Conventional personal finance wisdom suggests everyone should have an emergency fund to cover unexpected expenses or job loss. “Most experts” believe your emergency fund should have enough money to cover 3 to 6 months of living expenses.
It appears that many people have not been willing (or perhaps able) to take this wise counsel and are still living paycheck to paycheck. It’s painful to see how quickly a crisis can develop when the income spigot turns off.
While the “3 to 6 months” of living expenses is just a rule of thumb estimate, I’ll grant that it is a much better estimate than an emergency fund of $0.00. But since all rules of thumb are inexact shortcuts, it’s worthwhile to examine this one to identify its implicit assumptions and some things it might miss.
“3 to 6 Months…”
Thanks for narrowing it down for us, “experts”. This sounds like a carefully considered estimate, but the high end is (checks math) double the low end. And some experts go further and say that you might need as much as 12 months. At least they didn’t say “a pile of cash bigger than a breadbox” (“Which notes?” “It depends…”), but that’s about as precise an estimate.
If you are hoping to cover the loss of income, I would argue that living expenses – which you were paying with that income – are a reasonable estimate of what you might need. How many months of living expenses should you have? How ‘bout a conservative estimate of how long it’ll actually take you to replace the income? That might be two weeks or two years or never, but your own situation – your skills and powers, supply and demand in your field, etc. – will be far more telling than a generic 3 to 6 month timeframe.
So that addresses lost income. But your emergency fund is also supposed to protect against unexpected expenses, and that’s where things get a little weird.
“..of Living Expenses”
What are unexpected expenses? They are things like medical emergencies, major home and car repairs, and surprise travel expenses. They are extraordinary costs that happen infrequently with little or no warning.
And how do these relate to your regular monthly living expenses? They don’t. There may be a whisper of correlation, but I’d be really surprised if the cost of your emergency appendectomy was a function of your monthly mortgage, car payment, and grocery bill. The idea that these two totally different classes of expenses relate to each other is just wrong.
Do you want to know what is a far better estimate of what you might need for an unexpected expense? The cost of that potential expense. For healthcare costs (if you live in the Mad Max U.S.A.), that’d be your maximum out of pocket. For your HVAC, it’d be the cost of a new unit. For your car, it’d be whatever a major repair costs for your ride. You can’t predict when these emergencies will occur, but you can make a good estimate of how much they will cost.
Basing the “unexpected expense” component of an emergency fund on one’s actual risk should drive significant differences across people. A Canadian apartment renter with no kids or car has a very different risk profile than someone in the U.S. with an old house, 4 kids, and a long driving commute. Their provision for unexpected expenses should reflect that.
Even with an accurate sense of what surprise expenses you might have, there’s still a mathematical and philosophical question that needs answering. How much of that total potential damage should you actually save in an emergency fund? All of it? Surely not. Should you set aside for the most expensive 1-2 items? Should you probability weigh the risk of each expense and then add some cushion to be safe? I checked with the experts, and they said, “It depends.” Your risk tolerance and your total financial situation will help answer that.
One of the best ways to prepare for emergencies is to role-play an actual emergency. What would actually happen if were hit by a perfect storm of your own personalized surprise expenses? What would you do, and what would your cash flow look like? That may be more informative than blindly setting aside 3 to 6 months’ of living expenses.
The Best Emergency Fund Is No Emergency Fund
I believe most experts would advise against holding your emergency fund in stocks or pork bellies or Bitcoin. Having your rainy day fund in cash or near cash ensures that it’s actually there when you need it. However, holding cash is expensive when you could invest those funds in assets with better projected returns. An emergency fund is just another form of insurance, and like all insurance, it costs money.
There are ways to reduce or remove this need for insurance. First, remember that some of an emergency fund is meant to cover living expenses. Why not attack those expenses themselves? Any reduction – especially in the fixed costs you can’t cut in a crisis – should lower your needed emergency fund.
Second, build up your DIY muscles. They’ll help with regular expenses (see above) but can also assist with surprises. Recently, I needed the coils and spark plugs replaced on my Mini Cooper (slogan: the cost and problems of a BMW, without the cachet). Numerous shops quoted me over $600, and that made me mad. My YouTube advisors walked me through it for ~$150 (bonus: now I own a torque wrench).
And finally, once you have a big enough pile of assets, the need for an emergency fund goes away. While I don’t have a lock box full of cash with “emergency” written on it, our asset allocation does include some fixed income and (when I’m feeling plucky) cash waiting for an opportunity. I should hopefully be able to cover any surprises from that. That may sound very Scrooge McDuck to people living paycheck to paycheck, but living below your means for many years does add up.
Everyone should save for a rainy day, but blindly following the “3 to 6 months’ living expenses” counsel of experts probably isn’t the best approach. Prepare to cover lost income until you could get back to work – and that could be more than 6 or less than 3 months. Prepare to cover your unexpected expenses as they may be very different from mine (and are unlikely to be a multiple of your monthly grocery bill…). Keep your expenses low and your savings high, and someday you’ll finish up right where we all started: without an emergency fund at all.