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Rethinking A Financial Planner’s Staple… The Emergency Fund

8 December 2008 4 Comments

The emergency fund. The staple of every financial expert or financial blogger out there. You have to have it. It should be money set aside untouched used only for emergencies. Some people recommend having money representing 2-3 months of full expenses and some recommend 6 months or even a year! After paying off debt, the emergency fund is the cornerstone of every financial plan. Only after establishing this all-important chunk of money are you free to start investing money elsewhere. This is undisputed advice in the financial arena. Well, I’m here to challenge the universally accepted. Let’s look at a new way to think about the emergency fund.

Cash Isn’t King

Money in a savings account or money market account is making on average 2-3% right now in most accounts. Hardly worth writing home about. But, an emergency fund’s primary goal isn’t to earn a huge return, it is to provide money that you have in case of an emergency so you don’t have to use plastic to pay emergency expenses.

When You Can Place Less Emphasis on Emergency Funds

For many 20-somethings, especially the single ones, who are in good health, you can reconsider the standard advice on emergency funds. Is your company doing well and you have confidence in keeping your job? Then, maybe you can be a little more aggressive with some of the money in your emergency fund. If you don’t have anyone dependent on you, you are very sure you are going to keep your job and you are young, active and healthy, I would recommend keeping some money in cash, but definitely not any more than a month or two in expenses.

On the flip side, if you have a family, might lose your job, have some health issues, definitely place a larger emphasis on the emergency fund.

Alternative Ideas

The good news is that there are plenty of other investments out there that are extremely liquid. Stocks are very liquid and you can usually get your money out of stocks (unless they are illiquid penny stocks) in a matter of days. For most emergencies, a few days time to get money will work out just fine.

The bad thing about keeping emergency funds in stocks is that you might be forced to sell your stock for a loss when you might have originally had a long term perspective when you bought the position. Because of this, I would recommend having any emergency money that you want in stocks to be in stocks that have nice dividend yields. This will provide a nice return (probably more than your savings or money market account) and hopefully get some appreciation over time in share price.

What Constitutes an Emergency?

For the crowd I discussed earlier, the young, healthy individuals with a secure job and no dependents, you can definitely be more aggressive with your financial plan. What circumstances would warrant selling stocks or getting money for an emergency? Well, getting laid off might definitely require you to pull some money so that you can pay rent or your mortgage. A serious medical emergency would also warrant such a move. Credit card debt should not warrant an emergency because you should have already factored in this debt in the first place; you should have paid this off before investing in stocks.

What about a pay decrease? You should avoid using emergency funds to compensate for a pay decrease unless it is a very substantial decrease. In the case of a minimal decrease, simply adjust your lifestyle. Take your lifestyle down a notch so you can pay your bills and still keep your emergency money in their investments.

Also, you might find you can get creative in finding emergency funds depending on how much you need. Perhaps, you can borrow a few thousands from your family (be sure to have set terms of re-payment). Or, you might have some cash value in some life insurance that you might be able to cash in.

Conclusion

The bottom line is that a cash reserve or emergency fund is always a good idea. The amount of money you need set aside in an easy to access savings account, however, can vary widely depending on your situation. Remember, most financial advice out there is basic advice geared towards individuals with minimal investment or financial knowledge. If you are more advanced and are willing to accept some more risk, perhaps you want to be more aggressive.

As for me, I like to keep around $5,000 in a cash reserve in normal circumstances. However, I recently took some of this money out to buy more shares of some of my stocks because the prices have come down so much. Basically, I like to keep my cash in my ING account for emergencies OR great investment opportunities. If I deplete the funds for investment purposes, my next few months of savings will go to get that balance back up towards the five grand level.

If you have individual questions based on your circumstances, I would love to give you my thoughts on your situation. Add a comment to this article if you have a question.

4 Comments »

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