The topic of “emergency funds” is popular in the realm of personal finance. The general idea is that things come up (car repairs, medical bills, job losses, etc.), and you need some accessible funds (savings account or money market most likely) so that you’re prepared for such scenarios.
Typically, the discussion is focused on avoiding debt. And that makes sense. You certainly don’t want to have to use a credit card to pay for a several-thousand-dollar expense.
But having an emergency fund isn’t essential just for the purpose of avoiding debt. It’s also essential if you want to be a successful investor.
Emergency Funds and Investing
If you have a decent amount accumulated in your retirement accounts, you’ll likely be able to withdraw from them (rather than use a credit card) to pay for large, unexpected expenses. But ideally, of course, you’d never have to tap into your 401(k) or IRA to fund current spending.
In fact, you don’t want to have to even think about having to do so. If, somewhere in the back of your mind, you know there’s a chance that you’ll have to withdraw money from your 401(k) or IRA to pay for current expenses, you’ll always be worrying about fluctuations in your account value.
And if you can’t stop yourself from worrying about your account value, you’ll never be able to invest in a manner that’s appropriate for long-term savings. You’ll have to invest extremely conservatively. (Either that, or you’ll invest aggressively, only to panic and sell immediately after a market downturn someday.)
My Own Emergency Fund
For me, the size of emergency fund that allows me to sleep well at night (no matter how wildly my IRA value happens to be fluctuating) is 6 months of living expenses. For you it could well be different.
My wife and I use ING Direct for our emergency fund. It’s not always the highest rate, but it tends to be pretty respectable, and I’ve been very happy with their customer service and website. (Also, I’m not the type to spend time swapping between accounts for half a percent here or there.)
If you don’t have one yet…
Get moving. Just open the account somewhere (As long as there are no fees, it doesn’t matter too much where you open it.), and get started building your savings up.
Then you can move on to all the exciting stuff–opening an IRA, maxing out your 401k, and so on.
New to Investing? See My Related Book:
 |
Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less It qualifies for free shipping on Amazon if purchased together with my other book, Taxes Made Simple.  |
"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing
{ 12 comments }
The “have an EF” rule is standard and safe advice. I do not question that it is the right advice for the masses.
However, I have always wondered if it is optimal. That is, if the expected size of a future unlikely need for a large pile of cash is low enough, it might be optimal to not save so much in an EF and to put more money to work.
In other words, it might not be a bad thing to have to raid one’s retirement savings depending on the size of the raid, relative to the opportunity cost one is losing by tying up a sizable amount in an EF. It is even possible that putting the money work ends up paying for the raid (follow?).
I’ve never seen anyone clearly work an optimal EF strategy with these ideas in mind. I think it’d be interesting, if only a theoretical pursuit.
TIE: You bring up a good point. Certainly, by keeping money in a savings or money market, you forgo some amount of expected return.
I suspect that the most crucial phrase in your comment is the “if the expected size of a future unlikely need for a large pile of cash is low enough” part.
I think it depends largely upon whether a person is concerned about spending a few thousand dollars for new appliances, car repairs, etc. or about spending tens of thousands of dollars for a potential period of unemployment.
For me, being self-employed, it’s much more to do with a lack of stability in income–hence the 6-month emergency fund. For somebody with a more stable job (gov’t employee, for instance), the optimal method may be to have a much smaller emergency fund (or, as you suggest, perhaps no emergency fund at all).
It would be neat to take a crack at explaining this mathematically. But with all the potential variables, I’m not quite sure where to begin.
Mike -
Yeah, that’s the key assumption. But one could do a study that illustrates the trade-off for various assumptions. Maybe if nobody else does it someday I will.
It has always struck me as odd, though, that otherwise empirics-based and reasoned investors will just assume that an N-month EF is correct. It may be conservative (which is good), but it may be so by a large factor. Or it may be inadequate. Who knows?
I wouldn’t get too carried away about trying to optimize an emergency fund. It should be based on your situation (income stability, family size, etc.), but we should think of it the same way we should think of bonds in a portfolio.
Bonds are meant to provide a safety net and balance the risk of equities. An emergency fund does the same thing for our income and unexpected expenses. While it may not always be the mathematically optimal choice, it provides a peace of mind that’s worth much more than that extra return in your portfolio.
Paul –
I agree that one shouldn’t go nuts with optimization. But I think being as informed as one can reasonably be is a good thing. The difference between a 6 month EF and a one year EF can be large and have major consequences for one’s future earnings. I think it is possible a seat-of-the pants estimate can be off by that much.
It is good to be conservative. One can’t really know how conservative one is being without analysis. When it comes to EF (as opposed to AA), there doesn’t seem to be that much analysis out there, just ballpark guesses and “do what helps you sleep at night” advice. That’s fine. But I think one can do better.
One can still use the “sleep test” even knowing the analytical results.
That’s all I’ll say about this. I’m not a crusader about this issue. If I cared enough about it I’d cook up an estimation technique myself. It is just a point about the “literature”. I think it is missing something on EFs. (And if I am wrong, I hope someome will alert me to a source.)
Here is a tip to further boost your returns on EF – create a CD ladder. How? Typically, interest rate on a CD is higher than a savings account. Say, your EF is $24K for 6 months. You open a 6 month CD for $4K, open another one next month and so on for next 6 months. Keep rolling them over at maturity.
The idea is to get the higher interest rate of a CD, but have at least one month’s living expenses readily available when you need it in true emergency without paying any penalties.
Nice job. I like emergency funds. Rather than looking at missing out on long-term investment returns as an opportunity cost when talking about emergency funds, I encourage people to think of not having an emergency fund as an opportunity cost compared to warrantees, “protection plans,” and additional insurance protections that may never get used.
Mike,
I have to disagree about building up a 6 month emergency fund before starting to invest especially for young single investors- it will take a lot of time it would take to build up that fund and compounding makes that a very costly wait.
Say a person saves 10% of their salary then they need 0.5 year * 90% =45% of their yearly income for their emergency fund. That will take 45%/10%/year => 4.5 years!
Say a 22 year old working their first job decides to build an emergency fund before investing so that they have 38.5 years of investing instead of 43 years of investing before retirement. Assuming an 8% CAGR and fixed yearly amount invested the cost of waiting is 31% of their portfolio!
That is a huge cost- and if they miss out on an employer match it is even larger. I agree that having an emergency fund is very useful- but not investing for years is too costly. I think it makes more sense to work on both simultaneously. Alternately save like mad for a few months and then invest.
-Rick Francis
Rick:
Sorry if I wasn’t clear enough, the 6-month number is just my number. I absolutely agree that for many investors, the number should be lower (perhaps far, far lower).
A big part of the reason mine is so high is that I’m self-employed, so my income can fluctuate rather dramatically from month to month.
Thanks for helping to highlight that particular aspect of the topic.
@Rick -
The 6 month number usually refers to 6 month’s worth of essential expenses, not 6 month’s worth of income. But like Mike said, it doesn’t have to be 6 months. Even a 3 month emergency fund will cover most emergencies. It does not have to and shouldn’t take years to build a reasonable cash reserve for emergencies.
Whatever method you use to determine the appropriate size for your own emergency fund, I still think establishing an appropriate emergency fund should take priority over long term savings for two primary reasons.
First, emergency funds are to meet short term needs. It generally makes sense to fund short-term goals before long term ones (I say “generally” because you do have to consider things like employer matches). Since the timing and size of emergencies are unknown by definition, you may not have a lot of time to save up for an emergency.
Second, if building an emergency fund sounds like a sacrifice now, how much more of a sacrifice do you think coming up with that money will be in a real emergency?
Mike,
In your circumstances a larger emergency fund is warranted- but did you stop investing to build it up, or did you continue investing AND build up that emergency fund?
Dylan,
I’m not against emergency funds- I think they are quite useful. However, I don’t think they are so immediately necessary to defer investing for any significant period of time. I even had a $1000 emergency fund before I started investing. That is only because I didn’t realize at the time how important it was to start investing as early as possible.
-Rick Francis
Rick: For a period, I stopped making IRA and 401(k) contributions to build up the emergency fund prior to leaving my full-time job. (Though admittedly, that had more to do with seeking personal happiness as soon as possible than it did with retirement planning.)
Comments on this entry are closed.