Seeing as this week suddenly turned into personal finance week, I thought I’d revisit an old topic: emergency funds.
So here’s the thing about emergency funds/reserves/whatever you want to call them:
- There is a well-known rule amongst financial planners that says “Before you start investing, you ought to have an emergency fund.”
- And that Emergency Fund should be “three to six months of living expenses.”
- That money should be kept in cash.
- And only used in emergencies.
Why do you need an emergency fund?
The basic reasons:
- There is a timing mismatch between your liquidity needs and your investment decisions. That is: your need for cash is always immediate, while your investment choices are (usually) designed for longer-term return. And selling off a long-term asset for short-term cash can be punitive – especially if you’re selling off at a bad time.
- Also, having cash in the bank feels good. And secure.
- And finally: life. Because it happens. And people find themselves making losses that aren’t always covered by insurance. And you don’t want those losses to force you into a spiral of debt.
So it might seem self-evident that one should have an emergency fund and it should be in cash.
But I do have some questions about that “cash” part.
I agree that, as a general rule, for people that don’t have any savings, the greatest return that you can get is your saving habit. And if that’s where you’re trying to cultivate a saving habit, then you really should save cash.
But as time goes on, I think that changes.
- Let’s say that I earn $2,000 per month (after tax), and my monthly expenses cost me $1,200 per month. There’s $800 of potential savings there – but because man does not live by necessity alone, I quite like spending the extra on having fun and living large.
- Then my financial planner looks at me sternly and says “You need to live less because you’re going to live longer than you expect: here’s a debit order, sign it.”
- So I start transferring $300 per month into a savings account.
- Now according to the emergency fund rule, I should keep a cash reserve of around $7,200. Meaning that I’ll be transferring $300 a month into a savings account for a full two years before I’m done.
- The thing is, each month, I’m massively improving my savings situation. In month 2, my second $300 is increasing my savings by 100%. In month 3, it’s up by a further 50%. And so on.
- So if you compare that to earning, say, a 10% return in an equities unit trust – then you’re not really missing out on much if you just keep it in cash. I mean, in that first month of saving, missing out a 10% annual return on my $300 would have meant forgoing $2.50. Which is barely a beer.
- But by month 12, my 12th $300 contribution is only increasing the savings account by 9%. And by month 24, my 24th $300 contribution is only increasing the savings account by a measly 4%.
- At that point, my investment decision is becoming increasingly important, because if the accumulated $7,200 could earn 10% per year (instead of earning almost nothing in a savings account), then each year, I’m choosing to sacrifice just over two months’ savings for the comfort of keeping things in cash.
- And is that worth it?
Before I answer that, can we all agree that my new situation is very different to where I stood two years earlier? I’ve gone from having no money put aside to having six months’ worth of living expenses sitting in cash.
And it’s at this point that I start to question the conventional wisdom of having it all sitting in cash “for emergencies”.
In fact, it’s at this point that I’d be saying “Go and get a credit card, you. Because congratulations, you’ve flipping well earned it.”
Credit Cards are for the financially disciplined
Once I have my emergency fund, here are the possible alternatives for dealing with it:
- Keep it all in cash; or
- Invest it, and get a credit card with a 55 day interest-free repayment period. And throw the “emergencies” onto the card. And earn air miles.
Other good news: once you’ve got the emergency fund, your time horizon has changed! You no longer need to liquidate at a moment’s notice – you can borrow short-term money in the full comfort of knowing that you have all the necessary assets to liquidate at some point over the next 55 days.
Which gives you time-flexibility.
And the other flexibility: The World Is Much Changed
So putting aside the 55 day free money that the bank and/or your medical aid provider will throw at you, there has also been a fundamental change in the status quo of “things”. There was a time when turning purchases back into cash was a difficult process. As I understand, it mostly involved having to pawn things to disreputable dealers in strip malls. And yard sales.
But today, we have eBay and Gumtree and Facebook. In no time at all, you can liquidate lounge sets and camera equipment and spare tickets to Coldplay concerts.
That is: as an Internet society, we have become more liquid. And the money that you need in an emergency does not have to come from your financial investments. You can start with flogging the non-essentials. And you can do it easily, at fairly low cost, from a position of not-being-all-that-desperate-really.
What all that means: it’s no longer quite so necessary to keep the emergency fund so liquid. At which point, I’d start to pull back on the sheer volume of cash sitting in savings.
The Sum Conclusion
My main feelings:
- If you don’t have an emergency fund, get one in cash.
- If have an emergency fund already saved up, then get a credit card and invest some of the cash.
- Credit cards aren’t evil if you’ve already got the financial discipline to put together an emergency fund. If you’re that disciplined, then credit cards are free money.
PS: final aside, just make sure that you’re limiting your exposure to emergencies with the right insurance policies. Because if you’re not, then any disaster could be truly disastrous.