The establishment of an emergency fund is one of the first recommendations you’ll hear from a personal finance “expert”. While you will hear a range of opinions on how much you should stash away for a rainy day fund, the underlying reason for the recommendation is the same.
An emergency fund, or a rainy day fund, is savings you have accumulated to protect yourself and your family from a catastrophe such as losing your job or having to unexpectedly face large expenses such as medical bills. It is an attempt to move away from being one pay check from broke.
How much you should save for a rainy day is debatable and mostly dependent on your own risk appetite. But for the most part you will hear people say that you should have at least six months worth of your expenses saved in an emergency fund.
Six months is a good place to start, and in my opinion should be increased in tough economic times when corporations are downsizing. You can always release some of the cash from your emergency fund when things start to look hunky dory again.
But why six months? There is really no good reason except one financial expert heard another say it and repeated it and soon the message spread across the industry. Realistically, this number should be whatever it needs to be to give you the comfort and peace of mind you need.
Generally yes. Most people are on a single stream fixed income, often their paychecks from their jobs. For those individuals, an emergency fund is critical.
However, there is another group of people out there who have multiple streams of income. For this group, though an emergency fund is important to have, it is not as critical as it is for someone who will be financially handicapped if they lost their job.
Most financial advice around drawing up a budget plan and saving cash along the way often assumes a single stream fixed income case. An individual should take into account total cash flow from all sources, while conservatively estimating cash from variable sources; In other words, amounts that fluctuate from one month to another.
Having more than one income stream significantly mitigates unforeseen financial catastrophe. The more the income streams, the less critical it becomes to establish a rainy day fund, especially a large one that ties up a significant enough amount.
Because excessive funds tied up in an emergency fund come with opportunity cost, additional income streams allows an individual to best utilize this cash on extraordinary opportunities that may cross their path without having to think too much about depleting the fun or replenishing it in the future.
Many readers of this blog are entrepreneurs of sorts. Though many of them have successful careers, others do not and solely depend on variable income from one or more sources. Those not on fixed income need to instill a strict discipline in saving toward an emergency fund at least until their income streams become significantly sizable and diverse.
The point behind establishing a reserve fund is to be able to access the cash when in need. Personally I like my cash in high interest savings or checking accounts, or fixed deposits / certificates of deposits that do not penalize to a point where I may end up getting less than my initial invested principal.
These are all liquid investments, or avenues from where I can access my cash relatively quickly and easily. Always ensure the institution is insured, such as FDIC protection on deposits up to a certain amount.
Having the cash accessible at all times also ensures you can quickly seize interesting opportunities that cross your path, such as purchasing the foreclosed home at a 75% discount, or investing in a significantly undervalued stock.
Many tap into their emergency funds to purchase a business or sustain their lives while they work on their start up. Taking a sabbatical from work to work on your business is a common approach to starting up businesses. However, you need an emergency fund to feed you and pay the rent while you work on your start up.
Then there are those who would eventually like to cut part or all of their insurance policies because they have enough stashed away to the point where they are “self insured”, or able to sustain a financial loss / catastrophe with their own / saved funds.
So do you need an emergency fund? Yes you do. How much of it depends on your ability to generate cash flow when in need and your personal risk appetite. When in doubt, think of the amount you need saved up in the bank to give you the peace of mind to conduct day to day business with no financial stress. Peace of mind is often underrated, and achieving this alone will significantly help improve other aspects of your business and life in general.
In addition, an emergency fund can be a mechanism through which you can position yourself to take advantage of opportunities such as the significantly undervalued stocks of 2008 or real estate during a great recession.
Before concluding, I’d also like to throw in the fact that an investment account like a Roth IRA can also been seen as an emergency fund. Many don’t know or forget that your contributions to a Roth IRA can be removed tax and penalty free at any point (only up to the amount you have put in).
I realize that this topic is relatively basic, and far too ordinary for financially savvy individuals who read this blog. However in the interest of those who may be able to benefit from this information, I hope I have done a fair job of articulating my two cents on this topic.
Readers: Do you have an emergency fund? How much have you stashed away? Why? Are you prepared to mitigate risk from financial uncertainty?