One of the pillars of sound personal finance is the emergency fund. An emergency fund is money set aside before everything else to cover unexpected expenses. This is the first step to building your financial future, even before you start investing. The challenge is it’s hard to predict when or if you’ll need money to cover your living expenses if you lose your job or experience unusual healthcare costs associated with a family member becoming seriously ill.
Therefore it should not be surprising that the most common question we receive with regards to emergency funds is how large should they be? For most people the answer is probably enough money to cover your living expenses for three to six months. That should be enough to give you time to find a new job. Ideally your living expenses are below what you currently earn. If not you should seriously consider what you would cut if you had to do without for a few months.
The actual amount you should set aside depends on four factors:
Age has a strong influence on the size of an emergency fund for a number of reasons. All things being equal, the older you are, the larger your emergency fund should be. Younger people tend to have lower living expenses, fewer unexpected healthcare incidents, and require less time to find new work.
Much has been written about the difficulty of people above age 50 finding new jobs. This translates into an increased time period for a search, which argues for a larger emergency fund. I would strongly encourage you to think about increasing the size of your emergency fund as you reach 50, especially if you work in an industry like technology.
The more in-demand your job, the lower the size of the emergency fund you need. These days software engineers with consumer Internet or mobile application experience are an incredibly hot commodity. The likelihood that someone with this background will be out of work for the standard three to six months is extremely low. In contrast, someone with a manufacturing background might want to have a fund well in excess of six months.
The length of time you may be out of work will vary with the geography, industry and the level you’ve attained in your profession. In many cases, senior management positions take longer to find than individual contributor positions. If you are inflexible about geographic area, you may need a longer time period to find new work. Each of these issues factors into the length of time it would take you to replace your income, and as a result, should affect the size of your emergency fund.
One of the most important factors to consider when deciding how much money to put aside for an emergency fund is the magnitude of your investable assets — yet many people ignore it.
Investable assets above a certain level eliminate the need for an emergency fund.
Mind you, that level might be an order of magnitude larger than your emergency needs. Above a certain threshold you can afford to withstand a significant loss and still have enough money to cover any bad things that might happen to you.
It’s most common to need your emergency funds in tough economic times, which are often correlated with significant stock market declines. Unfortunately as we have written before, that’s the time you least want to sell your investments. Therefore you should only be willing to fund your emergency expenses out of your investment account if your expenses will represent a small percentage of your depreciated investment account. There’s no good rule of thumb to rely on here, but based on a survey of …. employees we think you shouldn’t eliminate your emergency fund until your investment account represents 5 to 20 times the total amount of money you might need in the short term.
This is a bold statement, so let’s examine in more detail the case of eliminating your emergency fund once your investment account grows to 10 times your emergency needs. An emergency fund of $30,000, which translates to an investment account of $300,000. Even in the highly unusual market downdraft in the financial crisis of 2008-2009 where the S&P 500® was down 57% from its 2007 peak, your diversified portfolio would have been down approximately 40%. That means your investment account would have declined to $180,000 ($300,000 x (1-40%)). In that case your emergency withdrawal would have represented 17% of your now reduced portfolio value. To give you a frame of reference, 17% is approximately four times the recommended annual withdrawal for a retirement account. While it might be potentially painful to sell a portion of your portfolio at those depressed values, the low probability of such an event probably justifies a contingency plan one-time 17% withdrawal.
Depending on your risk tolerance, 17% may be too high or too low, which is why we suggest a range of 5 to 20 times your total emergency needs. Please keep in mind that even if you choose not to have an emergency fund you should still keep enough money readily available to tide you over for the three to four days it takes to get money out of your investment account.
Your extended family’s financial needs can play a big role in determining the magnitude of the emergency fund you set aside (extended family being defined as those in your family you are willing to help in a financial crisis — or that might ask you for help). The more money your family has, the less likely they will need to call on you in an emergency, and, relatively-speaking, the less money you need to set aside. In other words, if your parents and siblings have very little savings then setting aside six months of living expenses may not be enough.
Even if your family is reasonably comfortable you probably shouldn’t allocate less than six months of living expenses to your rainy day fund because you probably don’t want to have to go to your parents for money if you lose your job.
The appropriate amount you should set aside for your emergency fund is unique to your situation. Magnitude of wealth and riskiness of your job should play a big role in making your decision. In all but a few cases you should never invest your emergency fund in anything other than a low-risk account like a money market fund or insured savings account.
The magnitude of available return should not be a consideration; the safety of your principal is all that matters. Factoring in the four considerations above will take you a long way down the path of arriving at the right size emergency fund to keep yourself and those you care most about safe and secure and leave you with peace of mind.
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