Author Topic: How should you allocate your emergency fund?  (Read 1330 times)

COEE

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How should you allocate your emergency fund?
« on: November 02, 2018, 08:42:27 PM »
With I-bonds hitting their highest fixed returns (0.5%) since 2008, I thought I'd celebrate by creating this post (and buying some I-bonds)!

I have been wanting to followup my previous post about short-term investments with a post about what I believe is a good way to invest an emergency fund with the goal of preserving principal and maximizing risk-free return.  The point of this post is not to tell you how to invest your emergency fund*, but to describe how I have chosen my emergency fund allocation and why.  This is done in the hopes that it inspires thought in you in order to help you determine what is best for your scenario.

First, some background on I-Bonds:
An investment that I purposely didn't mention in my previous post is the Individual Savings Bond.  I didn't mention them because you cannot access the funds for one year after initial purchase.  The return on iBonds are set by a fixed rate (currently 0.5%) that is set for the life on the bond and a inflation adjusted rate which is adjusted every 6 months (currently 2.32%).  These two rates are combined using a mathematical formula to create a composite rate (currently 2.83%) that is the interest rate that is obtained for the next 6 months.  Every 6 months the interest rate changes based on the inflation (or deflation) of the previous 6 months.  More information can be found here, but let me summarize the highlights:

Pros:
  • Inflation and deflation protection - 6 month yield cannot go below 0%
  • All taxes on interest can be deferred until the bonds are redeemed.  Think of it like a miniature 401k or traditional IRA!
  • State and local tax free.
Cons:
  • Funds are unavailable for 1 year after initial investment (11 months if purchased the last day of the month).
  • You lose the first 3 months of interest if you redeem before 5 years.
  • You can only purchase $10k/year per SSN.  You can purchase up to another $5k in paper bonds in your tax return if you over fund your taxes for the year.
  • Likely dealing with Treasury Direct in some capacity.
With this additional information about I-Bonds, I have developed a 4-tier emergency fund which I believe is good match to meet the stated goal.

Tier 1) 1-2 months in checking
Tier 2) 2 months in high yield savings
Tier 3) 3 months in 13-week t-bills - laddered in ~4 week intervals
Tier 4) 6 months in I-bonds
  • Tiers 3 and 4 are state and local tax free and generally offer competitive rates
  • As mentioned before, Tier 4 is inflation AND deflation protected.
  • All tiers are guaranteed by the US government (if FDIC insured on Tiers 1 and 2).
  • Tier 1 is available for immediate withdraw.
  • Tiers 2 and 4 are highly liquid (after the 1 year holding period of tier 4) and funds are typically available within 2 business days
  • Tier 3 can be sold on the secondary market in a jam.  However, you could lose principal.  I think it's much better to negotiate with whomever you owe money if you really need to dip into that fund before maturity.
  • Minimal management required.  As few as two institutions can be used.
  • I consider tiers 3 and 4 to be part of my bond allocation within my investment portfolio, allowing me to hold more stock in other locations
  • If I ever have to access Tier 4, I'll hopefully be in lower tax bracket (job loss, early retirement, etc).
  • Also, if I ever have to access Tier 4, because I consider this to be part of my bond allocation, I may not need to sell my stock to rebalance.  This becomes more true as my EF becomes a smaller percentage of my investment portfolio.  This again allows me to hold more stock.
  • To fund tier 4, a bond ladder is recommended to maintain at least a minimum level of liquidity that allows you to sleep at night.
Of course, feel free to adjust this to suit your individual needs!  For instance, all of these investments can be scaled.  Some people prefer a 6 month or 2 year EF.  Or perhaps only do tier 1 and 2 as some people are comfortable with higher risk profiles for more than 3 months.  Some people might prefer CD's or Money Market Funds for Tiers 3 and 4 to maintain more liquidity, or to consolidate Tiers 2 and 3 into just a savings account.

A final note: It takes time to develop a sizable EF.  It's not a race.  Personally, when I started my journey, I was excited to make it to Tier 1.  As the stash grew the other savings just kind of happened.  Once you establish Tier 1 (and this can be quite the challenge for some people), then adding Tier 2 is the next logical step, as you finally start sleeping better.  Next thing you know, you're wondering how to not lose a bunch of value in the cash just sitting there.  That is what led me to find tier 3 and tier 4.  These have gifted me both liquidity and peace concerning a significant chunk of my cash losing ground to inflation.

Good luck on your journey - I hope you find this helpful!

* - I am not your financial adviser.  You make elections on which investment vehicle(s) you will choose on your own behalf.  I am simply providing information so that you can make a more informed decision on what vehicles may work best for you.
« Last Edit: November 02, 2018, 08:44:03 PM by COEE »

YttriumNitrate

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Re: How should you allocate your emergency fund?
« Reply #1 on: November 03, 2018, 10:01:59 AM »
Goodness that seems complicated, but if works, kudos to you.

Out of curiosity, how quickly can you access your tier III and tier IV emergency funds?

COEE

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Re: How should you allocate your emergency fund?
« Reply #2 on: November 03, 2018, 10:21:31 AM »
Goodness that seems complicated, but if works, kudos to you.

Out of curiosity, how quickly can you access your tier III and tier IV emergency funds?
I'm disappointed you think it's complex.  Most people have tier 1 and 2 already.  Tier 3 and Tier 4 really just help preserve principal due to inflation risk and are pretty easy investments to understand if you spend a couple hours reading up on them.

Tier 4 can be accessed in about two business days after the initial 1 year hold.  Again, it's important to ladder the investments here to maintain liquidity

Because of the laddering of Tier 3, each month of investments is available in 0-5 week intervals.  So basically you'd get 1 month of emergency fund within a month, and another about a month later, and then the final month of emergency fund a month after that.
Tier 3 can also be sold on the secondary market and I'm guessing (I've never done it) you can have all the money in about a week or so if your desperate.  You might lose a little bit of principal and interest doing it this way also.

PDXTabs

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Re: How should you allocate your emergency fund?
« Reply #3 on: November 03, 2018, 01:34:58 PM »
Funds are unavailable for 1 year after initial investment (11 months if purchased the last day of the month).

Cool, I didn't know this trick.

I just learned about I-Bonds recently and have been buying them since February. I'm looking forward to having some that are accessible.

I would echo YttriumNitrate's comment, this seems overly complicated to me. Once you have accessible I-Bonds, who needs a "Tier 3?" I have three tiers: checking & savings at my local credit union, online savings, and I-Bonds.

Telecaster

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Re: How should you allocate your emergency fund?
« Reply #4 on: November 03, 2018, 02:49:53 PM »
Not having an emergency fund is even simpler.

JAYSLOL

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Re: How should you allocate your emergency fund?
« Reply #5 on: November 03, 2018, 06:03:22 PM »
I don't run with much of an emergency fund ($1-2k) so anything more complex than cash in a savings account or cash in an envelope under the mattress doesn't make much sense to me.  There's lots of stuff I could sell off if things got tighter, and/or a line of credit to draw from. 

PDXTabs

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Re: How should you allocate your emergency fund?
« Reply #6 on: November 03, 2018, 10:29:07 PM »
JAYSLOL,

That makes sense to me. I would point out that I-Bonds are also a tax deferred inflation and deflation hedge. But sure, on average stocks plus a LOC works better (of course if stuff goes very far south you may find yourself with that LOC cut off).

JAYSLOL

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Re: How should you allocate your emergency fund?
« Reply #7 on: November 03, 2018, 11:11:17 PM »
That's true, in the case of the economy going really south I'm sure the LOC wouldn't be available anymore.  I have pretty low fixed costs (no mortgage) so I have a lot of room to cut back in hard times.  I would want a much larger emergency fund if I had a mortgage to pay every month. 

Indexer

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Re: How should you allocate your emergency fund?
« Reply #8 on: November 04, 2018, 05:16:42 AM »
I like it. I'm looking at adding I-Bonds as part of my EF. Thanks for sharing!

Concerning complexity, tier 3 seems the most complex, with the laddering requiring regular maintenance. Personally, I would switch this money into I-Bonds once your existing I-Bonds are more than a year old.


One important thing I found is that the fixed part of the rate, currently 0.5%, is set at the beginning and never changes for the life of the bond. Looking at some history, if you bought one in 2000 it would be paying 3.6% fixed + inflation, and the fixed rate is fixed for the life of the bond. According to their charts that means a bond issued in 2000 is paying 5.96% right now!!!

I-Bonds could work as a long term investment if you bought them if interest rates were ever high again. 2 or 3% fixed + inflation would be a great hedge against inflation and protection if rates fell again in the future.


The downside:  In 2015 we apparently had a period of slight deflation, which means all of the bonds with lower rates paid 0% for the next six months.

MustacheAndaHalf

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Re: How should you allocate your emergency fund?
« Reply #9 on: November 04, 2018, 09:10:40 AM »
The conventional emergency fund is available almost immediately, not weeks or months later.  But if you're specifically worried about a job loss, where money available in 5 weeks is still useful, then it could work.

PDXTabs

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Re: How should you allocate your emergency fund?
« Reply #10 on: November 04, 2018, 09:39:06 AM »
The conventional emergency fund is available almost immediately, not weeks or months later.

T-Bill and I-Bonds do not take weeks or months to sell/redeem, unless the I-Bonds are brand new.

use2betrix

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Re: How should you allocate your emergency fund?
« Reply #11 on: November 04, 2018, 09:49:25 AM »
My American Express Savings acct has a 1.9% yield. It can be accessed at any time with a simple online transfer to my checking.

If someone has like a $100,000 emergency fund, I could see the interest in stretching for that fraction of a percent. For most people here with relatively lower living expenses and smaller emergency funds, it doesn’t really seem worth it.

COEE

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Re: How should you allocate your emergency fund?
« Reply #12 on: November 04, 2018, 10:18:12 AM »
I suspect some of the folks that responded didn't fully read my initial post.  Surely some of the reply's suggest that not everyone read and contemplated the original post, but simply blew it off as noise.  Disappointing, as I have given this lots of thought and consider it to be superior to most emergency fund techniques... balancing risk, cash value, liquidity, and inflation protection.

I did float the idea of investing most of your emergency fund!  I noted that I consider tiers 3 and 4 to be part of the bond allocation within my portfolio.  That leaves only 3-4 months in cash that I don't consider "invested", at least for me.  Others may want to consider it as part of their cash holdings.  This is an incredibly gray area and will vary substantially with each person and their risk profile.

Even so, there is a unique difference between my technique and the technique of those wanting to "invest" their emergency fund - even if 100% in bonds.  The unique difference is that investment grade bonds are not guaranteed to hold their cash value.  My technique ensures that the entire cash value is guaranteed by the US government; recall, preserving the principal is one of the stated goals of this emergency fund technique.  The US defaulting on these investment vehicles is a risk, but it's so infinitesimally small that I consider it zero risk.

It is worth noting still that because I consider Tiers 3 and 4 to be part of my bond portfolio I may need to sell some stock someday to balance out my AA if I need to access these tiers.  I'm okay with this, but others may not be and may want to consider it part of their "cash" holdings.  Again, this is highly dependent on the investor and their risk tolerance.

Once you have accessible I-Bonds, who needs a "Tier 3?"
As for Tier 3.  I expected this tier to get the most scrutiny as it does seem a bit strange, but let me offer up the following thoughts.

Tier 3, as you imply, is indeed an extension of Tier 4, with the additional bonus of not needing to go through the 1 year holding period.  That 1 year hold can be long for an emergency fund.  And because of the underrated nature of the I-bonds being anything from a short-term bond (1 year) to a long-term bond (30 years), I believe it best to only access -Tier 4 in the most dire of circumstances (job loss or medical emergency, predominately).  You don't want to just get through the 1 year hold, and have to pull all of the money out just to put it all back in again the following month and need to wait another year.

In this way, Tier 3 is a bit of hedge in an attempt to not need the I-bonds, but to also back-fill Tiers 1 and 2 in relatively short order when smaller emergencies come up.  Also, most mid-sized emergencies requiring Tier 3 can almost certainly have a negotiated payment period, allowing for the ladder to pay out and have the cash available.  If no payment plan can be negotiated, I-bonds can still be used, giving 9 months of emergency funds.  That's a hefty chuck of change for most people.

I'm certainly not going to fault someone for wanting to do something different with Tier 3, moving it to Tier 2 or 4 is pretty logical.  Some will prefer a CD or Money Market fund, as I described earlier.  Some may go as far as not having a tier 3 at all.  I wanted to offer it up as part of the technique though, as I find it a good safety net for my needs, with a bit better yields, good liquidity, and state and local tax free.

Finally, I think I will follow up with a post that describes how to implement this technique, as I believe some of the comments about the perceived complexity are justified.  Perhaps this perceived complexity is due to the length of the original post?  Perhaps it I should shorten it?

COEE

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Re: How should you allocate your emergency fund?
« Reply #13 on: November 04, 2018, 10:46:26 AM »
If someone has like a $100,000 emergency fund, I could see the interest in stretching for that fraction of a percent. For most people here with relatively lower living expenses and smaller emergency funds, it doesn’t really seem worth it.

Not everyone here has lower living expenses, but they still save 50%+ of their income and will qualify to RE which also  qualifies them for mustachian status.  The math scales.  That's the wonderful thing about mustachianism.  There are mustachians from all financial backgrounds from the rich to the (technically) poor.

When you don't have much in an EF, you're right this is probably not worth the time, but as your emergency fund grows, then you start thinking about how best to invest that money to preserve the principal and limit the effects of inflation.  This should also scale with economic status.

COEE

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Re: How should you allocate your emergency fund?
« Reply #14 on: November 04, 2018, 10:53:54 AM »
I like it. I'm looking at adding I-Bonds as part of my EF. Thanks for sharing!
Thanks for the positive feedback, it's appreciated!

The downside:  In 2015 we apparently had a period of slight deflation, which means all of the bonds with lower rates paid 0% for the next six months.
How is this a bad thing?  I'm generally happy with a 0% yield during periods of deflation.

use2betrix

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Re: How should you allocate your emergency fund?
« Reply #15 on: November 04, 2018, 01:29:16 PM »
If someone has like a $100,000 emergency fund, I could see the interest in stretching for that fraction of a percent. For most people here with relatively lower living expenses and smaller emergency funds, it doesn’t really seem worth it.

Not everyone here has lower living expenses, but they still save 50%+ of their income and will qualify to RE which also  qualifies them for mustachian status.  The math scales.  That's the wonderful thing about mustachianism.  There are mustachians from all financial backgrounds from the rich to the (technically) poor.

When you don't have much in an EF, you're right this is probably not worth the time, but as your emergency fund grows, then you start thinking about how best to invest that money to preserve the principal and limit the effects of inflation.  This should also scale with economic status.

For most here, EF’s are not continually growing funds. Usually once people hit their set amount of months expenses saved, they no longer contribute to their emergency fund. I “like” to keep around $40k in mine simply because of my volatile work as a contractor.

6 months of living expenses for me is around $30k. Invested in your funds, vs my American Express savings, would “maybe” net me an extra $200/ year in interest. Granted, yours is also subject to changing rates due to inflation, while mine is not. Mine is also 100% immediately accessible, while again, yours is not.

I am a “higher” spender around here, with an EF that’s probably larger than average as well.

Granted, if someone had a $100k emergency fund (which is stupid for the vast majority at any income level) they may net around $550/yr in your method vs mine, but would still have the aforementioned downfalls of accessibility and flexible rates.

I applaud the effort and time you put into researching this nonetheless.

Telecaster

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Re: How should you allocate your emergency fund?
« Reply #16 on: November 04, 2018, 02:33:00 PM »
When you don't have much in an EF, you're right this is probably not worth the time, but as your emergency fund grows, then you start thinking about how best to invest that money to preserve the principal and limit the effects of inflation.  This should also scale with economic status.

That's the thing.  Your emergency fund should shrink as your net worth grows, both in percentage and actual dollar value (IMO, of course).  The purpose of an emergency fund is to have ready access to sufficient funds in case of an emergency. <your definition of sufficient goes here>.  Let's say "sufficient" is $4/month for six months or $24K.   $24K in stocks isn't sufficient because the market could drop tomorrow and those monies won't be available if you need them.  But $50K in stocks is enough. 

"Aha!" I can hear you say.  "If you have to sell during a big market drop your $24K emergency just became a $50K emergency!"   True enough, but actual emergencies are rare (the water heater unexpectedly going out isn't an emergency), and they don't necessarily come at market bottoms.    Over ten years, that $24K will likely become $50K, and $100K in 20 years.  By minimizing the cash drag of an emergency fund, your portfolio becomes more and more resilient over time.    If your portfolio is closing in on $1MM (which is true for a lot of people here) then $24K is close to a rounding error.  So why do you need to lock up a bunch of money in cash or bonds beyond your normal bond allocation?  You don't.   What it turns into is very expensive insurance once you figure in the opportunity cost. 

COEE

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Re: How should you allocate your emergency fund?
« Reply #17 on: November 04, 2018, 03:40:09 PM »
When you don't have much in an EF, you're right this is probably not worth the time, but as your emergency fund grows, then you start thinking about how best to invest that money to preserve the principal and limit the effects of inflation.  This should also scale with economic status.

That's the thing.  Your emergency fund should shrink as your net worth grows, both in percentage and actual dollar value (IMO, of course).  The purpose of an emergency fund is to have ready access to sufficient funds in case of an emergency. <your definition of sufficient goes here>.  Let's say "sufficient" is $4/month for six months or $24K.   $24K in stocks isn't sufficient because the market could drop tomorrow and those monies won't be available if you need them.  But $50K in stocks is enough. 

"Aha!" I can hear you say.  "If you have to sell during a big market drop your $24K emergency just became a $50K emergency!"   True enough, but actual emergencies are rare (the water heater unexpectedly going out isn't an emergency), and they don't necessarily come at market bottoms.    Over ten years, that $24K will likely become $50K, and $100K in 20 years.  By minimizing the cash drag of an emergency fund, your portfolio becomes more and more resilient over time.    If your portfolio is closing in on $1MM (which is true for a lot of people here) then $24K is close to a rounding error.  So why do you need to lock up a bunch of money in cash or bonds beyond your normal bond allocation?  You don't.   What it turns into is very expensive insurance once you figure in the opportunity cost.

This is precisely why I consider Tiers 3 and 4 (9 months total) as part of my bond allocation.  I hold the exact same amount of stock and bonds as I would if I put this money in a taxable account - or any other "investment" account for that matter.

Are you implying everyone should be 100% equities?

Telecaster

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Re: How should you allocate your emergency fund?
« Reply #18 on: November 04, 2018, 05:22:11 PM »

This is precisely why I consider Tiers 3 and 4 (9 months total) as part of my bond allocation.  I hold the exact same amount of stock and bonds as I would if I put this money in a taxable account - or any other "investment" account for that matter.

Are you implying everyone should be 100% equities?

Nope, I think it is prudent to hold a balanced portfolio with some bonds.  Reasonable minds differ what the weighting should be, but it is clearly prudent to hold some percentage of your portfolio as bonds.  However--and this is important-- if you view your Tiers 3 and 4 as part of your normal investment portfolio, then by definition they aren't part of a dedicated emergency fund.  They are simply funds you are willing to access in an emergency.

Now, let's say you have a true emergency which expends your Tiers 3 and 4.  Obviously, at this point you need to rebalance by selling stocks and buying bonds, otherwise you are in 100% equities, which both agree is not particularly prudent.    So in reality, the stocks are part of your emergency fund already because you'll be selling stocks to bring your portfolio back into balance in the event of an emergency.

You've obviously given a lot of thought to this, but I don't see where the added complexity adds any safety or any value. 

COEE

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Re: How should you allocate your emergency fund?
« Reply #19 on: November 04, 2018, 07:52:30 PM »

This is precisely why I consider Tiers 3 and 4 (9 months total) as part of my bond allocation.  I hold the exact same amount of stock and bonds as I would if I put this money in a taxable account - or any other "investment" account for that matter.

Are you implying everyone should be 100% equities?

Nope, I think it is prudent to hold a balanced portfolio with some bonds.  Reasonable minds differ what the weighting should be, but it is clearly prudent to hold some percentage of your portfolio as bonds.  However--and this is important-- if you view your Tiers 3 and 4 as part of your normal investment portfolio, then by definition they aren't part of a dedicated emergency fund.  They are simply funds you are willing to access in an emergency.

Now, let's say you have a true emergency which expends your Tiers 3 and 4.  Obviously, at this point you need to rebalance by selling stocks and buying bonds, otherwise you are in 100% equities, which both agree is not particularly prudent.    So in reality, the stocks are part of your emergency fund already because you'll be selling stocks to bring your portfolio back into balance in the event of an emergency.

You've obviously given a lot of thought to this, but I don't see where the added complexity adds any safety or any value.

I'm not going to continue to split hairs with you.  Potato/potato.  You obviously see things differently than I do.  That's fine.

I have found my emergency fund gives me the liquidity that I need to sleep at night and is easy to implement and maintain.

nyxst

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Re: How should you allocate your emergency fund?
« Reply #20 on: November 05, 2018, 09:14:21 PM »
The downside:  In 2015 we apparently had a period of slight deflation, which means all of the bonds with lower rates paid 0% for the next six months.
Quote
How is this a bad thing?  I'm generally happy with a 0% yield during periods of deflation.

I think they just meant that for the life of that particular I bond you purchase during the lower years, it will ALWAYS have a fixed rate of 0%, plus the inflation rated tacked on.... so, alternatively, if you spent $ on bonds in years with high fixed rates, you are "stuck" with a good fixed rate for the next 30 years, plus inflation rates...

I have a standard savings, a high yield online account, I bonds, and a CD ladder as a parts of my EF. I also consider my Roth IRA as an extension of my EF..... Plus, I know that I could float a month of expenses one of my credit cards or pull from a HELOC if necessary also, but I would not be comfortable doing either of those unless the cash to pay it off was just "between accounts" and would be paid before the credit card bill was due. It gives me peace of mind to have these different structures in place, since I am a single parent and sole income in my household, and I am no where near FI so I have a mortgage and things I am still responsible for.  The rest is in VTSAX, so it gets ignored for the most part. Once the kids are grown, I will probably change things a lot.

COEE

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Re: How should you allocate your emergency fund?
« Reply #21 on: November 09, 2018, 07:11:04 AM »
I have a standard savings, a high yield online account, I bonds, and a CD ladder as a parts of my EF.

Hmm - looks like we have similar systems - you've chosen CD's over Treasuries.  Which is fine.  I'd suggest checking out treasuries if you haven't before.  Primarily because they do generally offer a higher yield than most CD's right now, they can be auto reinvested upon maturity (for 2 years), and they can be sold if you need the liquidity.

My point with the 0% vs deflation is that if we ignore the fixed rate, deflation is generally one of the times that your earn the most interest with your I-Bonds.  Say you have a fixed rate or 0%.  You've averaged 2.5% based on inflation over the life of the bond and you've been on par with inflation.  Then you enter into a period of deflation at -1%.  Instead of losing principle, you essentially have a fixed rate of 1%!  This is the first time you've actually beat inflation over the life of the bond.

Another point - my understanding is that the composite rate cannot go below 0%.  However, if you have a fixed rate of 0.5% and you enter into a period of deflation at -0.2% then your return will be ~0.3% for that 6 month period.  For this reason, it is actually better to have lower fixed rates during periods of deflation.

protostache

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Re: How should you allocate your emergency fund?
« Reply #22 on: November 09, 2018, 12:30:46 PM »
I like my system (because it's mine, of course). This is the system:
  • All non-401(k) money goes into and out of a taxable brokerage account with margin enabled.
  • The core position is set to a Federal Treasury money market fund.
  • Every paycheck I have it set to automatically buy a fixed amount of a fixed allocation index mutual fund (FFNOX, specifically)
  • When the money market fund gets too big (I like to keep $15k-$25k, depending on what I think our cash needs are going to be) I buy more FFNOX.
The end. Every other account we have (401(k)s and IRAs) is also invested 100% in FFNOX. That gives us an 85% stock, 15% bond allocation plus the balance of the money market fund with zero mental effort and zero possibility for behavior error. Margin is turned on to make it possible to completely ignore the account even in the face of zero income for an extended period of time.

Boofinator

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Re: How should you allocate your emergency fund?
« Reply #23 on: November 09, 2018, 01:56:17 PM »
As some others have noted, having enough money in equities is an emergency fund. Is it slightly riskier in the sense that I may need to pull it out during a downturn? Yes. But the opportunity costs I would have given up over the last x years by investing in lower performing assets for an emergency mean that I would need a stupendous (50%?) drop in equities before I would break out even by having invested in those lower-performing assets. (Keep in mind an emergency fund, is the opportunity cost on the money when first funded. So over ten years it will likely have at least doubled in equities relative to low-risk investments.)

Dedicated low-risk emergency funds are absolutely necessary for people who get true emergencies because they spend every dime they have. Mustachians don't generally fall into this category. Therefore I don't feel one is necessary, but certainly ok if you are extremely risk-averse.