It’s An Emergency.

For investors, the time is now to put together an emergency fund that’s more than just cash.

Preppers be Prepping

Just before I left the country with the family on vacation I reflected on how fortunate we’ve been, saving and investing during a bull market. Index funds including; S&P 500, International, emerging markets, real estate investment trusts, and bond indexes; have all grown during the second longest bull market in history. 2009-2018

This growth over the past 9 years can make investors complacent. 401K millionaires feel like geniuses, what they’re really experiencing is the power of compound interest during a sustained period of growth. I also realize the market could enter bear territory at any time (a correction of 20% or more), which many believe it’s overdue for. The fact is, no one can predict when these market downturns occur. This always seems to be the case. Past summer holidays have included front row seats for Brexit and the EU debt crisis. It turns out these were both distant, false alarms and the bull just kept on running.

The sky was not falling. Would I be ready if it did? 

Through all this I stayed heavily invested in low fee total stock market index funds, letting it ride, reinvesting dividends. Even though I’m financially independent and working less than full-time, I hold only about 20% of my total investment portfolio in bonds and cash. Which is considered aggressive by many common allocation models. I keep a 30% allocation in low fee bond index funds, in my retirement accounts where dividends can be reinvested and compound tax free. 

It seems odd that I’d take an aggressive stance at my age (56!) especially since I I’ve lived through several large market declines and recessions including 2001 and 2008. During those periods I stayed fully invested in the market as well, and have benefited. This includes the period some called “the lost decade” in investing 2000 through 2009 when the S&P 500 recorded its worst ever 10 year performance. However, that poor performance only hurt you if you were pulling money out of the market during that period.

For those that stayed fully invested and purchased stocks and bond funds in the market during these years, they’ve done well, but could say they have some battle scars.

At the bottom it was particularly bad with stocks losing over 40% of their value and pundits saying we would have an L shaped recovery. Regardless I was able to confidently stay invested in stocks based on my emergency fund. The emergency fund is essential in avoiding market sell offs.

Have a Plan

This is why I regularly look back at 2008-2009 and plan for a similar decline at some point during the next few years. No one can predict when the decline will happen so I find it useful to have a plan based on a significant market drop with some historical reference in recent years. Planning for a bear market and a recession is only part of the story. When we look at building an emergency fund the most important part of the plan is not the percentage of the market decline but the length of the bear market, the recession, and recovery. The 2001 recession lasted only eight months. The 2008 recession was tougher, lasting 18 months and wiping out trillions in wealth.

So, when I think about my emergency fund I like to use 18 months as my timeline, as I’ve lived through that before. The primary purpose of an emergency fund is to enable you to get through a recession and market decline without having to sell off stocks at a diminished value, as many were forced to do in 2008 and 2009. This allows you to stay fully invested in the market and have the ability to ride out the storm while the markets recover. 

This is especially important for many Americans, who are already retired and depend on their portfolio for dividend income, and are following the 4% withdrawal rule in retirement. In this situation, you want to make sure that when the markets enter bear territory you would not need to sell any stocks and have enough cash and dividends to carry you through an 18 to 20 month recession.

Most of what I’ve read on emergency funds recommends keeping these dollars in cash (savings accounts or money market funds). However given current historically low interest rates on savings and money market accounts, I believe they should only be part of the picture. Since I’m using 2008 as my example I took a close look at how my US bond market index funds and my municipal bond funds performed during that period.

It’s possible to have an emergency fund with reasonable returns.

I’ve always kept a year of living expenses in a highly rated tax free municipal bond fund and a Fidelity money market fund, in my taxable brokerage account. Recently I’ve been looking at how I would actually draw that down during a recession to supplement any income I have coming in in early retirement. Since it’s called an emergency fund, I think it’s fair to look at worst-case scenarios, in my case a 18 to 20 month market decline with little or no business income coming in. This is especially important now, since during the previous recessions I was working full-time.

In the charts above you’ll see that my bond funds actually grew or were flat during the most challenging part of the great recession compared to 40+% declines For the S&P 500 and International Markets Yellow and Green lines. I understand that no two recessions look-alike and that bonds could be in an even more challenging environment during a longer recession. The key is to evaluate how much risk you are willing to take with bond funds. I’m open to taking the risk that the next recession will be in some way similar to 2008. During this time many people moved money to bond funds (often called the flee to safety) after they had already lost significant dollars in the market. This is something it’s best to avoid. If anything during the worst parts of a market decline you want to be buying stocks not unloading them and locking in losses.

So this is how I am putting myself in position for the next recession.

1. Keeping 18 months of living expenses invested in after-tax brokerage accounts and a Health Savings Account (HSA)
2. Allocating the account as follows; 30% Cash accounts and Fidelity municipal money market fund, 60% Virginia tax-free bond fund, 10% HSA account and treasury bonds
3. Of the taxable account total I keep about 5 months expenses in money market funds and treasury bonds. 
4. Increasing bond holdings in retirement accounts to 35%, in about three years when I reach 59 ½ I’ll be able to access these without penalty which will provide additional flexibility during a recession.

If you’re not sure what sure your total investment allocation looks like it’s important to figure that out first and include all financial accounts including company 401(k)s, IRA’s, bank accounts and investment accounts.

I use a free app called Personal Capital that allows you to link all of your accounts together and get a handle on your total allocation. It also gives you a solid breakdown of any fees you are paying and offers you alternatives which are totally optional. Many brokerage accounts also allow you to link your outside accounts at Fidelity they call this Full View. Regardless of which online tool you use, it is important to regularly review your total allocations and rebalance annually as the markets grow or decline. And start whipping that emergency fund in to shape.

The Frug