How Much to Leave Out of the Market

[mtgordon]

So I have money saved up and most of it is in the market. However, there is (obviously) some money that I have in my savings account to pay for monthly expenses. My questions is how much I should have in there. I am invested in Index Funds through Zecco so if I wreck my car and need money I don’t have to worry about paying fees to sell the ETFs.

I’ve heard people say that you should keep money out so that you’re not forced to sell in a ‘down market.’ However, I don’t really understand this. I don’t try and time the market so I don’t know when it is a ‘down market.’ If I don’t try and time when I put my money in why should I try and time taking it out?

Here are what I think are the important things I need to consider:
Buy/Ask spread (which is a fraction of a percent)
How stable my income is (right now is very stable)

Assuming the market will go up 12% (makes math easy) then that’s 1% a month. Therefore if your money is in the market 1 month before you having to pull it out for some reason (taxes, car/house repairs, etc.)

According to these things I would think that I would need to have very little money in a savings account and I could just sell when I need to buy something more expensive (like pay car insurance for 6 months, etc). This seems to go against what I believe to be the common consensus so please let me know how incredibly wrong I am.

[kimchi]

As a general rule, 6 months' expenses in an easy access high interest account is good to have - so you could essentially pay rent, bills, food etc for 6 months with no job. This should cover most emergencies.

If you live in The US, this should help avoid some of the tax hassles I know you folkes have with moving money around.

[mtgordon]

Good point. I forgot about taxes. So let's say that taxes are 30% (mine happen to be lower but for now we'll say 30%). In an average month I will make 0.7% on the investment. I still don't understand the argument for keeping 6 months of expenses out of the market.

I have heard it many times, but I have also heard it in terms of bankroll management and I am wondering if people are confusing the two for some reason. There may be some tax issue that I'm missing though where it should be more than the 30% tax on the gains. Any other ideas or ways to explain it to me?

[DcifrThs]

if you are a passive investor (leaving aside for now how you structure that investment), then the best thing for you is to have as much money as you can colelcting gains.

there is a catch, though, in that should an emergency occur, the loss you make in selling + taxes probably seriously outweighs the opportunity cost of keeping reserve funds earning ~5% in nominal terms.

therefore, leaving some % in savings is a good idea. that % needs to be enough to sustain you should any # of emergencies occur. 6mo expenses is just a benchmark.

Barron

[mtgordon]

I'm sorry I'm so slow about these things and I really appreciate the insight/help. What are the losses associated with selling? I was under the impression that it was just the buy/sell spread and then taxes.

Maybe I am misunderstanding the taxes. I was under the impression that with ETFs I would just pay taxes on the gains. It seems like those two things would only add up to 1%. What am I forgetting about that adds the extra 4%?

[DcifrThs]

[ QUOTE ]
I'm sorry I'm so slow about these things and I really appreciate the insight/help. What are the losses associated with selling? I was under the impression that it was just the buy/sell spread and then taxes.

Maybe I am misunderstanding the taxes. I was under the impression that with ETFs I would just pay taxes on the gains. It seems like those two things would only add up to 1%. What am I forgetting about that adds the extra 4%?

[/ QUOTE ]

transaction costs mostly. pretty minor and taxes on gains is what i'm talking about.

thing is, you can earn about 5% risk free so if you're earning more than that, and then have to sell, you will actuallyb e earning less after taxes. if you are earning <5%, then having it out of the market is a gain for you (although in expectation a small loss).

Barron

[gull]

The six months expenses is a rule of thumb, and a pretty poor one. There's no strong, logical argument for treating your emergency fund and portfolio separately. As long as you won't be hurt by taxes/commissions, put most of it in the market. (this all assumes your income is generally uncorrelated with the stock market)

[DcifrThs]

[ QUOTE ]
The six months expenses is a rule of thumb, and a pretty poor one. There's no strong, logical argument for treating your emergency fund and portfolio separately. As long as you won't be hurt by taxes/commissions, put most of it in the market. (this all assumes your income is generally uncorrelated with the stock market)

[/ QUOTE ]

we've all agreed that the 6mo is a rule of thumb.

the point is that you don't know when you'll need it so you don't want to be exposed to tax/TC issues when youdo need the money.

therefore, having some money in cash (given that you earn 5% on it) won't significantly hurt your returns, and will save you money in taxes/TC if such an emergency should occur.

Barron

[Jeff W]

[ QUOTE ]
therefore, having some money in cash (given that you earn 5% on it) won't significantly hurt your returns, and will save you money in taxes/TC if such an emergency should occur.


[/ QUOTE ]

I guess that's true in that if you earn less money you pay less in taxes. Your after tax returns on equities are still going to be a lot more than cash--risk premium+tax deferred growth since interest is taxed annually while equity growth is mostly tax-deferred.

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
therefore, having some money in cash (given that you earn 5% on it) won't significantly hurt your returns, and will save you money in taxes/TC if such an emergency should occur.


[/ QUOTE ]

I guess that's true in that if you earn less money you pay less in taxes.

[/ QUOTE ]

i think you are looking at this too narrowly.

we don't know when the random expenses will occur, if they trigger capital gains on assets you've held for a while, then the taxes will be substantial. thats just an example.

thing is though that the longer you hold $X in cash, the larger the expected discrepancy between what you could have had and what you have becomes. but if 6mo expenses aren't a big deal (like a small % of your overall portfolio), then it isn't too important either way.

i haven't gone through a full thought experiment on this but it seems it doesn't make a big difference one way or the other. the goal is not to trigger large tax bills from sales of assets to cover an emergency when you could have that in an emergency fund earning some interest.

there are definitely arguments against that and they've been discussed. offhand i don't know which is better, but it, again, doens't seem to make a bi gdifference.

Barron