Saving in the fast lane of high yields

Investing in volatile assets may have the potential for higher gains, but it's not the best way to build an emergency fund.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: People are often advised to keep emergency funds in a secure investment vehicle that's highly liquid, like Treasury bills or a money-market fund. But wouldn't it make more sense to invest emergency funds in a higher yielding asset class, use a home equity line of credit for financial emergencies and then sell off some of the higher yielding assets in the emergency fund to repay the line of credit? - Dale, Charleston West Virginia

Answer: This is one of those strategies that comes off flawlessly in theory and may very well work in real life too - except when it doesn't.

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And, unfortunately, the times when it doesn't work well are the very times when you will most likely really need the security of a bona fide safety net. To give you a sense of what I mean, let's do a little thought experiment.

Suppose that instead of putting your emergency money into a money market fund you invest it in something with a shot at higher gains, say, a combination of stocks and high-yield bonds. And to tide you over in the event of an emergency, you take out a home equity line of credit. So far, so good.

Instead of tying up money in a relatively low yielding, money market fund, you've got it where, over the long-term at least, you've got a shot at higher long-term returns. And you've got a reserve in the form of the home equity line of credit that you can draw on if you run into trouble and need money in the short-term.

And let's further suppose that, due to subprime problems, an unexpected rise in inflation or interest rates, a drop in consumer spending or for some other reason, the economy begins to deteriorate and you find yourself laid off from your job.

So when your severance runs out, you start borrowing from your home equity line of credit. Fine, no problem. That's what it's there for, right? And you're not worried because you figure you'll probably get another job soon. And even if you don't, you've got that money invested in stocks and high-yield bonds that you can always tap into to make your loan payments.

But what if the very economic conditions that led to your layoff have spooked investors as well? And suppose those spooked investors have driven down the price of stocks and high-yield bonds because they're concerned about companies' ability to generate decent profits and repay their debt obligations.

And, although you're still convinced that over the long-term your stash of stocks and high-yield bonds will generate a solid return, in the short-term they're taking a beating. In fact, they're worth 20 percent less than you paid for them.

At this point, maybe you're beginning to feel a little worried. You're drawing on a home equity line of credit on which the interest meter is ticking, while at the same time the value of your emergency fund has fallen. No need to panic, of course. You may still find another job soon, and the balance in your emergency fund may turn around as well.

Besides, in a worst case scenario, you've always got the equity in your house to fall back on to pay off the home equity line of credit. Of course, that's when you realize that home sales in your area haven't exactly been booming, the inventory of homes is climbing and home prices in your area have sagged a bit.

So now maybe you're beginning to feel a bit queasy. Your emergency fund is falling in value, your home's not worth as much as it once was, you've got a home equity line of credit that's racking up interest charges every day - and you're out of a job.

Now, is all this really likely to happen? I'd say probably not, although given what's been going on lately in the stock market and the housing market I wouldn't say that it's totally implausible either. Indeed, I'm sure many people are already living one or two parts of this scenario.

My point, though, is that the whole reason to set up a back-up plan for financial emergencies is so that you have something you can truly rely on if things start to go wrong.

The problem I see with your system - putting your emergency fund into assets with a potential for higher returns - is that you're asking your emergency fund to do double-duty: provide ballast in the event of financial upheaval and at the same time generate above-average returns. I'm sorry, but it can't do both those things because they're mutually exclusive.

Indeed, the times you're most likely to have to draw on your emergency account - in times of financial turmoil - are the times that riskier assets are most likely to be falling in value. That's why the only money you should be investing in volatile assets (i.e., those with the potential for higher gains) is money that you won't need in the short-term.

Granted, there's no such thing as absolute security against financial calamity. But you can set up a reasonable system of safeguards that can cushion you, even when things go terribly wrong.

The first step in creating such a system is to put away three to six months' worth of living expenses into a safe liquid account that you can draw on in the event of an emergency. It's important that you be able to get to this money immediately and that you don't have to worry about the value of this account dropping in value.

Although some people have had qualms about them lately, I still think money-market funds, with their stable net asset values and check-writing privileges, are the logical place for such an emergency fund, although there's nothing wrong with keeping some of it in a bank savings account or short-term CDs as well.

Once you've done that, you should also have a back-up for your back-up. That's where the home equity line of credit comes in. You apply for this line when things are going well for you financially because a lender is less likely to provide such a line if you've already lost your job or you've run into other trouble. But you use that line of credit only if your first line of defense - your emergency fund - begins to wear thin.

You can check out the terms currently being offered by various lenders on home equity lines of credit by clicking here. If you don't own a home, see about setting up a personal line of credit through your checking account wherever you bank.

Your third line of defense, of course, is all the other investments you own: the money you've set aside, most likely in stock and bond funds, for retirement, college savings and the like.

The point at which you would tap these assets is a judgment call. Generally, you don't want to tap these accounts if you can help it, although you may decide to if you've gone through your emergency fund and you're worried that you're racking up so much home equity debt than you may have trouble repaying it.

I'll be the first to admit that investing three to six months' of living expenses in a highly stable but relatively low-return, money-market account won't give you the highest return on your assets. But, remember, that's not the goal. The goal is to make sure that you've got a safety net that will be there to catch you when you need it.

If there's a decent possibility that your safety net will be lying on the ground as you're falling toward earth, well, then you really haven't got a safety net. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.