice.
Now, I don’t actually have any direct problem with Betterment writing such an article. It is pretty clearly branded with the “Betterment” name across the top, so they’re not doing anything sneaky or disguising things.
They’re merely choosing a flavor of very optimistic personal finance advice that also happens to have synergy with how Betterment makes money.
I believe this article falls into the class of writing that I would call “advertorial,” meaning that it’s material distributed (and possibly written) to encourage people to take advantage of Betterment’s financial products. As I said, I don’t think this is particularly unethical or anything – it does have the business name clearly labeled all over the place – but it is extremely important that people keep the fact that this is a paid Betterment article in mind when making financial choices based on that information.
This article is an example of why you need to always be smart about where you get your financial advice. The people sharing that advice – myself include – do not always know the ins and outs of your financial situation. Some of them may have ulterior motives. Some may not be experts at all.
Instead of simply trusting the first financial article you read on a topic, here’s what you should be doing.
First, whenever you’re reading about any new financial topic, look for other perspectives and ideas. Don’t just rely on one source for your financial ideas, no matter what they might be. As I said above, authors are not perfect. There can be lots of reasons why a specific financial article is offering advice that isn’t right for you.
I strongly encourage people to read and learn about personal finance and investing. Check out some books from the library – not just one – and read them. You’ll quickly find that some writers match up well with your personal perspectives and risk tolerance, while others do not. The thing is, neither group is necessarily wrong – some writers just have a really high risk tolerance, while others have a low risk tolerance. Some writers are really optimistic about the future and find facts to support that optimism, while other writers are realists and some are even pessimists. Those differing perspectives are going to drastically change the advice they provide.
Second, for minor financial decisions – like a new frugality tactic – try before you commit. Most frugal tactics only cost a dollar or two to try them out, like buying a generic version of an item or buying a LED light bulb. Rather than fully committing to something new like that based on someone’s word, just give it a try first. Buy one or two LED bulbs and put them in a frequently used socket to see how they work out. Try store brands one item at a time rather than filling your cart with generics.
Third, for bigger financial decisions – I’d say anything with a potential impact of $100 or more – get lots of perspectives and information before making that decision. Never, ever rely on one perspective or one source of information – and that includes me. Every single person out there sharing information or perspectives on personal finance issues has their own level of risk tolerance, their own level of personal and financial optimism (or pessimism), their own level of personal frugality, and so on. That doesn’t even touch on potential ulterior motives, like the person’s desire to sell you on a product while also providing “advice.”
Never, ever rely on just one source for information for any significant financial decision that you make. That one source is never a perfect source of information. Instead, you should get your information from a variety of sources in the hopes that the flaws of each source cancel each other out and you can get to the true heart of the matter.
Be smart. Learn about finances from lots of different sources. Be wary of advice that comes in the form of “advertorial” – it doesn’t mean the advice is useless, but it’s often selected to come to a conclusion that’s beneficial to the company that sponsored it.
In the long run, you’ll be very glad that you put in the effort.