The convention wisdom is that you need 3 to 6 months’ worth of cash on hand to cover emergencies BEFORE you start investing. There is no substitute for the reassuring feeling of fast, hard cash on hand.
Sounds rational, right? But it’s not quite so simple. A growing number of experts say that there’s more wiggle room in this question of cash reserve than you might think. The latest thinking suggests that there are five things that you should take into account when deciding how much cash you need before investing:
- your monthly expenses
- the kinds of crises you want to prepare for
- your job skills and your industry
- whether you have equity in your home to be tapped
- the opportunity cost of delaying investments
Two important points before you start jotting numbers.
First, make sure you’ve paid down your high-interest debt. This means high-interest rate credit cards, but potentially also student and car loans. If the loan can be written off against taxes, there may be some gray area, but the guiding principle is straightforward: If the interest rate on a loan is higher than the expected return on an investment, it’s wise to pay off the loan before making the investment.
Second, make sure you have health and disability insurance. Neither a big portfolio nor a big cash reserve will be as valuable as insurance if you have a serious health problem – and those can strike at any age.
Still, even with insurance and no debt, you want to have available cash not hard-to-access investments, to handle job losses, hospital copays, and damages to house or property. Moreover, you don’t want to resort to borrowing money on credit cards, at interest rates higher than the interest you’re earning on your investments.
But just how much do you need in that fund?
Since the Department of Labor began keeping track in 1948, the average duration of unemployment has oscillated between 10 and 20 weeks, or about 2.5 to 5 months. The average during this recession has risen to 40 weeks, or 10 months.
On one hand that’s a scary number. But those statistics also suggest that the appropriate size for an emergency fund will vary from person to person. Being unemployed as a software engineer in Silicon Valley has a whole different meaning that being unemployed as an auto worker in Detroit, as Jon Bischke wrote last summer. According to the Jobs Council, over the last three decades, high-growth enterprises less than five years old have created 40 million net new jobs, accounting for nearly all the net new job creation in America. If you have the skills for this startup economy, you are better off than most.
“For those in careers with a large, ongoing demand or who have relatively strong job security, three months’ worth of expenses is probably enough of a cushion. Those with bigger career demands, such as higher-paid managers and executives or couples who work in the same industry or at the same company, might want nine months to a year’s worth of expenses in the bank,” says The Wall Street Journal’s Complete Personal Finance Guidebook (hat tip to J.D. Roth at Get Rich Slowly).
David Weliver of Money Under 30 created a spreadsheet to help determine the size of an appropriate emergency fund. The basic idea behind his formula: minimum monthly expenses multiplied by the amount of months it may take to find a new job, minus existing liquid savings (and with an additional consideration if you’re income is irregular, i.e. commission or freelance based).
The zero-dollar emergency fund
Some writers suggest taking one more factor into account: whether you have equity in your home. Author Liz Pulliam Weston, among others, has suggested that credit cards and home equity lines of credit can be used to pay for life’s emergencies. Her argument: An emergency fund of even three months’ worth of expenses can take years to accumulate, and can come with large opportunity costs.
Of particular note is Ms. Weston’s assertion that would-be investors should not pass up the chance to contribute to 401(k) funds in order to build an emergency fund if it causes the investor to give up “free money” in the form of employer-matching contributions.
Ms. Weston’s suggestion that investors can rely on HELOCs in cases of emergencies may hold up less well since banks started closing the credit lines without warning in 2008. But relying on credit or home equity as on part of an emergency plan seems to some like a reasonable contingency plan. In The Wealthy Barber, author David Chilton writes (again, hat tip GRS):
“I’m not against emergency funds, but I do feel that $2,000 to $3,000 is much more realistic than $10,000. If you’re afraid that an expensive emergency looms in your future, establish a $10,000 credit line at your bank.”
Especially in an interest rate environment in which you can get a HELOC with an interest rate of less than 5%, it seems like a smart idea.
What’s the right answer?
Lately I’ve been thinking about whether the time is right for me to begin investing. As a grad student, it’s not that I have more cash on hand than I know what to do with. Rather, I’m aware of the power of compound interest, and time isn’t standing still: I know that investing early can have an enormous effect on the growth of your capital.
There’s an immediate appeal to Ms. Weston’s zero-dollar emergency fund—why pay the opportunity cost of parking rainy-day dollars in a low interest rate account when emergencies are rare and carry unpredictable costs? After all, there’s no reason to think even 6 or 12 months of expenses will cover every contingency.
Then I thought about the unexpected expenses I’ve had over the years, from root canals to car trouble to pay cuts I’ve endured. It seems prudent to sock away some money to bear the initial brunt of surprising events. It also seems reasonable that the size of my emergency fund should be based on my own circumstances, and not be based on a catchall answer right for everyone. For me, the amount of the emergency fund I build will be based on a combination of how I feel about my job security and what I think is possible to save.