Emergency Fund revisited

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.

New allocation

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.

With a Savings Account in the US you can expect to get around 1% interest a year at today’s rates from places such as Ally, American Express or Barclays.

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.

Longer term

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.

7 thoughts on “Emergency Fund revisited”

  1. Hey Dividend Life,

    Personal life is indeed personal! I had thoughts on the emergency fund vs savings as well just recently and made it into a post.

    How do you define your savings vs emergency fund and investments?

    In our case, emergency fund and savings are both in cash. The savings are for upcoming known big expenses like upgradings the rooms of the kids, exterior light: things we can already name. The emergency fund is for unplanned things like a suddenly broken dishwasher.

    1. Hi Ambertreeleaves,

      Oh I didn’t see your post before writing mine, but I just read it and I think we have similar approaches in general. I’ve described my various accounts in my Charter but here’s a summary:

      My basic accounting formula:

      Money for Investing = Income – Emergency Fund Contributions – Savings Contributions – Living Expenses

      Savings: Money reserved for larger purchases outside of normal living expenses. I view my Saving accounts as a set of separate Goals each with a 2+ year timeframe. Currently I’m saving for a new laptop (replace every 5 years), pay off my mortgage (15+ years), new car down-payment (2+ years), house repair (no fixed time) etc. I use a mixture of Cash and the Vanguard Wellington fund (a mix of stocks and bonds). Shorter-term goals such as a laptop are 100% cash, longer term goals e.g. mortgage are 25% cash, 75% Wellington…it depends on the timeframe. My excel file calculates the value of each savings goal based on the cash / investment percentage I’ve allocated.

      For appliances, I do need some more specific goals as they would come out of my house repair Savings goal at the moment. I plan on buying new appliances regularly; in theory I’d like to plan to replace them (say) every 8 years before they break. So I should make a savings goal for that and when I reach the goal, just replace the appliances. I include money for house repairs in my monthly Living Expenses budget but that’s really for cases where I call out a plumber or electrician or something.

      As far as investments, they’re grouped according to their purpose. I have investments as part of Savings (VWELX), as part of my Emergency Fund (VTSAX) and as part of my Income Fund (my portfolio). Although they’re held at the same brokerage; I keep the numbers and funds separate so I don’t count e.g. WWELX as part of my Income Fund and any income it produces doesn’t show up in my monthly Income Fund reports; it’s indirectly seen as an increase in my Wet Worth number.

      Best wishes,

  2. Until some time ago, 4/5 years ago, my emergency fund was a nice and safe sovereign Zero coupon. The value rises constantly (slowly) and cost of investing/disinvesting is not that big. Shame that ECB decided to F**k it all up with QE and now these bonds fluctuate worse than a mid cap stock during a recession 🙁
    Hence, I stay liquid with my EF, saving accounts in Europe are risible, and it normally takes a lot of time to take the money out, as you need to commit to a longer investment to get decent percentages…
    ciao ciao

      1. One of the worst moves in the history of economics (in my opinion and I hope that they prove me wrong). Instead of boosting confidence of the public (like eliminating this crappy bailout procedure that is getting people worried every day), they care only of eliminating problems for the banks, so more free money to them who in return don’t invest in the market because it’s too risky… So they all buy bonds instead, prices skyrocket and you need to look elsewhere to get a crappy 2% net return… 🙁

    1. Hi DFG,
      3-months is certainly good – I must admit I tend to make plans to achieve my EF targets slowly as I always think that the money would be better earning more income than sitting idly in my EF. Plus I like being able to watch progress towards another goal.

      Best wishes,

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