Welcome Back Debate Fans!

Are you ready for Grumpus to grumble about the concept of investing the Emergency Fund (EF) in equities?

Or should I say “GGGGGRRRRUUUUMMMMBBBLLLLEEE” in my best sport’s announcer’s voice?

A Quick Recap

I’m back with another round of Debate Club. I hope everyone enjoyed round one. Just to re-cap, ChooseFI episode 66 prompted this series of articles in response to the idea of investing an EF. In episode 66, and the follow-up episode 66R, Brad and Jonathan (the hosts) enthusiastically endorsed Big Ern’s (the guest’s) idea that the traditional EF, invested in some sort of cash or cash-equivalent account, was a bad move. Instead, all three agreed it made more sense that a person invest their EF in equities.

In response, I argued in my first article of this series that Episode 66 lacked nuance and suffered from a mistaken definition of the EF. In other words, Ern, Jonathan, and Brad set up a strawman argument and easily knocked it down. By the end of the first article, I created what I felt was a level playing field on which to engage in a debate about the merits and drawbacks of their argument. Thus, I moved on to the second article.

In the second article, Debate Club Round 1, I examined what I felt was Ern’s most powerful point left in his argument’s favor; probability. The bottom line is that Ern’s analysis of the macroeconomics during a series of his own articles, lead him to believe the likelihood that the average person would need their EF (invested in equities) at the exact time the stock market hit bottom, was fairly low. Thus, he assessed it made a lot more fiscal sense to invest an EF in equities, as opposed to cash, in order to capture the growth that equities bring. I argued that for people who worked in industries with a high correlation between recession and job loss, that was dubious advice.

Response!

To my surprise, Ern responded with a new article which broke down mathematically the risk associated with placing an EF in cash vs. equities. It’s cool that my little two-part article prompted such a well-analyzed response. OK, maybe that overstates the causal effect. I can’t quite link his latest article to mine specifically. However, I can say that after he adjusts his statistics for several factors, like serial correlation, Ern argues that the math shows investing your EF in 100% equities isn’t as risky as you’ve been lead to believe.

I can neither refute nor confirm Ern’s latest argument since I’m not a math major or statistics wiz. If you are, I suggest you read the article and draw your own conclusions. What I can say, is that Ern’s a betting man, who will bet in favor of the probabilities every time. If his bet comes up trumps, he’s capable of absorbing the loss both mentally and fiscally. He admits as much throughout his series of articles on the EF, including this latest one.

Ern also responded in the comments section of my Round 1 article. He basically asked why I argued the probability point? He believed he’d conceded in Episode 66 that his advice wasn’t for people who didn’t possess a safe job. I responded that I didn’t believe simply mentioning job security in passing on Episode 66 was enough. The subject deserved an in-depth discussion in its own right. For their part, Brad and Jonathan haven’t responded at all. Which brings everyone up-to-date on the EF Debate Club.

With that said, I’m going to cover the other half of Ern’s risk argument from his first five articles on the issue in depth in this round. Strap your thinking helmets on kids, because this gets confusing quick.

Round 2: Rational Economic Behavior and Risk

Throughout Ern’s first five articles on investing the EF, he builds a fairly complicated case around the idea of risk. Part of his argument is based on probability, which I covered last round. However, other parts of his argument include references to the mental accounting bias, the fungibility of money, rational behavior, and the efficiency frontier. I’m going to attempt to break it down Barney style; in case you are like me and your knuckles scrape the ground when you walk. The trick is how to simplify his points without diluting his argument.

For those of you who read Round One of the Debate Club, you’ll remember this quote from Ern, “unless you are crazy, crazy risk-averse, the emergency fund is still not worth it!“. It’s apparent that Ern views an EF invested in cash as a crazily risk-averse based on probability, but does he view it as anything else? It turns out he does. He also views it as inefficient.

Ern argues people should view risk across their entire portfolio, as opposed to their individual accounts (e.g. the bucket method). Anyone who chooses to view risk separately among their different accounts succumbs to mental accounting bias. Mental accounting is based on the idea that money is fungible. Not familiar with that term? Fortunately, I am. It means that money can be moved from one account to another … fairly easily. So easily in fact, that the separation we impose on accounts is more mental than real.

Fun with Money

We used the “money is fungible” argument a lot during my Global War on Terror deployments, especially when it came to linking drug dealers to insurgent activity. The dealers weren’t necessarily supporting the insurgency, but they did business with the insurgents; just like they did with everyone else. Let’s say a dealer wanted to buy opium or hash from insurgent-held areas (often the best areas to grow the stuff). The dealer gives $100K to his cousin, who in turn sends it through a Hawala to his mother’s uncle.

Mother’s uncle receives the money, and in turn combines it with several other orders, totaling $1mil. He treks over to insurgent territory and buys the drugs from the insurgent version of Kevin Bacon (since we are now separated by several degrees). Uncle comes back with $1mil in drugs, splits it up accordingly, and sends the correct amount of drugs to the cousin. The cousin eventually brings the drugs to the dealer. The dealer then moves the drugs through the smuggling network to Europe, Africa, or the Middle East to reap the insanely high rewards. Get it?

The Point About Fungibility

Now, was the original dealer who gave the $100K to his cousin, guilty of supporting the insurgency? While he gave the money directly to his cousin, the cousin used a Hawala to send money to his mother’s uncle. Is the $100K that goes in one end of the Hawala, the same money that comes out the other end. Some version of that $100K eventually made it to the insurgents as part of that $1mil total, but whose money was it by the time it got there? Naturally, we’d argue that since “money is fungible”, the dealer might as well have paid the insurgents directly. If that argument was accepted by higher command, then we’d queue the Predators.

I jest! Our Rules of Engagement (ROE) weren’t that loose. We’d simply attempt to detain the dealer, interdict the drugs, and give everyone hugs and kisses. It was fun … gibility of money in action. Ha! And I bet you thought this part would be boring.

Back to Ern’s Argument

Now, what’s this mean in relation to your personal finances and investing an EF? Well, according to Ern, since money is fungible, it’s irrational to view an EF that sits in a cash account as separate from the rest of your investment portfolio. Instead, a person should view it as the cash portion of their entire portfolio. Following this line of thinking, the typical purpose for holding cash in a portfolio is to mitigate risk, but as Ern points out, there are more efficient methods to mitigate risk over an entire portfolio — methods that earn higher returns. He plots it out on something called the Efficiency Frontier, but also sums it up this way:

I can fully understand that someone is uncomfortable with the roughly 15% annualized risk a 100% equity portfolio would bring. So, if someone wants 12% risk and not a single basis point more one could argue that 20% cash is one way of getting there. But it’s not a very efficient way because you could also get to that same expected risk level by mixing in other uncorrelated or even negatively correlated assets (such as longer duration bonds) that have higher expected returns. You will get a higher expected portfolio return at the same risk level.

He further points out:

By artificially constraining your portfolio into one risky and one risk-less bucket for emergencies, you likely get lower returns than having optimized one large portfolio with the same overall average risk target.

Summarizing Ern

That’s Ern’s risk-inefficient based argument in a nutshell. Since money is fungible, it’s irrational to view accounts separately. Thus, all accounts should be viewed as part of a whole. Once you view your portfolio holistically, you realize there are more efficient methods for mitigating risk than holding a part of your portfolio in cash — primarily by investing in non, or negatively, correlated assets to equities.

In conjunction with his “there’s a low probability you’d need a cash EF” argument from round one, the “it’s irrational and inefficient to hold cash to mitigate risk” argument acts as one hell of a second punch in a one-two combo. We’ll see if it knocks me out for the count, or if I am able to dodge and parry.

Round 2 Rebuttal: It’s OK to Act Irrational

Let’s start with the mental accounting bias. The mental accounting bias is a theory developed by Richard Thaler, the now, Nobel Prize-winning economist. Thaler pioneered the study of behavioral economics and became famous for his work in explaining why humans act irrationally when it comes to money. This is important because up until Thaler’s point in time, economists of all stripes used “Homo Economicus” as their standard model for how people acted inside their economic models. Homo Economicus always acted rationally when it came to money. Always. Economists used Homo Economicus because they believed it was too hard to study and explain economic behavior at the individual level.

Thaler believed differently and has spent his entire career proving it is possible to study economic behavior at the individual level. He describes economics as it appears in real life, not how it should appear on paper. What he found was that rather than humans acting rationally, the majority tended to act irrationally when it came to money. In other words, he turned the models built on Homo Economicus on their head.

Turns out that just enough people act rationally that most economic models hold in theory. However, when applied in real life, economic models quickly turn messy. Thus, when asked what he’d do with the prize money after winning the Nobel Prize in Economics, he responded he’d “try to spend it as irrationally as possible.”

“What it is, what it was, what it shall be.”

Why is that important to the argument at hand? Well, mental accounting isn’t good or bad, it just is. Or, viewed alternatively, the use of mental firewalls to effectively reduce the fungibility of money could be used to either good or bad effect. To use the same type of language Ern used in one of his articles, when he exclaims “cash EFs are irrational”, my response is “Yes, agree. And?”.

The fact is, the large majority of people aren’t rationally driven by numbers or efficiency arguments like Ern or economists. Richard Thaler just won a Nobel Prize for proving as much. To put it into terms that us sci-fi nerds understand; when it comes to money people are a lot more like Kirk, and a lot less like Spock.

To further my point, Freakonomics podcast, created by acolytes of Richard Thaler, recently ran an episode which demonstrated how scientists find examples of rational economic behavior far more often in the animal kingdom than among humans. The most memorable quote from the episode was in response to a question about where observers would most likely find Homo Economicus-like behavior: humans or animals? The response:

“… leave out the “Homo” part and you’re okay“.

Quit Y’er Complainin’

What does this do to Ern’s argument about investing an EF in equities? In my humble opinion, it puts the argument into context … a lot of context. Ern isn’t describing how things are, but the way they should be when he argues for the rationality and efficiency of investing an EF in equities. Unfortunately, doing so glosses over the fact that most people aren’t able to control their worst urges and temptations as an individual economic actor. So while Ern’s arguments might have merit for those whose risk capacity and psychology can handle the ride, his advice isn’t for everybody. In fact, it’s hardly for anybody.

This is the issue Ern doesn’t grasp when he complains that many personal finance proponents celebrate the idea of separating money into buckets. The bucket system is a method that accepts people’s economic behavior as it is; not the way it should be on paper. Thus, it’s not trying to change everything about people’s economic behavior, just nudge them (another Thaler idea) in the direction of better fiscal habits. Which probably explains the popularity of the idea. In the land of the blind, you don’t need perfect, prescient, vision; you just need one eye, to be king.

Summation

In life, everyone can’t optimize everything; and that’s OK, as long as people understand why. As I pointed out in Part 1 of this series, some people can’t absorb the loss of their EF — something called risk capacity. In Part 2 (round 1 of the Debate Club), I statistically broke out which professions are more at risk of job loss at the same time stock markets historically tank (i.e. when you would need your EF). In this article, I pointed out that most people just aren’t wired for optimal economic behavior at the individual level. Taken together, I think my three articles provide a robust defense for those who choose to keep their EF in cash.

Which isn’t to say that Ern’s arguments regarding the rationality and efficiency of investing an EF in equities lack merit. I think they hold a lot of applicability actually, but only for a certain subset of individual economic actors. In fact, in a future article, I intend to discuss whether or not Ern’s arguments merit consideration among my Golden Albatross audience.

Don’t Worry, Be Happy

Ern’s “bet big in favor of the probabilities, and suck it up if you lose” advice is not meant for everyone. As I just pointed out, it’s not really meant for most of us. If the bucket method for handling your EF is the 101 of personal finance advice, then Ern’s “invest your EF in equities” is the 401 level.

Finally, please don’t fall prey to Ern’s dour language that implies people are dumb if they don’t invest their EF in equities. The fact is you’re not dumb if you keep your EF in cash, simply human. Actually, as Austin Power’s would say, “you’re a little bit of alright!” because most people can’t even manage enough rational economic activity throughout their lifetime to build an EF. It just so happens that some dude named Thaler won a Nobel Prize for proving that exact point to a lot of smart people recently.