There is a problem with financial advice.
For years, individuals have been told that high-yield savings accounts are the perfect place to hold “emergency funds,” the cash you or your family may need in face of an unexpected emergency. When in fact, these so-called cash accounts have been robbing people for years.
Do I mean that banks are literally stealing money from accounts? No, what they are doing, however, is not providing enough of an interest rate on your deposited money to keep up with inflation. The result is your money usually decreases in value as it sits there in the bank, exposing you to the real risk that your savings won’t cover you when the emergency hits.
Instead, I strongly recommend keeping spare cash in what is known as the Ultimate Liquidity Portfolio or simply the ULP, detailed in a book I co-wrote with Shann Matthiesen called "How to Stash That Cash". Here’s a brief summary.
The ULP is a conservative investment account comprised of just two components:
- 88% Bonds, specifically an ETF or mutual fund that tracks a broad index of US Intermediate-Term Treasuries (debt issued by the US federal government that is exempt from state and local taxes)
- 12% Stocks, specifically an ETF or mutual fund that tracks the Total US Stock Market index
The unique interplay between these two investments results in a portfolio that has historically kept pace with or exceeded the rate of inflation, bettering the return of traditional high-yield savings accounts by about 3% per year.
The ULP produces great results because it corrects for the four fundamental problems with the typical “presumably riskless” cash-like instruments.
- It protects against the right risk by correctly defining risk as “the risk that the money I have won’t enable me to purchase the things I need to purchase,” instead of the misperceived risk that “the number of dollars I have does not go down in absolute terms.”
- It has provided significant real returns, i.e., returns after inflation. As the economy has grown over time, the ULP participates in that value creation. Over the last four and a half decades, this has meant a tripling of your relative purchasing power vs. cash.
- It has performed well under a wide variety of market circumstances—protecting not just against inflation, but against recessions, catastrophic crises, and other economic events.
- It provides tax-advantaged yields from federal government bonds (completely exempt from state tax) and from dividend-paying stocks (mostly taxed at lower “capital gains” rates) vs. the fully taxable interest payments generated from high yield savings and other similar accounts.
Here’s a little more detail on each of these critical points.
1. ULP protects against the right risk
Tomorrow, your $10,000 isn’t really $10,000.
High yield savings and similar cash-like instruments are typically used for “emergency funds,” savings you might need to access in case something goes wrong. The goal of your emergency fund is to enable you to maintain the purchasing power of your money, so that when you go to buy/replace/fix/etc., you can buy what you need.
The main mistake people assume when they are investing is that if they started with $10,000, and are guaranteed to end up with $10,000, they have safely “preserved” their purchasing power. This is called a “nominal” guarantee. This is the idea behind savings accounts, money market funds, CDs, and similar cash-like products. And it is the fundamental mistake people make with their savings. Why?
Because prices go up over time (you’ve seen this referred to as inflation). The refrigerator that cost you $500 might cost $525 when you go to replace it. The cost of the carpet might go from $200 to $205. Prices move up and down all the time, but overall, prices typically increase between 1%-3% per year, eroding the value of your savings.
The people who offer high yield savings and other cash-like instruments have made a killing on you for years because they “guarantee” that your money will still be there. This plays on a fundamental flaw in our decision-making process called loss aversion. We think that preserving our $10,000 covers our loss, but the true loss is the loss of purchasing power, and the risk of that has been far greater in cash-like instruments than with the ULP.
Using monthly data for the last 26 years, the ULP has preserved your purchasing power after taxes and inflation*
~61% of the time over one-month holding periods vs. 59% for high-yield savings
~84% of the time over three-year holding periods vs. 49% for high-yield savings
2. ULP provides real returns without the craziness of the stock market
If you were denied an annual cost of living increase at your work, you would (rightly) be upset. The same should apply to your investments. The most important thing your emergency fund needs to do is to preserve your purchasing power. Focus on real returns, not nominal.
Since 1972, cash has generated a real return of about 0.7% per year. If you put $10,000 to work in cash in 1972, the "real" value of your $10,000 investment as of May 2019 would be about $13,800.
In the same period, the ULP has generated a real return of over 3.5% per year. If you put $10,000 to work in ULP in 1972, the "real" value of your $10,000 investment as of May 2019 would be over $50,000.
The winner of this long run return battle is, as we probably know, stocks. Stocks have provided a real return of 6.1% per year. So, the same $10,000 investment in stocks would be worth more than $160,000 at the end of the period. This seems attractive, but let’s spend a moment debunking the other extreme position - that you should just dump your emergency fund into stocks.
INVESTORS DON’T PERFORM AS WELL AS STOCK INDEXES DO
Certainly, for long-term holdings, stocks have proven to be a wonderful investment. In practice, however, these are not the returns people get in stocks, because people typically sell when stocks go down and buy when they go up, reducing their real return by between 2% and 5%. That is why in our charts we factor in a 2% loss per year, so in our example above, you would end up with about $65,000 instead of over $160,000.
Stocks are also prone to significant short-term losses, so an emergency fund comprised solely of stocks would carry a high risk that your savings would not be enough to support you in that emergency situation.
HOW MUCH ADDITIONAL “RISK” DO YOU TAKE ON FOR MORE RETURN?
The ULP provides its additional return over cash for minimal “risk.” There are numerous ways to measure this, but one easy way to understand an investment’s risk, or loss potential, is to look at the worst year, and then a typical “bad” year—the kind you might expect every five to six years.
Using this risk assessment over this time period: a $10,000 investment in cash was worth $9,615 after its worst year; $10,000 in stocks was worth $6,290; and $10,000 in the ULP was worth $9,051.
So, for an additional $550 loss in the worst year, you gained 2.8 points of real return over time (Remember, it’s why you ended up with $50,000 instead of $13,800 in the long term). To get the next 2.6 points of additional return from stocks you’d have suffered an additional loss of over $2,700, more than five times the additional loss potential.
After a bad year (their 5th worst year during this period ), a $10,000 investment in cash was worth $9,800; $10,000 in stocks was worth $8,650; and $10,000 in the ULP was worth $9,420. An additional $380 of risk in a bad year got the additional 2.8 points of return. You had to risk an additional $770 in stocks to get the next 2.6 points of return, exposing you to more than twice the downside for the additional gain.
3. ULP has performed well across a variety of market and economic conditions.
We just talked about a bad-year scenario, but financial history is replete with much scarier stuff, namely market crashes. These are moments when you are most likely to need your emergency funds.
During the dot-com crash of 2000-2002, stocks lost 44.1% of their value. The ULP lost 2.7%. During the great financial (subprime) crisis of 2007-2009, stocks lost 50.9% of their value. The ULP lost just 4.7%.
The ULP also tends to recover its value very quickly. The ULP gained its full value back just 8-14 months after both crises. Stocks, on the other hand, took over four years to recover in each case.
In fact, from 1972 until today, the longest it has taken the ULP to recover is 16 months, after it lost just 5.63% during the massive rate hikes of the early 1980s. Time and again, the ULP has bounced back from interest rate, debt, recession, and countless other interruptions.
The ULP Vs, Stocks During 6 Major Market Crises
Russian Debt Default-0.11%-17.57%
Longest Periods (in months) Before Getting Back Nominal Dollars:
2nd Worst 1553
3rd Worst 1125
4th Worst 921
ADDING 12% STOCKS ACTUALLY REDUCES RISK WHILE BOOSTING RETURNS
How is this possible? It has to do with the unique interplay between stocks and the specific type of intermediate-term bonds in the ULP.
In short, the ULP generates returns in four ways: dividends from stocks, price changes of stocks, interest payments from bonds, and the price changes of bonds.
In the economic boom times associated with higher corporate profits and higher stock prices, the Federal Reserve raises interest rates in order to combat inflation. As the bond market takes account of this, interest rates on intermediate-term bonds go up and the price of bonds goes down. A good example is 1996, the middle of the Clinton-boom years when real economic growth was almost 4.0%:
- Stock market–gained
- Bond yields–increased
- Bond prices–fell
In that year, the return on the ULP was 4.2%. Intermediate-term bonds gained just 1.92%, but the powerful stock market drew up the average.
When fear strikes and the economy goes south, you have a different profile. A good example is 2008 as the subprime crisis played out.
- Stock market–crashed
- Bond yields–cratered
- Bond prices–rose
The counterintuitive result is that adding stocks to this intermediate-term bond portfolio actually reduces the volatility. In fact, if you eliminate stocks entirely you get more volatility, longer drawdowns, and lower real returns by about 0.5%. This has been the magic of the ULP.
4. Tax advantages of the ULP
The advantages here are pretty clear: The interest paid on savings accounts and CDs are taxed at ordinary income levels at the state and federal level. The interest paid on federal bonds, which make up almost 90% of the ULP, is exempt from tax at the state level. This small change can make a huge difference to investors!
For example, the exact same $250 interest payment for a high-income resident in California would be subject to $125 in tax if it came from a bank, and only $92.50 in tax when it comes from bonds.
As we discussed earlier, stock dividends are also a source of return for the ULP. However, most of the dividends you receive are exempt, meaning they get taxed at lower capital gains rates.
SOME SIMPLE TAX ESTIMATES
Everyone’s tax situation is different. However, for the sake of illustration we’ve included some basic tax assumptions to show how taxes can impact your returns. We estimate tax burdens using a 24% federal tax rate, a 6% state tax rate, and a 20% capital gains tax rate.
Let’s examine the taxes paid on three portfolios: Stocks, “Cash”, and the ULP.
First, why do we care so much about taxes? Interestingly, because of how each investment is taxed, all three of our portfolios pay roughly 1.5% in taxes per year assuming historical returns. This is most meaningful for cash investments: since you only gain 0.7% before taxes, cash actually loses money over time under these assumptions. The practical impact of this is that if you hold your emergency fund in savings accounts or other cash-like instruments, you should assume in most years you will have to add funds just to keep up with rising prices.
Again, using average tax assumptions, the tax payment for someone investing in the ULP is about 1.8%. However, since the ULP’s return is higher means that the ULP has historically beaten inflation, and then some, even after taxes.
The goal of the ULP is to preserve your purchasing power; over different and unknown time periods. The ULP has achieved this more frequently than stocks or cash, before or after inflation and taxes, during a wide variety of economic conditions, and over a wide variety of time periods.
A FINAL LOOK AT ULP PERFORMANCE, WITH SOME CHARTS
Taxes and inflation make a big difference. Here’s a chart showing the performance of $10,000 invested three ways over the last 27 years:
Here is what’s actually happening after taxes, inflation, and performance “slippage” (impact of typical investor behavior) from stocks.
Again, I use a lot of assumptions, and your tax situation may vary somewhat - but, the after-tax, after-inflation reality is what counts, and it is very rarely what is actually discussed or considered. Be smart - measure what matters!
If you would like to learn more about the ULP, consider buying our book about it, here.