Friday, July 10, 2015

Do I need an emergency fund?

Conventional wisdom states that individuals should have an emergency fund covering six to twelve times monthly expenses. This means that if your monthly expenses are $2000/month, you need to have $12,000 to $24,000 available in your checking/savings account. If you have a sudden one-time expense, you can use the funds from that emergency fund. After that, you can replenish it with monthly income. If you get fired from your job, you know that you will have some 6 – 12 month breathing room, before you land your next job.

I used to subscribe to the idea of the emergency fund. In my article on margin of safety in financial independence I discussed that I keep 3 – 6 months of living expenses. However, I am no longer keeping massive amounts of cash. I would say that I probably have cash covering one or two months expenses at most. Of course, there are a few reasons for that.

The first reason is the fact that I have a decent nest egg saved up over the past 8 years.

This "emergency fund" is covering close to 18 times the amount of my annual expenses. My annual dividend income is covering a little more than 2/3rds of my monthly expenses. A large portion of that income is coming from investments in taxable accounts. A growing portion of that income however is generated from tax-deferred accounts. I expect that in the future, the portion generated from tax-deferred accounts is going to increase substantially. To access the money, I need to jump through hoops. However, it is possible to access it, by knowing the rules and applying them proactively. Knowledge is power. My nest egg is invested exclusively in stocks. I have hoped to have something like 15% - 20% allocation to fixed income, which is equivalent to roughly 4 – 5 years worth of expenses. Unfortunately, fixed income valuations seem out of touch with reality for the time being. I am hopeful that fixed income will be more attractive at some point in the near future. If I were to exclusively live off my nest egg, I would definitely strive to have some allocation to fixed income. This would be CD’s or US Treasury/Agency bonds of various maturities.

The second reason why I am not worried is because I have various forms of insurance and do not have assets that could require expensive replacement. For example, I have always had health insurance since I started living on my own at the age of 18. In this case, any catastrophic payments would hopefully be paid by the insurance company. For example, I once had to have series of tetanus shots at an ER, which had a cost of $10,000. My insurance ended up covering everything, except for a couple hundred dollars.

I also do not own my residence (yet), hence I will not have to shell out ten thousand dollars for a roof or thousands of dollars to replace appliances or heating/air conditioning units. A few major expenses I would have to shell out in case of an emergency could include buying a car or covering unemployment. I would actually argue that I am in a better position than most people in North America, because technically I could live for 18 years without having a job. If I have a major illness, I am hopeful that my insurance will cover most of it. If insurance won’t cover it, and it is too expensive for my nest egg to cover it, then chances are that a typical emergency fund would not have saved me anyways.

The third reason I do not believe I need an emergency fund of 6 – 12 months expenses is because I am frugal and have several streams of income. Those include my main job, dividends and some income I generate on the side. I consistently save at least half of my paycheck, and I could also cover a little over 2/3rds of my expenses with dividends. As you can see, I have the cashflow to cover most typical emergency situations. Even if I only had my salary, a 50% savings rate could produce enough savings to cover most normal items in no time. This could be further helped by the float generated by credit cards as a temporary means of paying expenses ( to be paid off duly at the due date)

The fourth reason I do not believe I need a large emergency fund, is because I have an excellent credit score and lines of credit I can tap. For example, if I had a major car repair, I could put it on my credit card, and pay it off as soon as it is due. Depending on my credit card cycle, this expense would not have to be paid until at least a month in the future. I could also take out the cash dividends generated from my portfolio, along with savings from my job, and pay off that short-term debt in no time. That way I would earn rewards points, not have to pay any interest, and still using float from my friendly credit card company.

The fifth reason is that there is an opportunity cost to holding large amounts of cash on hand. If I had $24,000 sitting in cash, I will have an opportunity cost of roughly $740 foregone dividend income at an average yield of 3%. In other words, by keeping so much in cash that earns nothing in a checking or savings account, I am missing out on dividend income I could have earned had I put that cash in stocks.

As you can see, my nest egg, and my line of credit can provide liquidity in the event that I need cash covering 6 – 12 months worth of expenses. If I am unemployed for an year, or if I need a new car or I have sudden expenses, I will be covered. I believe the real reason for an emergency fund for most people is because most do not save anything. If you spend all your income, you will get in trouble when you have large unplanned expenses. If you live paycheck to paycheck, a large one-time unplanned expense can derail your finances. Once you have a track record of consistently living within your means and saving a large portion of your income, you can then safely go on to the next level of personal finance. The next level is called building your nest egg. This includes both taxable and tax-deferred investments such as stocks and bonds.

If I have a really huge expense, because I have a rare condition that required hundreds of thousands of dollars in spending, and which will not be covered by health insurance, I can then simply liquidate my nest egg. A nest egg is not worth saving, if I am not around to enjoy it. Same level of thinking goes for close family too. However, the typical emergency fund is not going to cover that huge expense either. This is where a nest egg can provide a much better cushion than an emergency fund. This is why everyone should strive for building a nest egg, that can cover 300 - 360 months worth of expenses, rather than an emergency fund covering a mere 6 - 12 months of expenses.

Full Disclosure: None

Relevant Articles:

Happy Financial Independence Day
My Dividend Goals for 2015 and after
Margin of Safety in Financial Independence
How to accumulate your nest egg
The World’s Best Dividend Portfolio

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