• 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.

    • Thank you very much. Was just thinking about whether to include EF or not, and your post happens to reference my desired allocation and age group. Had gone with your strategy of 90/10/20K before you posted it but wasn’t sure it was right until I read this article.

    • Jules,

      Glad to be of help. I know you didn’t mean it this way but just in case anyone misreads it, of course I am not advocating a 90/10/20k allocation. I just used that as an example.


    • I think the rule is simple. You only count in you allocation those sums that you will rebalance with. You won’t use your emergency fund to rebalance, and you won’t use your house to rebalance. So your emergency fund doesn’t count as “cash” in your allocation, and your house doesn’t count as “real estate” in your allocation.

    • Don,

      I do rebalance my emergency fund. Or, to be more accurate, I rebalance my cash holdings. I have a plan for my cash holdings. But it is in dollar amounts, not in percentages. So my AA reflects that.

      For example, say I want to hold $1,000 in cash for each year of my age. So, at age 30 I hold $30k but at age 60 I expect to hold $60k (in constant dollars).

      It would not make sense to me to exclude cash from my AA just because it has dollar targets and not percentage targets. It is important for me to rebalance in/out of cash to hit the targets and to accommodate growth, inflation, expenses, and so on.

      Why does an AA only need to be in relative terms? It doesn’t.

    • I put the emergency fund I used to have to work in my portfolio a few years ago when my portfolio grew to a sizable amount. In a pitch, I can always draw down from the fixed income portion of my portfolio. I don’t feel a need to bring it back even in the current economic environment.

      Emergency fund is typically cash, and is a drag on portfolio returns in the long run.

    • indexfundfan,

      I appreciate your perspective. I do wonder if, on average, one might be better off with a smaller EF. The typical argument for an EF is that one should not be forced to upset one’s savings or one’s AA in an emergency. But if one has enjoyed higher gains for years by putting EF funds at greater risk then the net result could be positive, even accounting for emergency use. I would love to see some scholarship on this. I am not aware of any.

      In my case, a substantial portion of my EF is a cash-flow buffer. That is, I can’t put a chunk of it to work anyway (perhaps about half). Some of the rest I can put to slightly better use than a money market at very low risk (e.g., I Bonds). I do admit to having some excess cash that may not be rational to hold. But that depends on the scholarship referenced above that I have not yet seen.


    • Just count the EF as part of your fixed income allocation.

      In your example if you want 90/10 then the EF would be included in the 10.

      Problem solved.

    • Ted,

      90/10/$20k is exactly what the investor in my example wants. 90/10 is not.

      It isn’t hard to track a fixed cash holding separately.

    • I think I will try to recommend this post to my friends and family, cuz it’s really helpful.

    • A portfolio should be thought of as a cash stream that becomes available for spending at different times in the future. Different time frames require investments with varying levels of safety of principal. For the fixed income portion of a portfolio, that means matching up maturities of bonds or other instruments (CD’s) with an expected need in the future. The EF is part of the fixed income portfolio that could be used in the immediate future.

      To keep things simple I include my EF as part of the fixed-income allocation. Using the old rule of “your age in bonds,” my target equity/FI allocation is 67/33, but I’m going for 60/40 as I feel more comfortable with this allocation. Most people, in fact, have too much in stocks. Benjamin Graham in The Intelligent Investor, in fact, recommends that all investors target a 50/50 allocation.

      Including the EF in asset allocation is not a big problem for several reasons:

      1) You wouldn’t want all your fixed-income (bonds) portfolio to be in low-yielding cash. If your AA gets out of whack due to a swoon in stocks, you would look to liquidate longer duration, higher-yielding bonds first (as they most likely have appreciated during a stock market downturn).
      2) Rebalancing can be done over time. Underperforming asset classes can be added to, while you can avoid adding to outperforming asset classes until the AA is back in line with targets.
      3) AA is just a target.

      The problem of EF skewing the AA is more of a problem for a small portfolio. The beginning investor has time on his side and should be able to quickly get to a target AA while maintaining his EF. An EF is the highest-priority for most people. That implies after the beginning investor has an EF, he should probably only invest in stocks until he gets to his target AA, then start introducing higher-yielding (but more volatile) fixed income investments like bonds.