Over the next few weeks, whilst the blog is on a break, I am posting some older articles that new readers may not have gotten a chance to read. This one originally posted in December 2020.
An emergency is not for chasing returns
A month or so ago I wrote about a common need of many people to try and optimize their emergency fund at the expense of low risk and accessibility. There is a desire to optimize every dollar. But if that comes at the expense of putting it in an account that is too risky or one that is difficult to access, then in my opinion, that is not a good emergency fund.
Imagine being in a financial pickle and not being able to use your emergency fund because it has either lost too much money or takes too long to get your hands on.
My basic conclusion was that an emergency fund is not a place for seeking high returns. Priority is somewhere as safe as possible that is unlikely to lose money, and somewhere where the money can be withdrawn immediately.
Ironically, by having a substantial emergency fund, you can achieve better returns overall.
A conservative emergency fund can lead to more risk elsewhere
Let’s say someone decides to forgo an emergency fund and decides to invest this money in shares instead. Their feeling is that if they need the money, they will just sell the shares, taking the risk that they could lose a lot of money. Our hypothetical Harry is a real risk taker. He wants every dollar working for him.
Often (not always) when the market is performing poorly, so too is the economy. As it turns out Harry has just lost his job and the share market has tanked. He needs to withdraw some money and lock in some big losses to fund the next few months of expenses until he finds a new job.
Now imagine Sally had a sizeable emergency fund in an online savings account. Not setting the world on fire with returns, but that doesn’t matter. It’s in as safe a place as any and she can access it quickly.
Because Sally has 6 months of leeway, she can make some more confident decisions. Unlike Harry who is beholden to his employer, Sally is not so reliant on her job for survival. She realizes her job position is going to take a big hit in the recession, so she repositions herself into another job that has more security, but less pay. Without the back up savings it is hard to make such bold moves.
Or maybe there is no recession. It could be performance meeting time. Sally should have much more confidence in demanding a pay rise and/or bonus than Harry. She has more leverage to walk away if not given what she wants. If Sally loses her job, she will be upset but it won’t be the end of the world. Harry doesn’t have the same safety net to be so bold with his career.
Having a sizeable emergency fund may also help lower insurance costs. It may mean she can have higher excesses on car, contents and house insurance. Or maybe she could even go without contents insurance. Perhaps have a longer stand down period on income protection insurance.
Finally, because Sally has her short term needs covered, she can be more aggressive with the rest of her investment portfolio. She won’t need as many bonds as Harry. Or maybe Harry only invests $800 of his spare $1,000 each month in case he needs $200 for something unforeseen. Because Sally has a fully funded emergency fund she can invest all her spare $1,000 without worry.
Having an emergency fund that you can rely on, should ironically see you achieve better returns overall than if you try and get too cute with your emergency fund. It will give you the confidence and safety net to be more aggressive with your career, investments, and negotiations which should see a far greater return on investment.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here