In last week’s blog post, I shared a number of tips on how to manage the COVID-19 crisis in your personal finances. I had mentioned the emergency fund as an important vehicle in your financial setup to manage unforeseen disasters. Set up the right way, the emergency fund can buffer away risks of intermittent earning and buy you loads of peace of mind. The importance of having an emergency fund has been underlined by the current COVID-19 situation. But how does it really work? What is best practice?
Note: This is a revised and updated version of a similar blog post I wrote more than two years ago – now in English! Those who have followed MFF for a longer period of time may appreciate the additions to the original version.
My long-term readers already know that financial freedom, for me, is closely linked to personal freedom. With that, I also mean the independence from the state sponsored welfare systems and political influence which comes with the benefits doled out. I am convinced that individuals should first and foremost provide for themselves before (in a second step) having to rely on the state in case of unexpected emergencies.
Now you might argue that a light touch state (“night watchman state”*) would only interfere in such harsh circumstances for the individual anyways. Unemployment insurance or similar benefits would only be designed for precisely such extreme situations. I would still insist that I would not want to rely on such schemes irrespective. First, these benefits are tied to specific conditions which may not apply to you. E.g., in many countries unemployment benefits for the self-employed would not be available. Second, some schemes may be designed such that you would first have to tap into savings and other financial resources, in effect only providing for a bare minimum (“too little to live, too much to die”) rather than helping out in situations of intermittent cash flow. Third, these benefits are sufficiently scarce that they do not cover effectively what you and your family truly need. So, rather than relying on such schemes, wouldn’t it be nice to take care of yourself?
Which emergencies are we covering for with the emergency fund?
Emergencies come in many shapes, just as life takes its idiosyncratic turns for each and every one of us. Financial hardship can come from unemployment due to a bankrupt employer or due to a pandemic (as we learn these days), long-term health issues due to a sport accident, an expensive car repair for the car you need to commute, a hurricane damage on your home’s roof only partially covered by your insurance. All these events have in common that they a) are completely unexpected, b) have a highly negative impact on your personal finance, and c) have a low probability of occurring.
The COVID-19 crisis and its economic consequences in the form of a sharp recession are no exception to these events. We a) did not expect the magnitude and impact of the COVID-19 crisis. Half a year ago, most of us would have laughed at you when you said that millions of people worldwide would literally be under house arrest. b) Oh yes, COVID-19 will have a negative impact on your personal finances. If you lose your job, for sure. If you are lucky enough to keep your job, things might still get a lot bumpier at work – don’t hope for a handsome bonus at year end 2020 either. Certainly, the crisis will leave their mark in your investment portfolio. And finally, c) I would not want to go into statistics, but the probability of such a pandemic happening was apparently only correctly assessed by Bill Gates (in 2015) and by the Simpsons (in 1993) 😉 certainly not by millions of people around the world, including myself!
How much money should be in the emergency fund?
I recommend to hold three to six times your monthly expenses in your emergency fund. With that, I think I am in good company of many other bloggers or financial media such as CNBC. Notably, I would look for the multiple of monthly expenses not of monthly income. In an emergency you would not need to continue saving according to your typical saving rate, so covering your expenses should really do in such a situation. The range of three to six times monthly expenses stems from the riskiness of your income streams, i.e., the probability of indeed losing your income and not getting back on track quickly. To pick a couple of examples:
- A civil servant would not worry too much about job loss or the bankruptcy of the government (unless you are a civil servant in Venezuela or Argentina…) and stick with a 3 month emergency fund
- An employee at a S&P 500 company should consider their job and income rather safe and should go for a 3-4 month emergency fund, depending on the financial stability of the company, I would suggest
- A pilot at a major airline might worry a bit more and go for the 4-5 months’ worth expenses
- A self-employed artist might go for the 6 month emergency fund, if not more given the intermittent nature of their income
The COVID-19 crisis should confirm this rule of thumb as different sectors of the economy face different vulnerabilities to the economic effects in a recession.
At the same time, I would encourage you to make your emergency fund not bigger than necessary. As the emergency fund will be held in cash, you are losing yield on the money in the emergency fund. Holding cash will earn you a certain, long-term, negative return due to inflation.
How to invest the emergency fund?
Please: Don’t “invest” the emergency fund at all! The key to the emergency fund is that it is readily available at all times, without having to sell securities, potentially even in adverse market environments. I recommend holding the emergency fund in a separate savings account without touching it on a unless needed. As such it will be the source of peace of mind for you! You can count on the money sitting there for the unlikely case it was set up for.
Sometimes, gold* or silver coins* are mentioned as the perfect safe haven. Precious metals might provide long term inflation protection but they are not suitable for your emergency fund. Why? You may be severely handicapped to transact with your gold or silver in case of emergency. The conversion to cash may be indeed difficult and you will suffer from a significant bid-/ask-spread when going in and out of physical gold or silver.
And no, an overdraft or credit card limits are not part of the emergency fund! It might not be available when you need it most as your bank changes their mind to extend credit as you lose your job.
Personally, I keep three months of expenses. Roughly two thirds of my emergency fund are in a savings account. The remaining third, I hold as cash (predominantly in small notes ;-)). I am typically a big fan of cashless payments, but in case of a true emergency with power outages, etc. even this could be problematic. With this focus on cash, I was wrong during the COVID-19 crisis, as cashless payments surged due to the contact restrictions and rapidly changing consumer behavior, but so be it.
I see a clear hierarchy as you build your financial freedom which goes along the following steps:
- Repay all (consumer) debt
- Build your emergency fund
- Invest and build your wealth
This hierarchy has a couple of important implications. First, please, please, please repay your consumer debt / credit card bills first. You are paying outrageous interest and should do away with these obligations first and foremost. Second, once your emergency fund is filled, there is no need to tap into your accumulated wealth any more as you face financial adversity. Neat, isn’t it?
Your best approach to fund your emergency fund is to direct your monthly savings (after a budget review!) towards the emergency fund until it is fully funded. The budget review might be the first step to free up money in your monthly budget which can go towards savings. Finally, once you had to tap into the emergency fund due to a crisis, I would immediately fill it up again before moving on to further investments.
Do you have an emergency fund? How much is in it? Did you tap into it due to COVID-19? If no, do you think you will have to use it? Looking forward to hearing from you with a comment or an e-mail on firstname.lastname@example.org