One can charge “garbage in, garbage out” but one should apply that equally to all methods. I find the “Oh, I dunno, a year seems good enough” type approach no less garbage-y. It is just far less explicit about assumptions. But those assumptions are still there. They must be.

Let me put it this way. I’m not denying the value of a good night’s sleep. As I’ve said (on my blog, if not here), that’s ultimately how I do it too. But I also think there is value in mathematical analysis. It is just another perspective. I can keep several in mind at once. Maybe that’s unusual.

2.
Those who worked on risk models for the mortgage securities etc. markets came up with seemingly pretty mathematical algorithms, too. But the assumptions were so large that the models in application were extraordinarily flawed. It seems to me that this is the case here, too. Add in: What kind of errors should one attribute to one’s estimate of the probability of an emergency? If one computes 1/5 using the approach above, to me 1/2 is not that far away, considering the errors in estimation. The three rates of return named by themselves may vary a lot from one year to the next. In other words, a factor of safety (well known in engineering circles, for one) should be used. This is maybe more famously known as a huge “fudge factor,” because uncertainties are so large and compound when combined in an algorithm.

3.
I think people should continue to plan their EF around their sense of the cost of a worst case scenario. Using a certain number of months of current paycheck makes more sense to me than arriving at a hard number as the alleged algorithm above seems to push. To me, the algorithm is a flimsy disguise for garbage-in, garbage out computation. I profane passing this off as good applied mathematics or even good finance guidance. Instead, there should be a follow-up to this article noting how so many got suckered into such thinking with the recent bubble, and look where it got us.

One things to consider the purpose of emergency savings fund is not have to cash out of other investments at an inopportune time. Once you get past a certain level of savings, at least from my experience, you no longer really need specific emergency savings allocation. You can take it from your fixed income portfolio and liquidate your other assets when you need to.

I’d argue an EF is similar. There is no “right” amount. The best amount for any one person/family can only be known in retrospect as is the case with every type of insurance I can think of.

With EF and insurance questions, comfort level of the person in question is hugely significant. Discounting the “sleep at night” argument here is dangerous because all the analysis in the world can’t produce the “right” answer for each individual–maybe what would be “right” for each person on average, but not for each individual.

All that said, I applaud efforts to narrow the range of what would make sense for most people as an EF. At the very least, it’s a place to start.

Taking the insurance point of view, well, sometimes it is worth buying extra insurance and sometimes it is not. How does one decide in the EF case? Should you “buy” an extra month’s worth or not? How did you decide how to answer that? What are your assumptions? Why is that the right answer?

That’s really what I’m getting at.

I think @Dylan’s point comparing the EF to insurance is a good one, because it’s a similar transfer-of-risk argument, i.e., there’s always a cost involved in transferring risk, and the cost goes up/down depending on the probability of the event insured.

My meta-point here is that there is a lot of huffing and puffing over this issue but very little actual quantitative analysis or sensible, rigorous theory. I don’t see the point in all the strong opinions if they can’t be backed up by something other than “sleeping at night.” That is how I decide this, and I freely admit it is a weak basis. It isn’t how I decide many other things for which more empirical evidence exists. (I don’t choose index funds because they help me sleep at night. It is the evidence that they work well that is what helps me sleep.)

I would like to see more studies of emergencies and emergency funds. What size(s) are really necessary and for whom and why? Hatcher’s work is the first I’m aware of to attempt a rational theory. Good for him. We need more.

Thanks for the reminder.