All for Joomla All for Webmasters
FINANCE

Everyone needs an emergency fund. But how big should yours be?

Why most people need an emergency fund

You must have an emergency fund!

So say almost all financial professionals, myself included – for most people.

But what if you really don’t need an emergency fund, at least not in the conventional sense?

Unless you’re still fully dependent on your parents, you probably have at least some financial obligations.

It may be something as small as your share of the rent for that place you’re living in with several roommates or a car loan payment. It may also be paying full rent for your place, paying your mortgage, putting food on the table, keeping the lights and water on, or paying health insurance premiums.

As we grow older, almost all of us take on more and more financial obligations.

Even if you’re the most uber-frugal person in the world, if you get married, have kids, or have aging parents who weren’t careful enough to make sure their retirement is funded, you’ll have to pay for more things over time.

What if you have an unplanned expense or sudden loss of income such as:

  • Your kid has multiple cavities
  • Your car breaks down
  • Flooding in your house destroys furniture that needs to be replaced
  • Your partner needs emergency surgery to remove an inflamed appendix
  • Your employer sends you on an extended unpaid furlough because of COVID-19

It isn’t a matter of if, but when something negative and unexpected will hit your finances. That’s when having money set aside for emergencies can save you.

How much you need depends on many factors, not least of which is your level of non-discretionary expenses. Another is how much is riding on your having that money. A third is what other options you have in terms of a safety net.

Is it an emergency fund if it isn’t super-safe?

Most pros will tell you to keep your emergency fund somewhere that you can access easily and immediately, and where there’s close to zero risk that its value drops.

That would mean you’d keep your emergency fund in one of the following:

  • High-interest savings account
  • Money market account or mutual fund
  • Certificates of Deposit (CDs) – Here, you’ll lose some of the interest if you withdraw your money before the CD matures, but the principal is safe.

The problem with safe options

Especially in times like today, when interest rates are close to zero, it’s next to impossible to find a safe place for your money that earns enough interest to offset inflation and taxes. This means that if your expenses are $5,000/month and you decide you need 6 months of expenses, you’d be putting $30,000 on the sidelines, where after taxes and inflation you’d be losing almost $400 of purchasing power each year. Over time, this puts a big drag on your wealth-building.

Maybe you don’t need a massive super-safe emergency fund

I’m sure you’ve purchased some sort of insurance. It could be auto, health, life, short-term disability, long-term disability, renter’s, homeowner’s, umbrella, long-term care, etc.

If there’s a risk of loss, you can find someone who will take it on in your place, for a fee (a.k.a. premium).

Essentially, insurance is a contract where you agree to lose some money with 100% likelihood (your premium), in return for the other party, the insurer, taking on the much smaller likelihood of a much higher expense should the risk turn into reality.

For example, let’s say you’re a 30-year-old American guy. The Social Security Administration actuarial table says you have a 0.1865% likelihood of dying in the coming year. That’s about a 1 in 536 chance. You could probably buy a life insurance policy for $1,000 that would pay out $500,000 if you were to die this year. The insurer takes on the high-consequence (financial) risk for you, and charges you a small fraction of the benefit each year.

You can think of your emergency fund as a sort of self-insurance policy.

If you want to be super-safe, you have to pay a “premium” in the form of losing purchasing power each year.

If you’re willing to take on a bit of risk, your “premium” gets smaller because your money can be invested in something that provides a positive after-tax inflation-adjusted return on average. In any specific year, you could lose money.

Why I don’t keep a lot of money in super-safe accounts

When I buy insurance policies to cover catastrophic losses, I set really high deductibles because I can afford to pay those out of pocket, and it reduces my premiums each year.

Similarly, I don’t keep much money in checking, savings and money market accounts. If I have an emergency financial need, I’ll cover it from my investments. If the markets happen to suffer significant losses just before then, my losses would be locked in, and I’d lose a good bit of money. However, because I have enough invested, even if I need to sell after the markets drop by 50%, it won’t dramatically impact my finances.

The point here is that I know the market will have a down year on average about every fourth year. Most of those down years will be relatively minor, perhaps a loss of 10%. However, there is a minutely small likelihood that I’ll have a massive emergency financial need just when the market has that very rare drop of 50% or more. I’m willing to take that tiny risk in return for building  wealth faster.

Deciding if you don’t need massive super-safe accounts

If you’re comfortable taking on a higher level of risk to make more money, you may consider keeping most or all of your reserves invested. If that’s you, here are some alternative ways you might be able to cover an emergency financial need if it happens when the stock market is down significantly:

  • Credit cards with 0% interest introduction rates that won’t expire for a year or more (if you have a great credit score)
  • A salary advance (if your employer is willing)
  • Selling assets other than stocks, such as appreciated real estate (if you own any)
  • Family support (if that’s available)

However, each of these has a caveat. You may lose a significant amount of money if none of them pan out and you need a lot of money to cover an emergency exactly when the bottom drops out from under the market.

The bottom line

If you can take on risk without losing sleep, you can avoid keeping a lot of money in a super-safe account where it loses purchasing power each year.

This is easier if:

  • You have relatively few and small financial obligations that you can’t stop.
  • You have a great support network.
  • Your income is diversified across multiple sources.
  • You have enough invested that you could afford to sell a year’s worth of expenses into a severe bear market without derailing your financial goals.

If several of these describe you, perhaps you’ll be comfortable making the same choice I did.

Source :
Click to comment

Leave a Reply

Your email address will not be published. Required fields are marked *

Most Popular

To Top