Doubting Grumpus

I spent a recent weekend and a good part of the following week “engaging” in the main ChooseFI Facebook group on the topic of whether or not it’s a good idea to invest your Emergency Fund (EF). This debate was prompted by ChooseFI Episodes 66 and 66R in which the “Invest Your Emergency Fund” thesis was broached, examined, and positively endorsed by the hosts and their guest. Just to be clear, I argued (congenially, of course) that in general terms, it was a doubtful thesis. More importantly, though, I pointed out (along with several other people) that the framework for the debate was poorly constructed. This was primarily due to a lack of defined terms.

For the record, I’m a big fan of the ChooseFI Podcast, and not only because they interviewed me. The hosts, Brad and Jonathan, typically dole out challenging but sound Financial Independence (FI) advice. Although they stooped low to interview me, their guests are also typically top notch. In fact, their guest for the “Invest Your Emergency Fund” episode was Big Ern McCracken. Ern runs the Early Retirement Now blog — of which I’m also a big fan. Ern’s not only a valued member of my Golden Albatross FB group, but we even collaborated on an article for my website.

Left and Right Limits

Thus, it’s not without trepidation that I pen an article which takes issue with my FI compatriots. Healthy debate, even among friends, can prove stressful. I’m not even entirely sure I’m the right man for the task. Ern made several statistic and probabilistic arguments in favor of investing the EF, and as my three loyal readers know, my knuckles scrape the pavement when I walk. However, for the good of my audience (and theirs quite frankly), I felt compelled to formulate some thoughts on the issue. Since my audience consists mostly of pensioners or potential pensioners, it’s a discussion worth engaging in. Who knows? The potential for a future pension may change the risk calculus for many of us one way or another.

Before that though, I want to bound this issue properly; especially since Brad, Jonathan, and Ern failed to do so. I intend to do that by stripping away the hyperbole and setting some agreed upon definitions. After that, I’ll discuss the concept of risk at some length. I feel it’s important to do this in order to ensure everyone is on the same page — which was not the case in the Facebook group or in the episode itself. This format choice will naturally push the length of the article longer than my normally lengthy articles. As a result, I intend to break this post into two parts: 1) boundaries and definitions; 2) an analysis of the argument and its merits. Right, onto the boundaries and definitions then.

Stripping Away the Hyperbole

I had to dig deep for this pop culture reference. Any Gen Xers out there remember the song “Talkin’ Seattle Grunge Rock Blues” by Todd Snider? I doubt it since it was a satirical parody folk song about the grunge scene in Seattle in 1995. In the song, a band looking to make it big engaged in all sorts of “gimmicks” to get noticed. Their main shtick was refusing to play or record their songs. Todd crafted some truly sublime lyrics including “Silence, music’s original alternative”. Or “That’s alternative. Hell, that’s alternative to the alternative. I feel stupid and contagious”. For some reason, those lyrics tend to bounce around in my head whenever I see people trying to outdo each other in a race towards the absurd. It’s like the musical version of “Ludicrous Speed” from Space Balls.

Now, that it isn’t to say that Brad, Jonathan, and Ern’s point was absurd, but it is to say they may have been a bit eager to prove their point. ChooseFI prides itself on slaying the sacred cows of conventional financial planning wisdom. In fact, the tagline for Episode 66 was “Challenging the Sacred Cows of Personal Finance”. I’m a big fan of questioning conventional wisdom, for many of the same reasons as Jonathan and Brad. If conventional wisdom doesn’t withstand scrutiny, there’s the chance to adjust behaviors in order to create better outcomes.

On ChooseFI they often refer to this as optimization or optimizing the path to Financial Independence. The idea is that a person can reach FI faster through optimization. A lot of small gains in efficiency add up; especially when considering the effects of compound interest. Also, one big gain at the sake of a dead sacred cow, can make a huge difference over several decades of saving. However, not all sacred cows or conventional wisdom succumbs to scrutiny. Or, to put it another way, not everything can be optimized.

Betteridge’s Law

Moving on with my somewhat tongue-in-cheek but somewhat serious point; the title of the episode foreshadows the fact that Brad and Jonathan know that the Emergency Fund sacred cow withstands scrutiny. The title for ChooseFI Episode 66 was “The Emergency Fund Is it a Bad Idea?”. That title is inflammatory. It’s click-bait designed to sucker folks like me into listening. As a result, people are inclined to either agree or disagree, based on their pre-formed opinion to the question. I am guilty of succumbing to that social programming. Like I said above though, ChooseFI’s content is typically solid. They don’t need to choose titles like that. Therefore they chose a binary (yes or no) question for a reason.

The explanation may lay in Betteridge’s Law of Headlines. I first learned about Betteridge’s Law from the hilarious article at Actuary on Fire (AOF). Betteridge’s Law basically states that journalists entitle stories as a yes / no question because, “they know the story is probably bullshit, and don’t actually have the sources and facts to back it up, but still want to run it”. Don’t look at me (ChooseFI guys), that’s an actual Wikipedia quote of Ian Betteridge. You chose your title, not me. I just pointed out its weakness.

Wikipedia also quotes Andrew Marr, a British Newspaper editor, who said:

A headline with a question mark at the end means, in the vast majority of cases, that the story is tendentious or over-sold. It is often a scare story, or an attempt to elevate some run-of-the-mill piece of reporting into a national controversy and, preferably, a national panic.

As a side note, I checked all my articles to see how many violated this law. There was one. One of my least popular articles actually. Coincidence? Probably not. I didn’t bother to change the title.

Back to my point, did I just win the argument by trashing their title? No, no, no. I don’t want Ern accusing me of succumbing to the Fallacy fallacy. However, I did want to plant that seed of doubt in your head. How’d I do?

What is an Emergency Fund?

My main disappointment with ChooseFI episode 66 stemmed from the fact that Jonathan, Brad, and Ern engaged in a conversation about the Emergency Fund (EF), without properly defining what it is. They double downed on that mistake in episode 66R. So as not to commit that same error, I think it’s worth noting that Investopedia defines the Emergency Fund as:

… an account for funds set aside in case of the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major repair to your home. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to draw from high-interest debt options, such as credit cards or unsecured loans.

That’s a fairly comprehensive definition. Investopedia is not the only site that describes the EF in those terms. The sacred site of all FI investors, Vanguard, pretty much describes it the same way!

The Operational Fund

The above definition is not what Brad, Jonathan, and Ern implied as their understanding of the Emergency Fund. They seemed fixated on the idea that an EF was meant for a person who needed to replace their washing machine. Granted, I can almost forgive them for this mistake since a majority of Americans cannot afford an unexpected $500 dollar expense. I can almost forgive them … but not quite. If you’re going to engage in a discussion for your 10,000 plus listeners and FB followers on investing an EF into the stock market, vice keeping it in safer accounts, it’s your responsibility to frame your argument correctly.

In reality, what Brad, Jonathan, and Ern mistakenly described in their podcast as the EF is, in fact, something different. I call it the Operational Fund, but there’s no well-defined term for it in personal finance literature as far as I can tell. Most people, who actually have enough money to cover expenses, probably just call it their checking or savings account.

Holy schnitzel! Did I just win the argument again? 2 and 0 baby … TWO and OH! Imagine me doing my touchdown dance, which includes the moonwalk and  crossing my hands back and forth over my knees as I walk like a duck.

OK, OK. I’m willing to concede that I didn’t win…quite yet. Besides, there are no winners and losers here, since we are all friends (right guys?). I just want to ensure a healthy and well-informed debate. To that end, how am I doing so far?

Let’s Talk About Risk, Bay-bee

Other than a hyperbolic laden title, and not properly defining the EF, the next biggest issue I took with the ChooseFI episode is that they never stopped to address Risk. I’m not talking about the classic board game (in which, by the way, I would totally dominate Jonathan if we ever played). I’m talking about the classic personal finance definition of Risk as Investopedia describes it:

Risk involves the chance an investment‘s actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment.

Don’t get me wrong, they talked a lot about Risk. However, they never defined it. Yes, their discussions covered the probabilities associated with a market crash when an EF invested in the stock market might be needed — which Ern argued was low. Yet, not once did they stop to articulate the difference between the willingness to engage in risky investing behavior (which might lose a person money), and the financial capacity of a person to absorb the loss. That discussion would have involved drawing the important distinction between risk tolerance and risk capacity, prior to engaging in their discussion on investing the EF.

Risk Tolerance vs. Reality

All humor set aside now, this is the most important point for part one of this two-part post. Risk tolerance “is the degree of variability in investment returns that an investor is willing to withstand”. Some people can stomach a lot of risk and invest heavily in equities (i.e. stocks). They are therefore able to watch their investments drop like a rock, only to rebound a year or five later. In general terms, the upside for these types of investors is that an equity-heavy portfolio has the highest chance for large returns; as long as they don’t panic and sell when the market is down.

The Godfather of the FI investing world, Jim Collins, embodies this philosophy. In Chapter 35 of his book, The Simple Path to Wealth, he basically points out that the further you go out on your investing timeline, the more risk simply turns into volatility. As long as you don’t need to sell your stocks for the money in the short term, and assuming you can stomach the “gut-wrenching” ride psychologically, then it’s almost a sure bet to invest up to 100% of your portfolio in a broad market index funds like VTSAX during your wealth accumulation years.

Other people are not able to tolerate much risk at all, and they know this, so they choose to invest a large portion of their money in bonds, or safer investments, that don’t vary so wildly in value. Again, generally, the upside for investors like this is that their money is safe(r). The downside for them is that they don’t stand to earn nearly as large of a return as someone invested heavily in equities. The important distinction between both types of investors above is that they understand their personality, and invest accordingly. Neither are likely to panic and sell.

However, a large majority of commercial investors (people like you and me) think they can handle the risk of an equity-heavy portfolio, only to lose their nerve and sell after the market tanks. They neither understand the math and/or their own psyche well enough to prevent themselves from making this mistake. This is a generalization, but there’s a lot of evidence behind it. Don’t believe me? Just Google “Dalbar’s annual study”. You’ll find no shortage of articles chronicling sub-par investor performance versus the S&P 500 and the Bond market over the past 20 to 30 years. In fact, as I’ve pointed out elsewhere on this website, and as Lance Roberts pointed out at Market Watch, the most recent Dalbar study showed “the 20-year annualized S&P 500 return was 7.68%, and the average equity fund investor’s was only 4.79%, a gap of 2.89%”.

Risk Capacity

Risk capacity is distinctly different from risk tolerance. Despite someone’s psychological ability to ride out the gut-wrenching volatility in the equities market, they may not have the means to absorb the potential loss in value that the risk represents. That may be because their investing timelines are much shorter. As an example, perhaps a person intends to retire soon, and start withdrawing money from their portfolio. Heavy exposure to the equity market would expose them to Sequence of Returns Risk (SRR) which could sink their retirement fund to an irrecoverable degree. Big Ern understands this better than most, as he’s written the definitive guide to Safe Withdrawal Rates (SWRs) in order to overcome SRR.

Alternatively, perhaps the person doesn’t have much money, to begin with. Therefore any drop in value may represent a loss they are unable to absorb. Furthermore, maybe they actually need to put the money to use. Thus, some people may not be able to risk anything at all when it comes to their money. This is my point, without a discussion about a person’s risk capacity, it’s not appropriate to discuss whether an EF should be invested.

My Major Issue

This is my major issue with ChooseFI Episode 66. The boys simply waded into a discussion on the pros of investing an EF. They never stopped to consider the  various circumstances of their audience members. Without that discussion, whose to say whether or not it’s an appropriate risk for someone to take? One size does not fit all in this case.

As we’ve discovered with the definition of an Emergency Fund, it acts as the ultimate insurance policy against the worst of the worst happening in someone’s personal finance life. Just like in real life, some people can afford to play the odds — primarily because the likelihood of needing the insurance is extremely low. Others, not so much. And then there are the people who can’t afford the risk at all. They need the insurance policy because if the worse were to happen, the expense would send their life out of control.

One Final Thought on the Way Out

I think I’m killing the debate to re-frame the discussion on investing the Emergency Fund. If I were an Italian Soccer player who just scored, I’d be celebrating like I just won the World Cup for my nation. However, since Ern is German, he’ll appreciate the fact that I feel more like a German soccer player who is the only one putting-out for his side on an off night during World Cup qualifiers. Episode 66 was definitely an off episode for what is otherwise a world-class ChooseFI team. That’s too bad. Normally the ChooseFI crew bring their “A” game to every episode, but in this particular case, they didn’t. Fortunately, devoted followers like me, are here to pick up the pieces. I’m happy to restructure the debate into something more worthy of their quality podcast.

With that said, it’s time for the real debate to begin. Now that we have the proper structure for a debate about the Emergency Fund, we can discuss the merits of what Ern, Jonathan, and Brad argued for in episodes 66 and 66R. I’ll be honest, I’m a little nervous. Even with a re-framed argument, there’s no guarantee that the merits of their points are any less persuasive. However, now that I have an even playing field (or pitch, for those still following my soccer analogy); I feel much more comfortable arguing in favor of a conservative investment mechanism for an Emergency Fund.

The ChooseFI boys created such tilted arena in Episodes 66 and 66R, that arguing the counterpoint in their Facebook Group was like pushing a rock uphill. My only hope is that their audience didn’t immediately run out and invest their EF in equities. That, after all, would represent some extremely lemming-like behavior; which, ironically, Jonathan and Brad are constantly arguing against. We’ll see though. Tune in next week to find out what happens, kids!