Including Emergency Funds in Your Asset Allocation

This post originally appeared on The Finance Buff.

Over on the Bogleheads Forum, occasionally someone asks whether or not to count emergency fund (EF) cash as part of one’s asset allocation (AA). Typically one holds a fixed amount of cash (or equivalent) as an EF. The amount is often a multiple of a number of months of salary or necessary expenses. Over the short- and medium-term, one’s EF may stay at a fixed dollar value because one’s salary or monthly necessary expenses may not go up.

Here’s what some find bothersome: If one’s fixed EF is counted as part of one’s AA, figured in percentages of stocks, bonds, and cash then an inconvenient time-varying distortion is introduced. (Actually, there’s a distortion even if the EF does not stay constant. All that is necessary is that the EF target is a dollar amount, not a percentage of the portfolio.)

To illustrate, suppose at age 30 an investor has $20,000 in cash as an EF, $10,000 in bonds, and $90,000 in equities. Apart from the EF, his AA in percentage terms is 90/10 equities/bonds. Including the EF, his AA is 75/8/17 equities/bonds/cash (I always list AAs in order from most to least risky asset class).

Imagine that between the ages of 30 and 35 this investor pumped another $100,000 into stocks and bonds in a 90/10 ratio. At age 35 he holds $20,000 cash (EF), $20,000 bonds, and $180,000 equities. Apart from the EF, his AA is still 90/10. Including the EF, his AA is 82/9/9.

In one sense the investor’s AA has not changed from age 30 to 35. Apart from his EF it stayed 90/10. But because the EF held steady at a fixed dollar level while his stock and bond holdings increased by $100,000 in a 90/10 ratio, his AA including his EF shifted from 75/8/17 to 82/9/9. Therefore, if he includes his EF in his AA then his AA shifts over time simply because his EF stays at a fixed dollar amount.

It’s annoying to have an AA that shifts over time even though your basic investment strategy is fixed. It makes it harder to track and rebalance. On the other hand, if you exclude your EF from your AA then you might feel like you’re not tracking it or counting it in your portfolio. That bothers some people, though I’m not sure why.

Here’s my solution. Nobody says you have to specify your AA in percentages. Absolute dollar levels are fine too. You can mix percentages and dollar levels if you want. The investor above is 90/10/$20k, held constant between ages 30 and 35. This reflects exactly what he intends to do: hold his EF cash constant at $20,000 and keep is stock/bond mix at 90/10.

If you want to peg an asset class or sub-class at a dollar level, just put that dollar level in your AA plan. If you want the amount to be relative then use a percentage. There is no need to worry about whether or not you should count your EF in your AA. Your AA should reflect your intentions. If you intend a dollar level then set your AA accordingly. Problem solved.

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