It’s been an interesting December. .
First, my car wouldn’t start. Turns out I needed a new fuel pump. Then, my Macbook had a fatal crash from the top of the refrigerator. (The Jimmy V speech was on at halftime of an Illinois basketball game and I wanted to listen while cooking.) To top things off, a pipe burst inside of my house.
On the good but also expensive side, I became a CERTIFIED FINANCIAL PLANNER® certificant (about $450 worth of fees). A good friend of mine was married (hotel room+gift). My wife and I booked a trip to spend a few days down in Florida. It’s Christmas, and well, Christmas isn’t cheap. Oh and one last thing, my wife’s last day at work is December 30. She’s is quitting her job, to start her own business in 2011.
The purpose of this post isn’t to make you feel sorry for me. This stuff happens to everyone. The real purpose is to discuss the hidden benefits of an emergency fund that I didn’t understand until I went through a few paychecks in just two weeks.
# 1 – Peace of Mind
I have around 14 months of living expenses, sitting in cash or other short-term investments earning next to nothing. (I wouldn’t normally have this much, but my wife and I are both making career changes) This is about 8 months more than the general rule of having 6 months of savings for an emergency fund. Yet, if I had anything less, I wouldn’t be able to sleep at night.
The opportunity cost of earning a greater return by investing some of my emergency fund into higher returning investments, is a tax I pay for peace of mind. This is one tax, which I’m glad to pay over and over again.
# 2 – Career Risks
You never know when that once in a lifetime job or opportunity is going to come by. Most of the time, it’s gone before you know it.
By limiting your emergency fund to a bare minimum, you also minimize the risks you can take. The few hundred dollars a year you might earn by having a small emergency fund, pales into comparison the amount you can earn by taking just one career risk.
For example, John has a $24,000 saved up in an emergency fund. Since John spends $2,000 a month, this emergency fund covers him for 12 months.
If John went with the generally recommended 6 months of emergency fund, he would have $12,000 to invest. If John invested that $12,000 and earned 5% per year, each year he would earn $600. In comparison, John would only earn 2% or $240 a year, if he invested that money safely in cash. Therefore, we can say that John’s opportunity cost of having a large emergency fund is $360 a year for John.
In my opinion, that’s a small amount to pay for peace of mind and a better chance of increasing his largest source of income.
What do you think?
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Photo by: The U.S. Army
{ 9 comments… read them below or add one }
Having just recently graduated college and moved back home, I have few living expenses at the moment. However, the emergency fund is constantly stressed in nearly everything that I read, and though I have few major expenses, it’s not unlikely that my car could go up in flames any given day. And so, once I land my first big job, I’m thinking that my emergency fund is the first place I’ll be setting my income aside. However, at this point in time with my very limited expenses, it seems more logical for me to set just a few thousand aside. Is this flawed logic?
I’m working towards a large emergency fund, but it’s definitely going to take awhile thanks to priorities of paying off/down debt. Earning extra streams of revenue is a huge goal so I can simultaneously contribute to both savings and debt reduction comfortably, but all these things take time. Thankfully our living expenses are dropping about $400 in February.
@Eric – It helps to think in terms of monthly expenses. If your monthly expenses are only say $500, then you don’t need to set aside a big emergency fund. You can probably get away with having just a very small emergency fund. If I were you, I would get a few grand in the bank and then start investing in my Roth IRA and 401(k) as fast as possible.
I totally agree, #2 is what I like to call an “opportunity fund”, rather than an emergency fund though. A technicality, but it puts a positive spin on having that much money laying around rather than just saving it in case something bad happens.
@Kevin – Love the term opportunity fund. If you haven’t trademarked that, I would like to use it later. (:
It kinds of reminds how I once heard of an alarm clock referred to as an “opportunity clock”.
Definitely a good point. I’ll be getting a promotion soon, and plan on diverting the difference between my new salary and my old straight into my high interest online savings account, in order to increase my family’s emergency fund from several months to upwards of a year. It will take a while, but one can’t buy the kind of security that cushion will give one’s family.
- Pat S.
http://www.compoundingreturns.blogspot.com
Good word! Unfortunately, the boring nature of emergency funds (possibly made less boring by the “opportunity fund” moniker!) makes it under-rated… but not by demographics which have experienced real financial pain. The “Depression Baby” generation (the parents of the Baby Boomers), who either lived through or adjacent to the Great Depression, knew first hand the sleep-at-night value of cash and didn’t mind “paying” the opportunity cost premium… in some cases, even to their detriment. Generations X & Y have received our own lesson in financial pain and employment insecurity through the Great Recession, and we’d be wise to have that shape our view of cash holdings forevermore.
Second cousin to the demeaned emergency fund is the misunderstood liquid, taxable investment account. The enormous amount of financial marketing spent on 401k rollovers to IRAs (when the brokerage firm can get a big chunck of assets in an account to be managed in an instant) has left many at a liquidity and tax disadvantage. Mid-term goals–like buying an investment property or second home, making a career change or supplementing education savings–are best served by this variety of account, in which you should be more aggressively invested than in your emergency fund and more conservatively than your IRAs. And while it comes with the occasional hassle of tax payable, it also allows for tax harvesting (matching gains with losses and zeroing out the impact).
Picture the IRAs as your long-term savings, the emergency fund as your short-term savings and the liquid investment account as your mid-term.
Great points, Tim, regarding the liquid investment account.
My wife and I have decided to hold a 3-month emergency fund. 1 month is held in a cash savings account. The other 2 months are in low-risk investments (ex. short term bonds). This way, if either of us were to loose our jobs, unexpected expenses, etc, we would have 1 month’s expenses readily available to withdraw and during that month we would be able to liquidate the other 2 months held in the investment account. In the meantime, the funds are not sitting idle in a bank account earning small amounts of interest but can work for us as an investment.
I recognize that 3 months may be lower than others might advise, but for our situation, it makes sense.
What can I say, I completely agree!