How to invest—yes, invest—your emergency fund

Even if the Federal Reserve raises interest rates this month, it still stinks to be a saver.

The average rate on a savings account is 0.1 percent and the average one-year certificate of deposit rate is just 0.28 percent, according to Bankrate.com. That's less than the rate of inflation. In the 12 months through August, the core Consumer Price Index , which strips out volatile food and energy costs, increased 1.8 percent.

Low interest rates make it particularly tough to build an emergency fund. That's an account that financial advisors recommend hold savings to cover three to six months of essential expenses in the event of an unexpected event, such as a job loss, car accident or health problem.

So should you stash your safety net fund in something other than savings accounts? Even with low interest rates, most financial advisors say no.

Many are concerned that if you invest your emergency fund it may decline in value when you need it the most because of market volatility and believe cash is the only true liquid option for such a fund to ensure you can cover sudden, unexpected expenses.

"It is not the job of an emergency fund to earn a high return or even a nominal return. It is the job of an emergency fund to be there in an emergency," said David Mendels, ‎director of planning at Creative Financial Concepts in New York City. "If it could be down when you need it then you can't count on it to be be there when you need it. If you can't count on it to be there when you need it, it is useless as an emergency fund."

Yet there is an opportunity cost to having an emergency fund that's earning less than the rate of inflation, said Dan Egan, director of behavioral finance and investments at Betterment, an automated investing service. Over time, people who put their emergency fund in low-yield investments will have to "top it off" to make sure the fund maintains its value because of inflation, he said.

"Cash savings accounts are not risk free," Egan said.

Betterment actually recommends investors put their emergency funds in a portfolio with between 30 percent and 50 percent in stocks and the rest in a diversified allocation of bonds. Most Betterment clients have a 40 percent allocation to stocks in their emergency funds and the robo-advisor uses low-cost stock and bond exchange-traded funds to create those portfolios.

If you go this route, consider investing at least 130 percent of your emergency fund goal in the moderate-risk portfolio of stocks and bonds to hedge against stock market turmoil, Egan said.

By increasing the targeted savings amount by 30 percent, it would allow the emergency fund to absorb a 23 percent decline while maintaining the level of expenses you want the fund to cover, Egan said. He used the 23 percent because it represents the largest peak-to-trough percentage drop a Betterment emergency fund with 40 percent stock allocation would have experienced since 2004 by his calculations.

If your monthly expenses were $2,000, for example, and you wanted to save four months' worth of expenses for your emergency fund, you would need to invest $8,000 plus 30 percent more — another $2,400 — under Betterment's advice.

Egan understands Betterment's approach goes against the grain of traditional financial planning, but he said he believes it's the right one.

Some other financial advisors do recommend similar approaches to emergency funds, such as investing in bond funds or using a Roth IRA, which allows you to withdraw contributions without tax penalties. All strategies involve taking more investment risk to earn better returns than liquid cash holdings. Depending on how an emergency fund is invested, you may also have to pay capital gains taxes when your fund's investments are liquidated to cover unforeseen expenses.

To be sure, such investments aren't as easy to convert to cash as a traditional savings account at a bank. At Betterment, it can take three to four days to liquidate a portfolio.

But how many emergencies require cash instantly? Egan said he used a credit card to cover the cost of a car accident a year ago and then paid off the balance with his emergency fund before interest could accrue.

Of course, that strategy only works if you have enough in your fund to cover such expenses.

Building an emergency fund is the No. 1 priority among the 5,500 U.S. households annually surveyed by Hearts & Wallets, said Laura Varas, principal of the retirement market research firm. Yet many Americans still aren't setting enough aside. Six in 10 Americans said they don't have enough in an emergency fund to deal with even minor expenses.

While advisors may disagree on whether to invest the money in the fund or leave it in a bank account, they do agree on this: The most important thing is to have an emergency fund, and one with enough money to cover your needs.

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