We live in a world full of risks. We encounter risks in the daily course of our work and the past year has taught us that even nature can present us with extreme risks. Savvy investors know that risk is ever present. So, an important investment principle is the ability to assess risk and take prudent steps to reduce the effects of unwanted developments.
After you have taken inventory of your income, expenses and assets, a great next step to safeguard your long-term plans is to establish an emergency fund. As you take this important step, it makes sense to answer a few questions such as how big the emergency fund should be, where you should maintain it and when you should use it.
First, what is the purpose of maintaining an emergency fund? Simply stated, an emergency fund exists to handle those unforeseen developments that might disrupt your life and force you to dip into investments to cover expenses. The situation could be one of an unusual expense, or a drop off in income. The emergency fund is a safe source of short-term funds that protects your investments, keeps them focused on long term goals and allows you to have peace of mind.
But how big should the fund be and where should it be kept? A common measure says to keep 3 – 6 months of expenses in an emergency fund. For most of us, that is a sizable chunk of funds to keep in a relatively low yielding account. Your long-term goals would be better spent keeping funds focused on longer term, higher yielding investments. So keep the emergency fund large enough but not too large.
Do you really need 3 – 6 months of expenses? It is surely a safe bet and peace of mind to have that amount in a safe place. Yet, one of the factors you might consider is the stability of your compensation and security of your income. The past year has taught us that there can be a wide range of security. Some occupations such as those who deliver communications services found themselves with more work last year, while those who work in more face-to-face industries such as retail or recreation were out of work for extended periods. For instance, clients in government service face less risk on the income side. So, the guide of three months expenses might be a good first consideration. Our clients who are entrepreneurs with more volatile incomes should lean toward the six-month guide, or more, as a first consideration.
When you evaluate monthly expenses, focus on the essentials such as housing, food, health care, utilities, debt payments and essential personal expenses. Don’t include nice to have costs such as entertainment, dining out, non-essential shopping, vacations or savings. You’ll suspend those activities during the emergency and return them to your budget once the emergency passes.
Another guide that might be more helpful is “the three horribles.” This method calls on you to identify the three most likely unexpected events that could go wrong and hold aside some funds to cover all three. For example, a major expense on a car (such as a transmission replacement), a major expense in the house (such as an unexpected appliance replacement or storm damage) and an unexpected trip for a family emergency could happen at any time.
The technique takes the events you described and places a dollar value on each of them. The emergency fund is the amount you would have to hold aside to cover these three items. For this example, the “three horribles” looks like this:
Major auto expense: $3,000
Household appliance replacement: $4,000
Travel expenses for family emergency: $5,000
Total Emergency Fund: $12,000
You might want to put a 20% buffer on top of these funds to make sure you always have enough. In this case, that figure would settle out at around $15,000. Regardless of the amount, pick a figure and commit to building the fund.
Your next consideration is where to stash this cash. You’ll want the funds to be safe from market — there when you need it, especially in times of market or economic turbulence. Next, you want the funds to be easy to access. This will ensure you’ll be able to take care of your emergency quickly. Finally, you want to store the funds in an interest-bearing account. The point of an emergency fund isn’t to make money, but don’t turn down the opportunity to earn interest on these funds. An excellent vehicle that fits these criteria is a money market fund account, available through a bank or mutual fund.
To make sure you will stick to your long-term goals, you’ll want to set some conditions for the use of your emergency fund. First, ask yourself if the expense is truly unexpected, or can you build this into a plan over time. Next, ask yourself if the expense is truly necessary, or can it be handled some other way. Finally, ask yourself if the expense is truly urgent, or is there time to research ways to reduce or eliminate the cost. If the answer to any one of these questions is “no,” then the expense is probably not an emergency and it should be factored into your larger financial plans.
Setting up an emergency fund takes work, so make it a first priority for your overall financial plan. Decide on a target amount, and then set aside a designated amount over time until you build your emergency fund in that safe and accessible place. For instance, a monthly deposit of $1,000 will build a fund to handle the “three horribles” in less than 18 months. You can build the emergency fund from there to fit your needs.
Life is full of risks, but they don’t have to derail your plans. Set up an emergency fund as a first priority. You’ll find it brings you great peace of mind and keeps you focused on your long term goals. ■