I decided to make some changes to my Emergency Fund this week, and since this is a change to my Charter, here’s what I changed and why.
Previously, my Emergency Fund (EF) was a 30:70 split between cash held in a Savings Account (30%) and investments in Total Stock Market Index Fund (VTSAX). At the end of February, the target amount for my EF was 9.6 times my monthly living expenses ($3900) or a total of $37,440, and it was 98.1% funded with a balance of $36,732.
I’ve decided to invest the cash portion of my EF to make it 100% stocks (via VTSAX). Dividends will be re-invested automatically. And in any month that it’s below my target threshold, I’ll add additional money to a maximum of $200 a month.
I’m also increasing the target this year to 10 times my Living Expenses, or $39,000. I’ll be reviewing my budget in June and so this target may change in the summer depending on any adjustments I make in the budget.
Why you shouldn’t invest your Emergency Fund in the stock market
Investopedia defines an Emergency Fund as “an account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major expense.”
Putting your Emergency Fund in stocks means that there’s a good chance it’ll be worth a lot less when you actually need it. If unemployment is caused by a recession then the stock market is likely to be losing value as well.
So you should keep your Emergency Funds in a safe liquid account, such as a High-Yield Savings Account or Certificate of Deposits. I don’t recommend that you follow my approach and put your Emergency Fund into the stock market.
Assuming an average 2% inflation rate with 1% interest, then you should also be adding an extra 1% to your Emergency Fund each year so that it maintains its buying power; otherwise it’s losing value over time.
With Certificates of Deposits (CDs) you may gain a slightly higher rate at the expense of more restricted access to the money.
Why I’m investing my Emergency Fund in the stock market
By its very definition, Personal Finance, is personal and unique to everyone’s individual circumstances. In my particular case, I think I’ve reached a stage in my FI journey where I can afford to take on more risk with reserve money.
I split my finances into different buckets, four of which are “Living Expenses / Cash”, “Savings”, “Emergency Fund” and my “Income Fund” that I mostly write about. These are all different accounts in various financial institutions and are kept separate from one another.
My Living Expenses accounts always contain 3 months’ worth of living expenses, and if I added my Savings and my Income Fund to that balance then I have a total of 56 months worth of living expenses. So in terms of losing my job, I could make do for several years.
Likewise if I needed to make a large purchase, say a house repair, then I could always use some of my Savings which are about twice the size of my Emergency Fund. This would come at the expense of delaying a long-term goal. But I’d also likely look into financing such a purchase with a low-interest loan in such a case.
Why keep the Emergency Fund at all?
This is where the behavioral and psychological side of finance comes into play. I’m naturally against selling any of my Savings or Income Fund for emergency expenses since that’s not their purpose. Having a dedicated and separate account for such a case eliminates that problem, and I wouldn’t have that same reluctance about using my Emergency Fund for an emergency. That said, I’ve never touched any of the funds in my EF since I’ve started it and I’ve slowly converted it from 100% cash to a mixture of cash, bonds & stocks to cash & stocks and now finally to 100% Stocks.
As far as stock market crashes, I’ve never had the urge to sell as the price falls; I’m naturally inclined to want to buy more at such times since they’re cheaper. I have a long-term optimistic view that all companies are working 24-7 to make more money and improve their share price.
When I reach full Financial Independence, e.g. the income from my Income Fund exceeds the monthly Living Expense budget, then keeping an Emergency Fund as a hedge against losing employment income makes no sense. So as my Income Fund income increases, I’ll be reducing the target levels for my Emergency Fund.
I’m also reviewing the mechanics of how my Income Fund pays out dividends to my Living Expenses since including a cash buffer in the Fund will smooth out payments; so I may also increase the amount of cash I reserve for Living Expenses in the future.
Quote of the Day
It is always your next move.