Emergency funds are a staple in financial planning. I am a firm believer that everyone needs one regardless of your risk tolerance, how safe your job is, how much debt you have, how much you have invested in the market, etc.
There were multiple debates on Twitter this last month about how much you should have as an emergency fund and whether it should be invested. Since the comments on Twitter were so split, I thought I would dive into this topic and share my opinion.
How Much Should I Have In An Emergency Fund?
The general rule of thumb is that you should have 3-6 months’ worth of expenses in cash in an emergency fund. I quickly want to note that having this in a high yield savings account that is separate from your checking is in your best interest. This way it is designated just for emergencies and also is accruing some interest as it may just be sitting there for a long time. Anyways… Rules of thumb can be useful, but let’s dive more into this and see where you individually should land on the spectrum.
I agree that the safer your job is, the less you need in an emergency fund. If you are a tenured professor you probably could hover closer to 3 months worth of expenses knowing your job is very safe. Another time you could have a lower emergency fund is if you have a dual-income household where both incomes are relatively similar (huge risk we face is loss of job, having another income helps so if a job loss occurs, you would still have income and could just decrease some of your spending on non-necessities).
On the flip side, if you are in sales, a newer business owner, or have a one-income household where your job is not guaranteed, you should probably have anywhere from 6-12 months of expenses built up. I typically advise clients around the 6-month mark unless they are a newer business owner or get paid full commission, then I recommend 9-12 months as their income can be super irregular. Next week I will have a post on how to handle irregular income. It is a personal preference, but having a safety net can do wonders for the anxiety you may have around money.
Lastly, you also need to consider your risk tolerance. The lower your risk tolerance, the more you should have in your emergency fund. However, this does not mean that this number always has to stay the same. For example, over the last couple of years, as I have become more comfortable with volatility and increased my risk tolerance and income (through investing and learning more about the market), I have decreased my emergency fund. It is okay to start with a higher emergency fund as you get used to the stock market, then decrease it as your risk tolerance increases. If you are married and one spouse leans more conservative, you may want to start with a higher number to alleviate stress for them. You have to compromise around money in relationships, it’s just part of it.
Should You Invest Your Emergency Fund
“I don’t want to miss out on gains in the market and leave this much money just in cash.”
“If the market goes up and to the right, why wouldn’t I just invest my emergency fund?”
These are two statements that commonly come up when people are talking about emergency funds so let me explain both.
I love that people are eager to be in the market and want to grow their money, but what are you going to do if an emergency occurs when your investments have a lot of gains? Well, you would have to sell and pay tax on the gain just to have that money taken out even if you don’t want to and would rather hold on to the investments. Or your other option would be to turn to debt if you don’t have an emergency fund. Having an emergency fund can help you not have to irrationally sell or make investment changes to raise money at times you don’t want to.
On the other hand, what do you do if you have an emergency and your portfolio is down? You now either have to sell at a low point and take a loss or you just simply don’t have enough money again to cover the emergency because your portfolio has gone down. Again you would have to turn to debt which is not the best option. Imagine having your emergency fund invested last year and then needing that money in March and your portfolio is down 30%… You would be in a tough spot.
As you can see from the chart above, the stock market does go up and to the right over the long term (based on history), but not necessarily in the short term. If you needed money during one of these downtimes in the short term (the red circles) you could be stuck with having less money than you need. This is exactly why you should keep your emergency fund in cash (high yield savings account). You do not want to be short of the necessary funds and be required to use a credit card or sell at a low point at a loss as we talked about above. From my experience, people I know that invest their emergency fund feel much more anxious as the market changes. The goal is to be a long-term investor, have cash available in the short term for the needs you have, and hold on to your investments as the market goes up and down. You do not want to be forced to make drastic changes or sell at bad times because you did not plan accordingly.
I hope this helps reiterate the importance of an emergency fund and why it should not be invested in the market.