Why I Maintain an Emergency Fund

QUESTION: What’s worse than seeing your stocks take a dive like many of us have seen lately?

ANSWER: Seeing your stocks take a dive and your car’s transmission suddenly going. Or your house suddenly needing a new roof. Or you suddenly getting let go from your job.

And those are worse still if you have to also go into debt to cover unexpected major expenses or to tie you over until whenever.

Having an emergency fund is a topic more suitable to the personal finance blogs. But it’s an especially good feeling having an emergency fund in this stock market, and during these uncertain economic times. That may seem trite to some of those on Wall Street reading Controlled Greed, but it isn’t for the rest of us retail investors.

Every definition of an emergency fund I’ve read is this: three-to-six months of living expenses in a separate account, such as a money market or bank savings account. This money is totally liquid so you can access it right away without penalty.

Some points:

• Three-to-six months of living expenses isn’t the same as three-to-six months of your salary. We should all be living on less than we make, so if you don’t have an emergency fund and want to establish one it shouldn’t be as daunting. Just figure out how much your expenses are for an average month and multiply by 3 or 6. Make it a realistic number. Don’t fool yourself by saying, “I could get by on such-and-such.” Be realistic about your average monthly expenses and work from that.

• With one exception, I think people should opt for six months’ worth of expenses in the fund as opposed to three. And that’s when a couple are both working full-time jobs and are virtually certain of keeping those jobs for the foreseeable future. Self-employed people and households with one full-time income should go with six months in their fund, in my humble opinion.

• Don’t worry about low returns, currencies, the falling US Dollar and inflation. Just keep your money in cash for liquidity. Your emergency fund is quasi-insurance giving you as much peace of mind as anything else. It’s not part of your investment portfolio -- that’s what brokerage accounts and retirement plans are for.

• One possible exception to the above would be to keep your first three months’ worth in cash with the second three months in 90-day CDs. I’ve heard of people doing this, but whether it’s worth it or not probably depends on the CD rate.

Now, some very smart folks don’t care much for emergency funds. Jonathan Clements, who used to write The Wall Street Journal’s “Getting Going” column is one, if memory serves. He doesn’t like having that much money sitting around earning low returns. And I believe Clements suggests having a home equity line of credit to access in case of emergencies. My problem with that is if something goes from bad to worse, you’ve potentially got your home at risk. And the same could be true if you’re a renter and used other credit.

I heard about emergency funds many years ago but never went that route. Because I was cash-strapped at that time (I was young) and later I just opted to put money in retirement plans and the like. But after a couple of times of having to use credit cards for unexpected expenses -- and then not having expected income come in from some clients and had to carry over credit card balances -- I finally learned.

For me, an emergency fund makes sense and establishing one would be item 1-B on my list if I was just starting out today. (1-A would be to never go into consumer debt.) But like I said above, the benefits are more than financial because of the peace of mind your emergency fund gives you.

And that’s a great thing in any market.

Comments

[rrgg]

It's worth mentioning that the emergency fund should include expenses for health insurance which is often lost with employment. Most people seem to ignore this expense.