Personal Finance Education Series: (4) Setting up an Emergency Fund
Enough warm up. It’s time to get to some real asset allocation.
In my third article, I spent sometime highlighting the importance of setting up a good savings plan. Fundamentally, this ensures that on a regular basis, you will have extra income that you can dedicate to saving & investing. For those MBAs out there in the audience, this largely means your assets will be going up and to the right in your favorite little two-by-two charts.
Unfortunately, this is where the complexity really begins, because as you start seeing money accumulate in your checking account, many people freeze up. They don’t know where to put the money. Retirement? Real Estate? Stocks? Bonds? ESPP? What do you do with the excess cash every month?
Well, this subject of this article is meant to point the way to the very first thing you should do with your excess cash. You need to set up an emergency fund.
No, an emergency fund will not make you rich. No, an emergency fund will not be invested in commodities, real estate, or sexy ETFs that mimic the movements of a long/short strategy. They will not go into straddles or complex derivative strategies.
But, an emergency fund is likely the most important part of a sound savings & investment strategy. Why? Because job risk is real and liquidity is king.
Before I get into preaching, let me give you a brief definition of an emergency fund. The perfect emergency fund is:
- Approximately 3-6 months worth of living expenses
- Kept in highly liquid, cash-equivalent assets
- Available almost immediately, when you need it, for unforseen events
Example. Let’s say you make $80,000 per year, but your basic living expenses (rent, utilities, dining, student loans, auto costs, etc) comes to $2500 per month. A good emergency fund would likely be between $7,500 and $15,000, set aside into a high-rate savings account or money-market fund.
I know what you might be thinking here. That sounds like a lot of money to not have invested for the future. $15,000 could be $30,000 in just a few years if invested aggressively. $100,000 in a couple decades. $250,000 by the time you retire. Why lock it away into something like a money-market fund? That will barely cover inflation!
Two reasons really.
First, job risk is real. You have to be the judge of this personally, based on your field, education, company, and risk tolerance. I personally work in the high tech industry, and this is a field that can move hot and cold relatively quickly. In a hot job market, jobs come knocking on your door. Unfortunately, people most often lose their job in exactly the type of environment where you don’t find jobs that easily.
Your emergency fund is your safety net. It is a guarantee that you can continue to lead your life, relatively securely, as you search for new work. 3-6 months is a good average for people who think that, for the most part, that represents a successful job search time in a down market. When I worked in venture capital, it was not unusual for people to be “between firms” for over 12 months. The modern workplace has very little job security, and this is where you protect your downside, not shoot for a big upside.
Second, liquidity is king. When the unexpected happens – whether it is an unforseen medical issue, job loss, or other unforseen crisis, you learn a painful truth about your finances. That truth is that no matter how much money you have on paper, it is liquidity that rules the day. Liquidity is defined as your available to translate your assets into cash, quickly, to make needed payments.
Cash in your wallet defines liquidity. Cash in a checking account can be accessed almost immediately. A Certificate of Deposit (CD) is a bit harder – you usually have to go through a processs to cash that out early, with penalty. A stock? You have to sell it, and wait days for the money to clear. An IRA or 401(k)? That takes time to break, and there is a stiff penalty for withdrawals.
When I graduated from business school, my student loans were at their peak, my wedding expenses were coming due, we relocated back to the Bay Area, my wife was looking for work, and I had just kicked off my new job in venture capital. I was fortunate to have stashed away enough liquid assets to cover everything, but it was close. You don’t want to get to a place where your remaining liquidity options are consumer debt, breaking into retirement savings, or other expensive sources of funds.
My top personal finance priority at the time, as per my learnings from books and magazines, was to build an emergency fund.
Many people keep their emergency fund in an extremely liquid account, like a local bank checking account. You do not want to count on high interest options, like credit cards, or options with large penalties, like retirement accounts, when you are in a pinch. Personally, I think there are a few more options that can help make sure that your idle cash is still extremely liquid, but still beating inflation for you. The best options, in my opinion, are the following:
When banks compete, you win! Ah, free markets. Got to love it. Every bank that wants to break into the consumer market does it by offering, for several years, a very high interest rate savings account. Three years ago, ING Direct was the best. Last year, Emigrant Direct. This year, who knows, even E*Trade offers over 5% on their cash balances! The point is, it’s very easy to find a high-interest savings account, and with electronic transfer between banks being free for sites like E*Trade, you can put your funds in any account that pays alot, and still have access to your funds within a few days.
Series I Savings Bonds. Guaranteed to Beat Inflation. Savings bonds are not as liquid as they used to be. In fact, there are penalties if you try to cash them out in less than five years, and you can’t actually cash them out in under one year. So why do I recommend them? The rates on Series I bonds are subsidized by the US Government. They are guaranteed to pay out a fixed amount above inflation, which is calculated every 6 months. For example, I have some from 2002 that pay 2% above inflation. So if inflation were 3.4% this year, the bonds would pay 5.4%. But here’s the bonus. You don’t owe taxes on the gains unless you cash in your bonds! That means, they accrue value, for up to 30 years, with no tax bill. Also, for parents out there, if you use the bonds toward education expenses, there is no tax due, ever. Also, no state or local income tax. It’s a good deal, and if you can get through the first year, they are very liquid, since you can cash them in at any time after that.
Everyone’s comfort-zone with emergency funds is different, but if you don’t have an emergency fund accumulated, it should be your very first savings goal. Saving up 3-6 months of expenses isn’t easy, so you want to put away your monthly savings into your fund until it reaches your goal. Don’t forget to “top it off” every year as your income and expenses likely increase over time.
Remember, the emergency fund is in place to protect you, your family, and your investments from unexpected problems. Some of your best investments, like stock funds, are designed to provide optimal returns when invested for the long term (5-10 years). If you are constantly withdrawing and then re-adding funds into your long term investments, you will wreck your returns. If you end up hitting your IRA or 401(k) during a tough time, you can set back your retirement goals by a decade or more.
An emergency fund not only protects you, it also protects your long term investment strategy from dark times.
So don’t focus on the fact that you could be making more on that money. Focus instead of that money as the enabler of the rest of your investment portfolio.
All of my upcoming articles will assume that you’ve done the right thing, and built your emergency fund up first. In fact, I will argue that building up an emergency fund is even more important than repairing the ultimate sin of personal finance – carrying a balance on your credit cards.