“Save it for a rainy day.” In addition to a popular Kenny Chesney song, this idiom has become well known and often used to refer to something that should be set aside for when a need for it arises. Although the country music star, Kenny Chesney, refers to setting aside heartache for a rainy day, the saying more commonly refers to the notion of money - the idea being to sock away funds to tide you over when times are tough (or gloomy like a rainy day). (1)
Instead of putting off saving for your financial future, it is important to go through the necessary steps now to ensure you have the groundwork laid down for a successful road ahead. One of those elements is a cash reserve, better known as an emergency fund. Emergencies are unplanned and are unfortunately an inevitable part of life. Instead of falling financially victim to the burden that can accompany these emergencies, you can be proactive and plan ahead by setting aside money for when these unexpected events occur. As a result, in addition to remaining in financial control, it also allows you to focus on the event at hand, and not be pulled down by financial complications at the same time.
So how do you build an optimal emergency fund, without sacrificing your other financial goals and lifestyle? Before diving into your personal emergency fund formula, it’s important to differentiate between an emergency fund and a savings account. An emergency fund is used for unplanned events – such as the loss of a job, medical emergencies, home repair costs, emergency travel, car accident repairs, etc. On the other hand, a savings fund is for planned spending – for items such as vacations, education costs, large purchases, gift giving, etc. The difference is between proactive spending vs reactive expenses.
An emergency fund should not be used as an incentive to make a big impulse buy. Instead, it should be treated much like an insurance policy – money set aside in which you are protecting yourself in case something goes wrong. (2) You want enough coverage to account for your unique individual lifestyle, but not too much that you’re overpaying (or in this case, setting aside too much money that could be used for investments or other savings for your future). After all, an emergency fund is just one part of your entire financial picture; therefore, it’s important to take it into account relative to funding other financial goals.
So how much do you need to plan for the unexpected? Although many believe 6 months of living expenses set aside is the magic number, others believe 3 months is more realistic. The key is to do a realistic assessment of your own life to make this determination. Consider the aspects in your life such as job security, ease of making supplemental income, anticipated medical expenses, flexibility of your spending, etc. Scan your current budget and understand what you could cut (if needed) to live on a minimal budget – expenses such as TV, entertainment costs and groceries may be cut back, while cell phone bills, internet costs, rent or mortgage payments may be less flexible. As you wrap your head around your current budget and how that may adjust, you can get a better understanding of how much your true living expenses are (in a worst case scenario).
Next you begin building your emergency fund. The key here is to simply get started – nobody is going to save up 6 months of living expenses overnight, but start with a realistic goal. For most, that first step is getting to $1000 in your emergency fund. From there, a good guideline is setting a goal of somewhere between 3-6 months of your “minimal” living expense budget - depending on where you land on the risk spectrum and your adjusted budget. Gradually build this up to get to your sweet spot by setting a plan. Whether it’s simply putting $100 aside a month, or more or less, get in a routine and establish the right habits early on, before it’s too late.
As you implement your plan, make sure your emergency fund is housed in an accessible place, but also in a secure place. Ideally you’d open a separate saving account at ISU Credit Union that can earn a fixed interest rate (typically these are around 1% annually). Although this is less than inflation, having access to a liquid account for these funds is important so you can access it whenever that need may arise.
How does this cash reserve impact your overall financial health? Cash isn’t a bad word in finance and shouldn’t be ignored. In fact, it does play a major role in your financial portfolio. In addition to serving as an emergency fund, it can also provide other benefits to note. For one, it allows you to take advantage of changing market conditions or to act fast on an opportunity, by having quick and easy access to your money. Furthermore, having a cash reserve can provide an underlying benefit on the emotional or psychological aspect of investing. Knowing you have this cash to fall back on can help you remain confident and feel in control during volatile or unsteady markets or investment strategies. It can serve as an anchor to fall back on. In fact, one study found a common theme of $3M+ investment portfolios – the majority of them have more than 10% of their portfolio in cash. Here is how it breaks down: (3)
- 8% held 50%+ of portfolio in cash
- 14% held 25-50% of portfolio in cash
- 40% held 10-24% of portfolio in cash
- 38% held less than 10% of their portfolio in cash
As an added bonus, in 2019 FICO is introducing a new UltraFICO score that benefits those with cash saved. This will act as a supplemental score to your credit score, and will provide insight into checking, savings and money market accounts. It will only impact those with bad or fair credit (scores in the upper 500-lower 600 range) and is just another reason to ensure your cash supply is built up and managed properly. (4)
Warren Buffet wraps up the notion of cash well: “it is like oxygen; everyone needs it and takes it for granted when it’s abundant but in an emergency, it’s the only thing that matters.” Remain in control of emergencies by ensuring you’re set up for the unexpected.