Here is the old way of looking at Emergency Funds:
- Keep 3 months of take home pay set aside if you are single, a renter and have a steady paycheck.
- Keep 6 months of take home pay set aside if you are married, have kids, and have a mortgage
- Keep 9-12 months of take home pay set aside if you are married, have kids, have a mortgage AND have variable compensations (such as anyone in sales).
The rules of thumb may work well for many investors, but in a lot of cases the Emergency Fund concept needs to be updated.
Let’s stop thinking about it as an Emergency Fund and start referring to as an Emergency Strategy. Not all emergencies are the same so the tools and approaches must be crafted with more care. Below is a better, more holistic approach to consider. It breaks the Emergency Fund into 3 categories, each with a separate approach:
1) Short Term Emergency Fund:
- 1-2 months of discretionary expenses set aside in a bank account. This is designed to cover smaller, unplanned expenses quickly and easily.
2) Long Term Unplanned Expenses:
- Insurance is the backbone for these expenses. Funds and savings are used as a supplement.
- Ensure that the HSA account is funded or could be funded up to the deductible limit in case of a health event that’s expensive to treat.
- In case of layoff or disability, the investor should know how much they would receive from unemployment or disability insurance and their non-discretionary expenses. That difference, if any, needs to be funded anywhere from 3-6 months depending on the investors situation. Certain careers are harder to come by than others and may warrant more funding.
- The amount determined should be invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market. Instead of sitting in cash earning nothing, it continues to grow and be productive.
3) Long Term Planned Expenses:
- Budgeting is the backbone for these expenses. The key to this will be taking stock of the investors current physical assets and determining how much and when each should be replaced. An investor with an aging roof and old car should have more saved than someone with a new roof and new car.
- The goal is to determine an ongoing amount that must be saved each month so that when something breaks down, the funds to replace it have already been saved.
- The funds are invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market. Instead of sitting in cash earning nothing, it continues to grow and be productive.
- In conjunction with the funds invested, it may be cheaper to establish a line of credit. And use the equity in the house to one’s advantage.
Too complicated? Here is a simplified approach:
Follow the rules of thumb outlined above to find how much should be in the Emergency Fund. Any amount over $50,000 could be invested in a specially designed conservative portfolio of low volatility stocks and/or target date maturity bond funds. It remains readily available, but continues to grow and be a productive asset.