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We talk a lot about investing and growing your wealth, but we don't spend enough time on how to protect it. These conversations may not be the most fun, but they are crucial for looking at the big picture and can play a significant role in sustaining growth.
Setting up a fund designated for emergencies is a clever safety play, but it is also helpful in sustaining growth.
Let's dive in!
An emergency fund, typically dubbed an "e-fund," is an account designated for unexpected events. The intent is not to grow wealth but to preserve your own. You can think of this as your own self-funded insurance policy. Its function is to ensure that unexpected events do not alter long-term goals or damage your financial structure.
It's not just some cash sitting on the side. Its function is to prevent more mishaps than create them. When unexpected events come up, you need cash to pay them off. This requires a payment on the back end. Specifically, it does three things well:
Protects Long Term Investments
The legend Charlie Munger once stated this:
“The first rule of compounding: Never interrupt it unnecessarily.”
In other words, leave your investments alone so they can continue growing. An e-fund allows those investments to continue by keeping them separated. The counterargument is usually, "Well, isn't the e-fund not compounding?" Remember, this is not meant for growth; it's designed for preservation so that your long-term funds, designed for growth, can continue to do so.
It prevents you from tapping into your investments when extra funds are needed. Plus, it's better not to keep an e-fund invested so it can stay separated from market fluctuations. Think of losing a job, for instance. It may be the result of a bad economy. So not only would you lose your job, but an invested e-fund might lose its value, too!
Reminder: The intent is not to know when you need your e-fund. We set it up, hoping we would never use it, but it has to be ready in case you need it now. With a time horizon of "now", it should be allocated to short-term assets for that reason.
Avoids Additional Taxes and Penalties
If you access your investments, you may have to sell them at a gain, creating a new tax liability for yourself. This is not an ideal situation if the job loss occurs at the end of the year and you get hit with a new tax bill a few months later.
If money is taken out of retirement accounts, not only could this be taxed but potentially penalized, too. It's the unexpected costs that make retirement accounts not great vehicles for short-term needs.
Prevents A Debt Trap
Let's be honest. You'll probably use a credit card if you have a large bill to pay. But if you don't plan to pay it off, you've just made your credit card the e-fund. It's not ideal if your balance accrues 20%+ in APR!
The intent of having the funds is to immediately pay the balance off so this doesn't go from a bad accident to a financial trap. The last thing you need is to have more problems compound onto others. For that reason, it serves as protection so you can continue your lifestyle with ease.
Creating an e-fund is a relatively straightforward process since it just comes down to organizing an amount of reserves. There are two components to this question:
How Much Should Be in an E-Fund?
This one is up for debate. The traditional method says 3-6 months. The amount is used as a rule of thumb where two household incomes need 3 months while a single income would require 6 months (more risk with fewer income sources).
I believe there are six variables behind this decision:
These are the top variables I see that determine this decision when putting together an appropriate size for an e-fund. Depending on how these are answered, there are cases to have a fund as low as 3 months or as large as 12 months. The more risk associated with them, the larger the e-fund needs. Using 3-6 months is a solid benchmark, but choose the size that aligns with you.
What Should Be in An E-Fund?
As I mentioned before, this should focus on safety above anything else. One common way is to set up a high-yield savings account. As cash, this is not subject to market fluctuations. Savings accounts are also typically FDIC insured, which insures up to $250,000 should the bank fail.
Another idea for more savvy investors is to set up a money market fund in a brokerage account. As a brokerage account, you can access it anytime. A money market fund is a type of mutual fund that invests in low-risk, short-term debt securities such as treasury bills, commercial paper, and certificates of deposit (CDs). While it is a security, its stability and accessibility make it a suitable candidate.
Similar to a high-yield savings account, this also has insurance, but through SIPC. This states that $500,000 is insured should the brokerage fail, with $250,000 of that covering cash claims. Keep in mind that as a security, they can lose value, and it may take several days to receive the funds from selling and transferring the funds, which is why the high-yield savings account is preferential for accessibility.
Of all the reasons that come into play, the top reason is a psychological one: peace of mind. I mention this one specifically because it's overlooked far too often. The reason? It's something you cannot calculate on paper. When we approach from a psychological perspective, we ask similar questions like:
Having your account for that purpose is nothing short of a relief. As an advisor, most of my clients had to dip into their e-fund for a short-term purpose. No matter how well we are prepared for life, things fall out of place.
Each time, they did not care about how much their fund lost to inflation. They just cared about being prepared so they didn't lose sight of their long-term goals. When we are uncertain, we make irrational mistakes. But when we are prepared for them, we are ready to tackle them.
An e-fund gives you enough confidence to enjoy your journey with less financial stress.
You know how to make money, but you're not sure if you're making the right moves financially. That's why I started Pashman Financial.
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