MI Rewind: Why and How You SHOULD Invest Your Emergency Fund w/ Chris Kawaja

0:00You're listening to TIP. On today's show, we're resharing some of the older episodes that are my favorites for a few reasons. One, we get a bunch of new listeners each week, so new listeners may not have heard this episode before. Two, even if you've been listening for a while, you may have missed this episode when it originally came out. Or three, even if you've heard it before, it can be a great episode to learn from again. If you've already heard this episode or you're not interested in hearing it, feel free to just skip it. There's no harm in that. And you can pick up with our new episodes next week.

0:30That's all I had for you for this new intro. Everything going forward is going to be from the original episode. I hope you guys enjoy it. On today's show, I sit down with entrepreneur and investor Chris Khawaja to learn about why and how he believes you should be investing your emergency fund using the ultimate liquidity portfolio strategy. Chris is a Stanford and Harvard graduate who worked at Goldman Sachs and Bridgewater Associates, which some of you may recognized as this is super investor in one of my favorite investors, Ray Dalio's firm. Chris is also a successful entrepreneur, author, and real estate investor.

1:06Chris definitely has an impressive background in entrepreneurship, investing, and academia. You'll hear just how brilliant he is throughout the episode today, and I'm very excited to share our conversation on his unique investing strategy. Many people listening to the show know that you need an emergency fund, but most experts recommend you stick that money in a mattress or in a high yield savings account and just leave it there for a rainy day. Chris's strategy is actually more aggressive with your emergency fund money because he recommends you go against what most experts say and actually invest your emergency funds in the markets.

1:40I'll let Chris explain this in more detail in today's episode, but it's a concept that fascinates me because I've generally been one that was willing to invest my emergency fund against the recommendations of other experts. So without further delay, let's get into this week's fascinating conversation with Chris Khawaja. You're listening to Millennial Investing by the Investors Podcast Network, where your host, Robert Leonard, interviews successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

2:18Robert Leonard Hey, everyone. Welcome to the show. As always, I'm your host, Robert Leonard. And with me today, I have Chris Khawaja. Welcome to the show, Chris. Chris Khawaja Thanks, Robert. Appreciate you having me on. Robert Leonard Let's start the conversation today by talking a bit about your background and how you got to where you are today. Chris Khawaja Okay. So I grew up in Toronto, Canada. I was the son of two immigrants, one of whom was a finance professor. And when I was 17, I was in my second last year of high school, but was on track to maybe graduate a year early. And in February of that year, I left minus something temperatures and snow on the ground in Canada, landed in California and visited Stanford where it was 75 degrees and people were in bikinis and my future was cemented from there.

3:06So I went to Stanford, I actually left high school a year early. I went to Stanford. After Stanford, I worked on Wall Street at Goldman Sachs for a couple of years. Then I worked at a startup. Well, it was a startup then. It's They make Invisalign. And then I went to business school at Harvard Business School. After that, I went back to Wall Street. I worked at a hedge fund called Bridgewater Associates with Ray Dalio. And after that, I joined a bunch of partners and started to work in more of an entrepreneurial business where we're all co-owners. And now I spend my time split between my online business, which is Big Chill, my blogging, and then my real estate and other investing.

3:45So that's where I got where I am today. And obviously, that's a condensed version. There are a lot of bumps and turns along the way, but that's what's got me here today, where I live in Northern California, about 25 minutes north of the city, San Francisco. Well, I certainly don't blame you for wanting to make the move from Toronto to California for the weather. I'm a New Hampshire native, so it's similarly cold here in the winter. So I definitely understand the desire to move to where it's warm. Absolutely. Yeah. It sucks some people in and I just never turn back. Robert Leonard I think it'll eventually get me too.

4:17Given everything that's going on in the economy right now, I think our conversation today is going to be pretty timely. In times like this, we hear a lot of people recommending having an emergency fund. And I even recommend this myself pretty often. How can money in a high yield savings account, like an emergency fund, actually lose money over time? Robert Leonard So this is the essential point. And it's really, in a way, what we're doing is we're tricking ourselves by thinking that these low bank interest rates, I think right now, high yield savings are in 1.5%. The fact is, if you look over history, these don't keep up with inflation, usually even before taxes.

4:54And what's brutal about high yield savings accounts is they're taxed at the highest rate. So if you add all of this together and even mock up equivalents for what high yield savings accounts should have looked like based on certain indices, you essentially you come out at high yield savings accounts, lose money. And that's a painful reality because people say, well, look, I put$10 ,000 in and I ended up with$10 ,200 a year later. But if you went to go buy things and everything that costs$100 is now$103, you actually have lost money. Especially after you go and of that$200 you made, quotes made, you had to give some amount to the government, maybe that's$75 or even$100.

5:32Robert Leonard I feel like a lot of people don't often think about taxes when it comes to their high yield savings accounts. I think it's talked about a lot in the investing community and in brokerage accounts, but not so much in the high yield savings account space. Do you think why might that be? So I think part of it is that people assume it's such a default for people to say, look, put six months of money into a high yield savings account, and that's your emergency fund. And I think that gospel probably was appropriate a couple decades ago before the advent of ETFs and commissions, pre-trading and all these other things, because it probably was a not terrible way to sort of preserve your money.

6:13And I think what's happened is when there's just gospel, if everybody says, hey, everybody always wakes up in the morning and brushes their teeth. I don't think people are questioning it a lot. And so for that bucket of money, there's been such gospel, such a belief in the right way to do it. And it's only recently that that belief really could have been challenged because of ETFs, because of a lot of other reasons. And so I think people just haven't thought about it because it just wasn't something to think about. The best option was just throw it in a bank account that felt safe and move on.

6:42Now, there are different fallacies, like I talked about, that I think make high yield savings even more psychologically attractive and less financially attractive. And that's mainly to do with the fact that people don't like the feeling of, quote, losing money. So they think that a bank account is zero risk. But to me, the risk of an investment is when it can't meet your goals. So for the case of an emergency fund, that's meeting your needs when an emergency arises. And for the case of a retirement fund, that's very simply, will it provide for retirement? And so if you know the goal, then you very quickly learn that high yield savings are not the best avenue for preserving your emergency fund.

7:19What are the three trends in finance that have radically altered the investing landscape so that savings accounts really just are no longer the best option for stashing cash? So that's a great question. I think the number one trend is ETFs. So if you had to invest, very simply, our portfolio recommends, let's just say high level, 88 % intermediate term bonds, 12 % total stock market index. Now, if you tried to do that, let's say 15, 20 years ago, Even if you found the cheapest mutual funds and the lowest minimums, just by definition, you're going to have to be into it for$10 ,000,$15 ,000,$20 ,000,$30 ,000.

8:01Now, the fact is most people's emergency funds aren't of that size, right? So the first trend is instead of mutual funds, you now have ETFs where you can get access to literally every company in the US stock market indices for pennies per year on$1 ,000 investment. So your minimum investment might only have to be$74 in a stock portion. So the first is the hurdle has gone down as you've gone from mutual funds to ETFs. The second, and this is pretty big, is commissions have been driven down and now in a lot of cases have gone away. Okay. So one thing that's nice about a bank account is there's not a commission making investment there.

8:42Now that there's no longer commission on ETFs, it has a lot of the ETF. It's the difference between the bid-ask spread. But we're talking even tens of pennies on a dollar when we're talking about what that cost is. So it's the move from mutual funds to ETFs, the drive down and just this massive competition that's been created by the brokerage industry, Fidelity, Vanguard, Robinhood, you name it, to bring commissions really low. And then I think just generally the access that investors have and the ease of use of online brokerages, it's so easy to open an account now and to get this exposure. That just didn't exist before.

9:24As far as one other trend that drives us away from high-yield savings accounts, taxes just tend to go up. Tax rates now are a lot higher than they probably were. 200 years ago, there weren't really taxes at all, just very few taxes for funding the government. And so I think generally speaking, as society aims to provide more and more for people and taxes go up, that tax tends to be taken out, unfortunately, on inflation-adjusted items. And so the 2 % inflation on such a low returning instrument as high-yield savings, it just eats away your return over time. Robert Leonard You write about the ultimate liquidity portfolio and how it's the ultimate investment strategy in uncertain times.

10:04And I'd say that we're in pretty uncertain times right now. So I think this is going to be a good conversation to have. So first, what is the ultimate liquidity portfolio strategy and what kind of track record does it have? Great. So I love this portfolio because I think it's very appropriate for what an emergency fund is trying to do. Okay. What is it? It's very simple. And although you could do it, I would caution you not to do it because I think you really need to believe in what you're doing. And people, if they just hear something on a podcast and then implement it the next day, are probably not likely to stay with it.

10:36But the ultimate liquidity portfolio on the surface is just 88 % intermediate term bonds. And there are a lot of ways to get access to that. Vanguard has ETFs and mutual funds that do that. And we refer to those, you can just read on my blog or refer to the book for what those are. And then 12 % of the US total stock market index. Again, VTSAX is a very common one that people use, but there are a dime a dozen out there. Schwab has one, Vanguard has one, everybody has one. And they have these very low trading fees. So at a very high level, that's what it is. But as far as the construction of it, it's important that it's really two different assets.

11:11And in the book, we talk about rainy and sunny as being, let's say you could create a perfect portfolio. Okay. You have certain chickens or a portfolio for a farm. Let's say you're trying to gather the maximum number of eggs very consistently, right? You need a consistent return. What you'd ideally have is a chicken that lays an egg every day it's sunny, and another chicken lays an egg every day it's not sunny. Then even though you don't know when it's going to be sunny and rainy, you know every single day you're going to get an egg. Now, obviously, the investment world is a little more complicated than that.

11:42And there's no such thing as these perfectly matched investments. But if you want to look historically, and we look back nine decades in our book, this mix of 88 % intermediate term bonds, and it's a very specific kind of intermediate term bond. And VGIT is the ticker for the ETF, if you just want to look up historical performance, this mix of 88 % intermediate term bonds and 12 % stocks just has a wonderful track record. And the reason is when times are bad, bonds tend to go up. And when times are good, stocks tend to go up. And so because of this ratio, and because they have these different characteristics where they're exposed really in some ways to different moves in the interest rate cycle, which ultimately is driving the economy, it's just a wonderful balance and it's extremely consistent.

12:25So that's what it is. And it's designed mostly to be simple. There are ways to actually get more return than doing 88-12. You could add a third short-term bond fund and change your percentages. Really, a lot of what we talk about is how do we create this behavior? So it's one thing to know it's 88 and 12%. It's another thing to know why you're sticking with it. It's another thing to understand how it performed in every single downturn and in every single upturn and really walk through that and understand it. because ultimately, and this is something I believe very passionately, the thing that hurts people in their investing is their behavior.

13:01So we all know you should buy low and sell high, and yet everybody buys high and sells low. Look, maybe it's only 98 % of people, but it's pretty close to everybody. And there are very good reasons why that's true. But this is ultimately an emotional defense against that. And it's there to provide consistency and this ongoing income that really is comparable after tax over most periods to a high-yield savings account, but then has this growth element because stocks do tend to grow over time. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review.

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16:08To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. Robert Leonard When I hear about the portfolio consisting of that many or that high of a percentage of bonds, it makes me wonder if that strategy fits towards younger demographics like millennials. I don't tend to recommend bonds here on the show, and you don't hear a lot of people talk about that specifically for this type of demographic.

16:47So do you think that that strategy is good for millennials with that many bonds? Robert Leonard Absolutely is. And let me explain what I mean by it being a good strategy. I think we have to think of our money in three different buckets, okay? And one of the biggest mistakes I see, and I've seen this a lot actually in millennials for whatever reason, is just the education that I received on Wall Street on terms of how to bucket money seems to have not permeated to this generation. So it's something I talk a lot about when I speak with younger people. And that's that you have to think of money as doing a job.

17:19And so let's just divide that into three basic jobs, just to keep it really simple. The first job is retirement. Okay. Retirement is a job where long-term at some distant point in the future, you're going to need some amount of money that funds you with some income for a long time. For that, and that's ultimately over time where you'll build where most of your portfolio will go. For that job, stocks are great. Now, I wouldn't recommend 100 % stocks for that retirement portfolio for the main reason being stocks don't always go up. And people say, well, eventually they will go up after five years, after 10 years.

17:53To which my answer is, if you bought stocks in 1987 or 1989 in Japan, you'd still be underwater. So for anyone who had an investment horizon that was 33 years or less, that was a really bad idea. So I don't believe in 100 % stocks, but I believe that stocks are very appropriate for that long-term portfolio. Because over time, stocks tend to perform about six to seven points above inflation, whereas this portfolio tends to perform about three points above inflation versus short-term securities and high-yield savings, which tends to be at inflation. So those are the three categories. Now, the other category, which is really easy, is your bank account, your checking account, just to pay your bills, right?

18:30What's the job of that? To pay your monthly bills. Real easy, okay? There's this middle bucket, and it's extremely important. And the reason it's extremely important is, and you have to think about it differently, what is the job of this bucket? The job of this bucket is to preserve the value of what you put in there after taxes. And you wanted to do that at the highest possible frequency. And so this portfolio was designed and the results show that over a three-year period, if this is your emergency fund, you have a much greater chance of losing money in stocks than you do in this. It's just extremely consistent.

19:03So is my advice, go invest in stocks? Sure. Or the retirement part of your portfolio. But the very first thing you should be doing in your investing strategy, obviously after having enough money to pay your bills. The second thing I'd say is probably paying off high interest debt. But the first money you invest should be in an emergency fund before you've actually invested in your retirement portfolio. And so I'd say, yes, absolutely. All millennials should have this and they should have it for their emergency fund. Once you have enough of an emergency fund, great. Please pour all your money into your retirement.

19:36And that's going to be the vast majority stocks. I have some ideas on how it It shouldn't be 100 % stocks that we discussed. But yes, absolutely, it's appropriate because, look, you're having it to maximize your chance of preserving value of money. It's not like a retirement fund, which is maximizing the long-term growth. And for that, go ahead with volatile investments. Those are great. And in fact, when times are bad, it's great for you because you're buying more shares every time you invest. So I think the question is, yes, it's very appropriate for that bucket of money. What's the biggest mistake millennials make?

20:08Not putting money in different buckets. they slosh everything together. And then you get confused and you don't know what portion is which, and you say, well, should I have bonds? And I think if you know the job, you know how you should invest. And yes, you need an emergency fund and the job of that is to preserve capital. This is the best way I know how to do it. Robert Leonard You talked about it being important to understand the historical returns of a strategy before investing in it. So when we talk about the ultimate liquidity portfolio, how is it performing right now? And then how did it perform over the last decade when we had such a strong bull market?

20:39I would assume that over the last decade through the strong bull market that a portfolio with 88 % bonds probably got crushed by the broad stock market index. How has it performed? Robert Leonard So over a 90-year period, and I know that feels super long. And the reason I look at 90 years is because there are markets of all stripes. Over a 90-year period, it's a little less than 3 % over inflation. Over the last, let's say 40 years, it's a little more than 3 % overinflation. And it's pretty consistent. How has it performed in the last decade? Well, the last decade has actually been pretty good for stocks and bonds.

21:17So it's performed pretty much in line with that. I don't have my exact annual performance notes in front of me, but you can just look back on Portfolio Visualizer and pick any period that you're interested in and see it's very consistent. I think more important than that is look at how it's performed in times of crisis. Okay. Because the first thing is, this is designed to preserve your money. How is it done this year? It's up this year. I don't know what it is as of today, but certainly a few percentage points. It's about an average year to a slightly better than average year just because bonds have done super well.

21:48So that's the first thing. The second thing is it does well when you're reading bad headlines. Why is that important? Because although people say, hey, I want to invest in stocks, the biggest fallacy is that people look at an index fund and assume that that's what the performance that they're going to get. But study after study after study, and you can just look this up online and you'll get hundreds of hits, show that the average investor in the stock market, and everyone thinks they're better than average, but the average investor in the stock market underperforms the stock market by between two and five points.

22:16So we talked about the stock market being, let's say, six to seven points above inflation. We talked about this as being three points above inflation. If you subtract two to five points, really the average investor is getting not the returns of stocks, but the returns of corporate bonds with all of the volatility that comes along with it. And I think your show does a really good job at educating people on how they can avoid that. But I can tell you that some of the very smartest people I know, I'm talking guys, millionaires, guys who had plans on what they were going to do in the next downturn.

22:48These guys sold when the market crashed. They were selling in March when things were cheaper than we've ever seen. So I recognize that people believe they're going to behave a certain way, but in practice, they don't. And I think part of it is emotional and part of it is just structural. Look, when you lose your job, you tend to cut your investing amounts. So there are just some structural reasons why it's hard to get those kinds of results that you see about when you just look at an index fund. Robert Leonard How much of this strategy do you think has been shaped by your time that you spent with Ray Dalio at his firm, Bridgewater Associates?

23:19I would say a lot of the strategy is informed by it. It's probably in some ways a very deep simplification of many of his principles. The one thing Ray, and I don't think he would say this if you interviewed him, but if you look behind what he's doing, probably his advice would sound something like everybody's a little bit too in love with stocks and everybody's a little too overexposed to stocks. And we feel that when we enter a downturn. And so Ray always said his goal and his dream was to find, I think he said, 20 to 40 uncorrelated investments. And the thing about stocks is stocks are highly correlated.