Can You Get Away With a Smaller Emergency Fund If You Have Investments?

It intuitively makes sense, but does it work?

It intuitively makes sense, but does it work? 

Life has a way of throwing expensive surprises at us when we least expect them. A pipe could burst inside your home. An issue might render your vehicle undrivable. You could get hurt and rack up a pile of medical bills or lose your job and go without a paycheck for months.

That's why it's so important to have emergency savings. Having money you can access in a pinch means you're less likely to charge unanticipated expenses on a credit card and take on debt. Ideally, your emergency fund should contain enough money to cover three to six months of essential living expenses. It should also be kept securely tucked away in a savings account.

But what if you have a robust investment portfolio? Can you get away with saving less money for emergencies knowing you can cash out investments as needed?

The truth is that as long as your investments are worth money, they offer you a degree of financial protection. But your investment portfolio shouldn't serve as your emergency fund. Even if it's healthy, having enough money in the bank to cover at least three months of living expenses still pays.

The danger of relying on investments for emergencies

You're no doubt aware that you can sell investments when you want or need cash. If you sell them when they're worth more than what you paid for them, you profit. If you sell them at a lower price, you lose money. It's pretty simple.

The problem with having your investments take the place of emergency funds is this: If the need for immediate cash arises when your investments are down, you risk permanently losing money as a result of bad timing.

Although you'll generally earn a higher return on your money in an investment portfolio than you would in a savings account, your principal isn't protected. On the other hand, if you keep your emergency fund in the bank, you're guaranteed to keep that principal intact. 

Imagine you need $2,000 for a home repair and that you cash out a stock position in your portfolio to access that money. If you paid $2,500 for those stocks, you're looking at a $500 loss. But if you put $2,000 into a savings account and withdraw that money for a home repair eight months later, you're taking out that same $2,000 but you'll have earned a bit of interest on it while it sat in the bank. 

Your best bet is to have a complete emergency fund available in savings and then put your excess cash into investments. If you skimp on your emergency fund because you have investments to fall back on, you risk taking losses that could be tough to recover from.

Furthermore, by keeping your emergency fund in a savings account, you'll remove much of the stress that comes with potentially having to cash out stocks or bonds at a bad time. And that peace of mind alone is worth forgoing some earnings on your cash.