Moving Beyond the Basic Emergency Fund
Perhaps the most basic and prolific piece of personal financial advice is this: establish an emergency fund of at least $1,000. Most people recommend doing this even before paying off debt?
Why?
It’s simple: if you’re trying to pay down your debt and put every available dollar toward that goal, what happens if something comes up that you don’t have the money to pay for? It goes on the credit card and you’re right back where you started. By creating a $1,000 buffer, you are making it possible to absorb some of life’s little emergencies without completely derailing your debt payoff progress.
Ok, so that makes sense but it’s also pretty basic. Super simplistic.
Many of you probably don’t have any debt (except for maybe a mortgage). Many of you probably have significant cash savings set aside for an emergency. How should you think about your emergency fund?
Why Have An Emergency Fund?
If this is you, you’re probably ready to think about some advanced emergency fund strategies. Today I’d like to tell you how I think about my emergency fund and why it might be advantageous for you to think about advanced emergency fund strategies.
So, let’s start with a basic question: why have an emergency fund? As we said above, the main purpose of an emergency fund is to handle life’s bumps without completely derailing your financial well-being. If a minor medical emergency or missing work for a month or a blown transmission is going to completely destroy your financial life, it’s super important that you have cash available to handle that situation.
An emergency fund is designed to be liquid and easily available so that you can quickly access that money when needed. An emergency fund can be cash, money in a savings account, an investment in the equity market — anything that allows you access to cash within 24-72 hours can be counted as part of your emergency fund.
Most financial advice says that you should keep 3-6 months of cash in a savings account and there ya go – you’ve got a well-funded emergency fund. If that helps you sleep well at night and makes you feel good then I say go for it. Stash the cash and call it a day.
But, if you’re interested in your money maybe doing a little bit more for you perhaps it’s time to rethink that advice.
Advanced Emergency Fund Strategies
I think it makes sense to have some cash on hand to handle little things that might come up — things that go above and beyond your day-to-day budget. That might look different for each person, but keeping a couple months of spending in your checking account probably makes sense.
Here’s one way to think about it: go back and analyze your spending for the last year or two, including any “emergencies”. What the average you spent per month? Did you remember to include any emergency spending? Ok, so whatever that number is, put 2-3 months of that in your checking account. Boom, you’re funded for most of your life’s reasonable emergencies.
Reasonable Emergencies?
Yes, reasonable emergencies. If you’re trying to keep enough cash on hand to handle every possible thing that could happen, you’re doing it wrong. Most of the stuff that comes up can be handled with a couple months worth of cash. Anything beyond that probably won’t require that much cash in that short of a period of time. Sure, it’s possible you get kidnapped and need to come up with tons of cash in a hurry, but c’mon. It’s probably not worth your time to plan for hostage situations. So, plan for your life’s reasonably anticipated emergencies, based on what actually happens in your life. Make sense? I think so.
What’s Next?
Ok, so after you’ve got a couple of months of spending stashed in the checking account what should you do? I think it makes sense to move excess cash into an investing account. I myself am in the process of making this change in my life. I’m no longer funding a traditional savings account. My savings account has cash in it still, enough to last for several months. But excess cash is now being funneled into my taxable investment account.
Why do this?
For starters, I have access to cash in the investment account via a debit card. I still earn interest because of the way the money is invested by my custodian. Additionally, if I need money in a pinch I can quickly sell an investment and have access to the cash within a couple of days — when the trade settles. Remember, this is money I would be accessing after I’ve used the cash already in my checking account. So if it takes a few days for the trade to settle and for me to have access to the cash, that’s really not a problem.
Now, someone might make the argument that by keeping most of this money invested, I’m risking losing up to 50% of it if the market really goes in the crapper. Also, it’s likely that I would need that money when the market is tanking because that often goes hand in hand with job losses and more widespread economic bad news. That’s true and not an unreasonable argument. This can be mitigated through asset allocation/diversification (a topic for another day) and by building up a war chest that is large enough to handle these swings without being completely obliterated.
How am I handling this?
Remember when I said I still have several months of expenses set aside in a savings account? While my taxable investment account is growing, I am maintaining the savings account as a bit of a hedge against that risk. I’ll probably shift money from the savings account into the investment account as I get closer to having an equivalent amount in the investment account. By maintaining a reasonably large cash balance in the savings account, I am also giving myself the opportunity to make a move should the market take a real nosedive.
So there you have it – a very quick and dirty rundown of advanced emergency fund strategies. Here’s the tl;dr:
- Keep a couple months of expenses in your checking account.
- Rethink the savings account — do you really need it?
- Put your excess money into a taxable investment account.
- Build the investment account to the point that even if it drops 50%, you’ll be able to cover several months of lost income or a somewhat major emergency.
- Keep on going. Now that your excess cash is really working for you, you’ll be able to look up in 10+ years and be pleasantly surprised at the progress you’ve made.
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