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Roger Nusbaum submitted a thought-provoking article on Thursday (5 Dec) slamming the WSJ suggestion to invest emergency cash, defined as the:

"three-six months worth of expenses that financial experts say people should set aside for some sort of unexpected hardship."

Initially I also rallied against this seemingly reckless advice, but upon further thinking, I actually think the WSJ is spot-on - with a few caveats. The investor who fits the profile below (age 25-55 with decent assets and strong credit balances) will likely be much better off in the long-term by keeping extremely minimal assets in direct cash and instead relying on home-equity credit (HELOC) and/or credit cards for short-term cash needs.

I will illustrate this approach both theoretically and mathematically below. I know this might be controversial, but I look forward to the expected commentary.

Caveats to my WSJ Endorsement

Key assumptions on the demographics: I'm assuming a 25-55 year old with health insurance, reasonable job security, a decent amount of assets ($50k+ either in the forms of diversified securities or home equity), and strong credit (low-to-zero concurrent credit card balance, limited other debts beyond student loans and home mortgage).

Judging based on my experience, with nearly 3 years as a Seeking Alpha community member, if you exclude the (large #) of older/retired members and the college contributors, this description fits the rough average of most active members here.

Timing is Very Poor: The WSJ is suggesting a higher-risk investment approach near all-time highs and correspondingly high market expectations. Based on historical patterns, risky advice like this usually comes out close to peaks. Ironically, when the best time to go "all-in" comes around (think 2009-2010), most 'investors' are plowing their money into bonds, gold, and cash. Luckily for most people in 2009-2010, most bonds have performed pretty well (until 2013) due to the cost/yield relationship. I shun the WSJ article based on timing because likely after the next crash they will submit some off-timed drivel to the tune of "Everyone should keep extra cash on the side!"

Credibility of my Opinion: Since I have nowhere near the credibility of Mr. Nusbaum, I will try to explain my position in much greater detail. I endorse the philosophy that "expert credibility" requires either massive personal success or strong endorsement from others with massive personal success. Since I have much less credibility than Mr. Nusbaum in both categories, I'll do my best to properly explain the theory here. I would argue that I am doing 'fairly' well in the investment world for someone who just celebrated their 23rd birthday.

The Theory

Investors fitting the above profile will be likely be much better off in the long-term (10+ years) if they never keep more than 1 month worth of expenses in 'emergency cash.' This does not include potential/transitional 'dry powder' in your brokerage account.

Suggested steps are below with brief examples.

Step 1: Highlight your Possible Emergencies

The first step is to determine what possible "emergency expenses" could arise. I recommend that every investor spends at least an hour or two brainstorming every possible (realistic) emergency and assigning a probability.

I completed this exercise with my fiancée recently due to her conservative bias of keeping high amounts (100% of her assets) in cash. She was very worried about 'potential emergency expenses.' In this example our potential needs for cash are:

- Upcoming (non-covered) wedding expenses

- Car breaks down

- Car wreck at-fault (we only carry liability insurance)

- Medical emergency (we both have medical insurance)

- Loss of a job (UI and 2nd income will tide over)

- Parents need help (unlikely since both sets of parents have 100% home equity and good health)

- Robbery, theft, or home disaster (all valuables are insured and we have renter's insurance)

There might be some additional expense possibilities, but this is the mainstream list. Since 'wedding' is technically more of a planned expense, the only major (likely) risk we have is an at-fault car wreck or major car break down.

Step 2: Examine Credit Potential

The next step is to evaluate your ability to survive under a "crisis mode" (loss of job, high medical bills, new car requirement, etc). This also includes a full evaluation of both your debt level and your required payments (mortgage, rent, utilities, car payments, etc).

In our example scenario we both had $0 in outstanding credit due (not including margin debt). We had enough untapped "free" (12/15m - 0%) credit card authorization to cover up to 6 months of expenses (based on required payments and bare minimum subsistence) and enough medium charge (7.5-15%) to cover an additional 6-9 months of expenses.

Many investors in their middle-ages should have the ability to tap a line of credit based on their home equity (HELOC). HELOCs are harder to secure than prior to the housing crash, but are still offered to most homeowners with strong levels of home equity (less than 50% debt/market). HELOC rates are typically much lower than credit card debt due to their secured nature.

Although critics will point out the difficulty of opening a HELOC while unemployed, these credit lines can be opened as an insurance measure during 'good times.' HELOCs often have minimum setup fees and low-to-no annual rates on undrawn funds. Even a theoretical 1% rate on the 'emergency amount' would be far cheaper than the opportunity cost of keeping cash versus not investing those funds.

Step 3: Assess Your Risk Tolerance

The next step is to determine your personal risk tolerance level. The above two sections should have sufficiently covered 'risk-ability.' Investors who are very risk-adverse, but don't invest accordingly are the types who got wiped out in 2008-2009 and stayed out of the market until recently, and will likely get wiped out again. Sadly, there are many investors who 'buy low, sell high' due to their (perfectly natural) bi-polar risk tolerance. Human nature subscribes us to a strong crowd tendency and the greed-fear complex. Investors must attempt to remain detached from emotions and subscribe to a rationally-backed approach. While seemingly common sense, that advice is much more critical to success than any decision on how to allocate 'emergency cash.'

I personally am extremely risk neutral, even sometimes irrationally risk-seeking. My fiancée is the opposite in this category.

I prefer a low-to-negative cash balance, while she clearly needs a decent amount (at least 2m of expenses) to feel secure. We didn't push to violate our personal tolerance levels in either direction and neither should you.

If investing 'emergency cash' and/or reliance on a HELOC unnerves you to the point of feeling panicky, then you will be better off sticking to the traditional cash reserve.

Step 4: Invest Accordingly

After assessing both your risk tolerance (step 3) and risk ability (step 1 & 2), invest according to this profile. If you have both high tolerance and ability, then keep low levels of cash and invest in corresponding assets. Conversely, investors with lower tolerances and ability should keep higher levels of cash and invest in safer assets like blue-chip stocks (ex: MCD, WMT, KO, XOM, PG). Regardless of your risk profile all investors should attempt to maintain an appropriate level of diversification.

With under $20k invested, the easiest way to accomplish this is to find a few total market ETFs with lower expense ratios. While blue chips are 'safe,' it's important not to be too concentrated in one industry (i.e. a portfolio of only tech or only energy could be very risky).

Please do not get hung up on the appropriate assets, as this article is more focused on the idea of 'extra cash.' Almost any investment philosophy (DGI, index, growth-only, international, full spectrum, efficient MPT) can be very successful over the long (10-20+ year) timeframe if emotional trades and strategy shifts are avoided.

The Math

This section will highlight the 20-year impact based on a very conservative (4%) and average (7%) expected rate of real (inflation-adjusted) portfolio return, two 'emergency cash' allocations (1m and 6m), and four scenarios-no major emergencies, one massive emergency after 10y (6m of cash needed), massive emergency every 5 years (6m of cash needed 4 times), and finally the 'king bearish' scenario with a major emergency every 5 years coupled with a corresponding 30% market crash. If you are more 'unlucky' than the 4th scenario, it's unlikely any amount of emergency cash would make a difference, as you would never have a chance to raise any assets to begin with.

The math assumes monthly expenses of $3k, yielding an investment of $15k and cash of $3k in the 'invest' scenario versus cash of $18k in the 'full emergency cash' scenario. Please do not get caught on the expense #s, as the ratio of returns %s is the key indicator here. While the 4% and 7% real returns are subject to debate, the real annual return on cash (savings, money market, or short-term CDs) is likely to be negative over the long run, so the 4-7% spread might be even higher in an inflationary environment.

No Major Emergencies

With $3k saved and $15k invested for the duration, the present-dollar return is $35,867 or nearly double the 6m allocation of $18k. With a 7% real-return, the present dollar return is $61,045, or 3.4x higher than 6m of cash reserves.

One Massive Emergency After 10y (6m cash drain)

This scenario results in $25,203 after 10 years (4%) or $32,507 (7%). In either case, you are far better off drawing down your investment fund by $18k ($7.2k-$14k left) than using cash ($0k left). After 20 years, assuming no more massive emergencies, and the need to replenish your $18k in emergency cash you would have $37,302 (4%) or $62,950 (7%) versus the $18k left in cash. This scenario yields a gain of 2.1-3.5x versus cash.

Massive Emergency Every 5 Years

Assuming you have to replenish the $18k in 'emergency' cash following each emergency ($72k total cash) versus 3 draw-downs of $18k (5, 10, 15y marks), the lower-yield (4%) ends in $39,440 and the higher yield (7%) ends in $69,654. This gives a gain of 2.2-3.9x versus heavy cash.

Disaster Scenario

Every 5 years the market dips by 30% right as you are unemployed for 6 months, fully eating the cash reserve pile. Since the long-term returns of 4% and 7% stay in place, the corresponding non-crash years of return will average 11.7% to 14.9%. To simply calculate the 30% crashes without corresponding bull years is bad math. To highlight this case, an excel sheet is included below. The return advantage of only keeping 1m of emergency cash, versus 6m of cash, even in this 'disaster scenario' is 1.2-1.9x.

(click to enlarge)

Additional Thoughts

Your 401k and up to $1M in IRA funds are shielded from bankruptcy. If your major fear is a large medical expense and you keep piling up cash or paying major insurance premiums instead of making retirement contributions, you could be making a major mistake.

It could be far more beneficial to keep a massive IRA and 401k and a skimpy cash/credit balance. If you are cursed with a major health expense, that you probably couldn't even pay for if you kept cash, you can emerge post-BK with your nest egg intact. This is especially important for older (50-65 year old) investors to consider as health insurance rates spike.

If you have retirement assets in excess of $1M, you probably shouldn't be worried about emergency cash as well since dividend yields alone should cover most of these (non-medical) costs.

Conclusion

Ultimately, every investor should pursue a strategy that is concurrent with their level of risk-ability (financial position) and risk-bias (personal views). Violating either of these principles will likely lead to financial distress. If you are a skittish (strongly risk-averse) investor, I recommend only extremely stable investments and lots of side cash. If you have minimal assets and less job security, I recommend the same.

Please view my piece as more of a debate starter than an attempt to make a "one-size-fits-all" recommendation to the community. I look forward to addressing the feedback and varying opinions below.

Disclosure: I am long MCD, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Investing 'Emergency Cash' Is Good Advice With Bad Timing