A couple of weeks ago, Jacob at My Personal Finance Journey wrote an interesting article asking whether your emergency fund and other shot-term savings should be considered as part of your overall asset allocation. You can read it for yourself here: Should You Include Emergency Fund and Specifically-Earmarked Savings in Your Overall Asset Allocation?
I’m particularly fond of this post for two reasons: 1) It was spurred by a question I asked him in response to the detailed personal financial plan you can find on his site. And 2) It’s a topic that I’ve always had an opinion on, but never really fleshed out.
What are we talking about here?
I’ve talked on here before about the importance of your asset allocation in determining your investment returns. The question here is what money do you include as part of this asset allocation? Do you count your retirement savings and your emergency fund in one big pot? How should you factor in that travel fund you put money into every month? What about the savings specifically earmarked for a down payment?
Jacob’s conclusion was essentially that you can go either way (keep things separate or count them all as one) and be correct. I agree with this assessment. As long as you’ve determined your needs and have developed a plan that meets them, good for you.
But I like to keep them separate. Here’s why.
Reason #1: I don’t need a specific percent of my money for short-term goals
I have an emergency fund. I also have multiple savings accounts specifically marked for different purposes, such as travel and car maintenance. And I have a different location where I’m saving up for a down payment on a house. If I included these as part of my asset allocation, I would need to determine what percent of my overall money needed to be set aside for these purposes.
That’s not really how they work for me. I have a specific dollar amount that I want in my emergency fund based on my living expenses. For things like travel and car maintenance, I have a monthly amount that I set aside that mimics my long-term spending patterns for these categories. For my house down payment, I again simply have a specific dollar amount that I’m aiming for. These needed dollar amounts don’t change if I have more or less money, and therefore really aren’t a percent of my overall net worth.
If I managed them as part of my asset allocation, then the percent dedicated to cash would be pretty high when my net worth was low. As my net worth increased, assuming my needs stayed the same, I would either need to decrease the cash portion of my asset allocation, or I would have more money in cash than I really needed. So it either requires a change in my plan or it causes my plan to get out of whack.
By keeping these short-term savings separate, I don’t have to do any re-adjusting and my asset allocation automatically stays in line with my goals. I have the fixed dollar amount in cash, and the rest is simply invested according to my personal investment strategy. Keeping them separate means I have less work to do to keep everything in line with my goals.
Reason #2: Different goals require a different asset allocation
My longest term savings goal is retirement. A slightly less long-term goal is college savings for my son. My short and medium-term savings include some of the goals mentioned above. Each of these goals have a different time frame and therefore require a different balance between risk and return.
Once again, trying to combine them all into one asset allocation would introduce complexity, as I would have to manage all of those different risk-return profiles in one big pot. Instead, I have an asset allocation for retirement, a different asset allocation for college savings, and a final asset allocation for short-term needs. Managing them each separately actually makes things easier because I don’t have to manage the interaction between them. For example, as my children actually approach college age, I can shift the allocation of my college savings to a more conservative approach without worrying about how that affects my retirement allocation. If they were all considered together, any shift in one would require a consideration of all.
There’s no one way to approach this issue. You have to find what works for you and go with it. The important thing is that you find a manageable way to work towards your goals. I find it easiest to keep things separate for all the reasons mentioned above, but I’d love to hear your thoughts as well.
Other articles I think you’ll like
Planting our Pennies: A detailed look at whether using debt to purchase a home, instead of paying in full with cash, is a good financial decision. I love this because it challenges some of the widely assumed “benefits” of home purchasing.
Stacking Benjamins: A great collection of advice from a lot of smart people on how to make saving money easy. As Joe says at the end, focus on the common themes running throughout and you’re sure to find a successful strategy.
Reaching Financial Independence: Living without a mortgage reduces stress, and increases your ability to do what you truly want with your money.
Fat Free Personal Finance: Really thorough breakdown on why your rent payment and mortgage payment are not comparable. Owning a home is often much more expensive than many people think.