When you do a google search for “emergency fund”, you get 15,700,000 results. On top of that, the trend of those searches has been steadily increasing over the last decade:
It is clear that this is a topic we are trying to get answers to. As usual though, we have tried our dam-nest to turn what should be a simple idea, into a complex decision process. How much should I keep on hand? Should it stay in cash, stocks, bonds, or a mix of all three? What type of account should I put it in? Do I really need one?
Welcome to PERSONAL finance.
Note: This topic will be viewed through the lense of someone in their working years. If you are retired, a different set of emergency fund rules would apply.
The reason that the topic of an emergency fund has becomes so interesting (Okay, maybe interesting is the wrong word for most people) is not that you need a PhD to figure it out, it is that everyone’s situation calls for a different form of emergency fund.
See, the question of should someone have an emergency fund, or better yet, access to some emergency funds, is a no-brainer YES! Everyone needs access to liquid emergency funds (Those who say they don’t have an “emergency fund” just mean they do not keep it in cash…at least that is what I hope they mean). I do not think you need one because you may need to replace a water-heater unexpectedly (Though it would help) but what it really is there for is to protect against periods of no of income.
Having to cover a $2,000 medical bill on short notice is very different from losing your regular monthly income from job loss. That is the storm we are trying to weather with an emergency fund.
The question is how to achieve this.
On one hand of the spectrum we have the Dave Ramsey and Suze Orman idea of an emergency fund which is to keep cash in savings account in order to cover anywhere from 6-18 months of living expenses. This is the simplest form of an emergency fund, but the trade-off is that it is the least efficient form of an emergency fund.
On the other end of the spectrum, some advocates will tell you that you should not have any cash for your emergency fund. You should invest in a taxable account, then use a credit card, home equity line of credit (HELOC) or some securities-based lending line to cover emergency expenses, then either pay it off via monthly cash-flow or liquidate some of your portfolio to cover the charge. An even more extreme measure, since rates are so low, is to pay back the loan slowly since you can earn more by investing in stocks*. The theory is that there is huge opportunity cost to have an account full of cash earning 0% (Not wrong).
*Note: I outlined where I think returns may end up over the next decade and based on that, a HELOC, even at low rates, may not be as tempting as one thinks. Similar to mortgage rates right now. Borrowing at 3-4% and “earning” 7%, like in the past, may not be such a slam dunk over the next 10-15 years. Be careful about using debt strategically given where we are with equity valuations and bond rates. I will admit, using a HELOC or Securities Based Lending line for a short-term plug while you pay it off from excess monthly cash-flows is a viable option to me.
Now most people will fall somewhere in between those two extremes.
There are many factors that shape what your emergency fund will (Or should) look like: Income sources and patterns, savings rate, insurance coverage, attitudes toward risk, etc.
An established psychiatrist who has a number of regular patients, saves 15-20% of their income, is properly insured, lives modestly, has very low debt and is comfortable with risk is probably fine to have a 3 month, or less, emergency fund that is invested in a conservative 30/70 or 40/60 portfolio (This person could probably get away with 1-2 months of extra cash in their checking account as an emergency fund).
On the other hand, an attorney who just started a solo practice, who will be facing irregular income for a while, only saves about 5%, is still paying off loans, and has a low risk tolerance, might be better of with a very liquid 6-12 month emergency fund in a savings account if possible.
The emergency fund decision is not a spreadsheet decision. If it was, it would be pretty simple given today’s interest rates. You would invest your emergency fund in some sort of diversified strategy, a conservative portfolio of 40% Stocks / 60% Short-Term Quality Bonds for example:
Yes you would deal with volatility (You would have experienced a 20% draw-down in a 2008 scenario), but the difference between the dark green and light green lines after 20 years is quite dramatic. Also, to help with the potential loss concern, it would be smart to increase the initial emergency fund amount. So if you needed $30,000 as an emergency fund, but wanted to invest some of it, increase the initial funding amount by 30% to $39,000. This way, even if a 20% decline happens right after you started the fund, you would still have the $30,000 needed. By choosing the cash route, you would have had to contribute money to your emergency fund on a yearly basis over the last 20 years just to maintain the same initial purchasing power.
As we mentioned though, the decision on what your emergency fund should look like is not a maximization issue. It is actually a minimization issue. The goal is to find the level of funding, and an allocation for that funding, that covers potential immediate financial needs in the case of an emergency so that risks and stress do not impact other financial decisions.
Rules of Thumb
Ask yourself the following questions and write down your scores:
- How diverse and steady is your household’s income? Very Diverse & Steady = 1, Diverse OR Steady = 2, Not Diverse or Steady = 3
- How quickly could you find a new job? Quickly = 1, Would Take Some Time = 2, Would Take Long = 3
- How much of your household income gets saved? 10+% = 1, 5%-10% = 2, 0%-5% = 3
- Are you and your family properly insured? Yes = 1, Somewhat = 2, No = 3
- Attitudes toward risk? Conservative = 0%-15%, Moderate = 15%-30%, Aggressive = 30%-50%
For example, let’s say you answered 1, 2, 1, 1, Moderate. A good starting point for an emergency fund would be 1 + 2 + 1 + 1 = 5 months of living expense, which if comfortable enough, could be invested in up to 30% stocks with the rest in short-term high quality bonds. Here is what it looks like in the worksheet I made:
If you would like to fill-out the sheet yourself, you can grab a copy here: Rules of Thumb Emergency Fund
This is a rough system of course and is only meant to get you started. The ultimate decision will come from tweaking it over time so that you are able to pass the sleep test.
As an example, I have a friend who would answer the above 1, 1, 1, 1, Moderate, yet he insists on keeping 12 months of living expenses in a high-yield savings account. He knows this is “inefficient”, but it makes him feel comfortable in taking risks with his other financial accounts.
There is no right or wrong. If you start with 4 months of living expense, but still feel antsy, go to 5 or 6 months and re-evaluate. If you try investing some of your emergency fund and start to feel stressed about it, go back to cash. Try out a few different methods until you find your comfort zone.
Pros and Cons of Different Emergency Funds
Cash in a Savings Account:
- Pros: Access to it same day via debit card, checks or transfer to checking account. Never a fear of nominal losses. Peace of mind.
- Cons: Unless negative inflation (unlikely), the cash will lose value in real terms, which depending on the size of the emergency fund and the length of the period, could be a fairly large opportunity cost over time.
Emergency Brokerage Account:
- Pros: Opportunity to have fund grow with inflation and not lose real value. Growth can outpace need (Excess cash can be redeployed to other goals like vacation fund, retirement accounts, growth oriented taxable account, etc.)
- Cons: 1-3 day delay to retrieve funds (Need a credit card or HELOC to pay initial emergency estimate). Fund can lose value in short-term (See chart above).
No Specific Emergency Fund:
- Pros: Assets remain in growth oriented mode (No cash “drag”). Can pay down loan via monthly cash-flows.
- Cons: Actual emergency can become even more stressful. Must rely on debt to cover emergency in short-term. Possible stress surrounding other financial decisions.
Your Emergency Fund
It is imperative that we remember three things.
- We all need emergency funds of some sort.
- What those funds look like can range from cash in a savings account to an aggressive brokerage account.
- Forget what excel says is optimal. Find your comfort zone first with your emergency fund, then optimize around the edges (i.e. 6 months of expenses feels good. After a little, consider allocating 20%-30% of it to a stock index fund and evaluate in a few months. Keep going until you find your sweet spot).
Try out the exercise on the “Rules of Thumb” excel sheet and see where you end up. Remember, an emergency fund strategy is a personal decision. There is no perfect emergency fund strategy for everyone. It will take some tweaking to find your comfort zone over time, but once you find it, a piece of your financial stress will drift away.
Have some fun out there!
Note: My sheet had me starting at 5 months but we currently keep a couple months (1) in a cash savings account linked to our checking account and (2) in a 30/70 mix. As mentioned above, we have tweaked our emergency fund from our starting point and are comfortable with the current setup. As with everything, this will be reviewed from time to time.