Today’s post is courtesy of Jacob, Ph.D. student in finance, frugal master, and one half of the Cash Cow Couple. Along with his wife, he enjoys living, laughing, and teaching others how to save and intelligently invest their money so that they can achieve financial freedom.
In the blogosphere, it’s common to see recommendations for emergency funds. I’ve seen some who claim an emergency fund is unnecessary, and others who’d prefer if you kept one the size of Texas. There isn’t anything inherently wrong with either choice, but you should probably understand time constraints and liquidity before you decide on an emergency fund or any other short term investment need.
Let’s first define an emergency fund. It’s typically a highly accessible chunk of money stored in a checking, savings, or money market fund. It’s there for what? That’s right, emergencies.
But what does highly accessible mean, and why does it matter? Well, we’re speaking of liquidity here.
Liquidity is often defined as the ease with which a portfolio can satisfy an investor’s needs. Easy enough. But what comes next is frequently confused by investors, popular media, and everyone in between. Liquidity is comprised of two parts – marketability and price volatility.
Marketability is an attribute that measures an investor’s ability to readily convert an investment to cash at prevailing market prices. This would be a function of fees, trading volume, and bid-ask spreads. In other words, the greater the cost of finding a willing buyer, the less marketable, and therefore less liquid an asset is.
Price Volatility is very different. Even if you can sell an asset quickly at market price, you must still be concerned with the current market price. Stocks are a great example because they are volatile and therefore not liquid. Sure, you can easily sell a stock after it falls 50%, but you’ll be locking in huge losses.
A great example is a story I heard about a lady who was advised to put her million dollar portfolio in an easily accessible S&P 500 index fund. She was under the assumption that it was liquid. Sadly, one of her goals was to purchase a $500,000 boat in just over one year. Of course, 100% equities is a terrible decision if you need half the principal in a year. The market fell nearly 40% and she was then in a terrible position deciding between the boat and almost no remaining savings.
The point of that story is simple. Don’t put your emergency fund or short term goal funds into the stock market. Doing so defeats the entire purpose of planning ahead. Keep the funds in a liquid account like the American Express high yield savings account that we use.
A matter of size
The next thing to consider is the size of your emergency funds. You’ve probably heard the rule of thumb that says 3-6 months of living expenses in your emergency fund. Maybe you heard 3-6 months of income. Whatever you heard may or may not be applicable to your financial situation. (Ed: No matter how much I have saved, it never feels like enough…)
There are several considerations here. First let’s consider employment and income fluctuations. If you are steadily employed, you probably need a smaller emergency fund than a traveling freelance writer with a variable income. Any variability requires an increased cushion. The reason is simple; you must cover baseline expenses, and if your income doesn’t show up for 2 months, you’ll probably appreciate the protection that accompanies an emergency fund.
Likewise, if you spend far less than you earn each month, you’ll need less than someone who is living paycheck to paycheck. It’s just basic math. You have much more freedom and flexibility when you have excess funds coming in once or twice a month. You can quickly adapt to the situation at hand.
If you’re a young or old retiree, things are much different. Because you are living on your investment portfolio, you have much more concern with price volatility in the stock market (if you own equities).
Consider someone who must sell $20,000 in shares of stock each year to cover basic expenses. If the market falls 50%, they’ll be forced to sell twice as many shares to get the same dollar amount. This can destroy a portfolio.
Instead, consider holding several years of living expenses in a liquid account that can be accessed during bear markets. Additionally, keep the funds required for short term goals set aside in liquid funds to avoid a situation similar to the one I mentioned above. Ordinary bonds in a portfolio can provide an extended cushion if the market is still low when these funds are depleted.
What are your thoughts on emergency funds?