You may find this hard to believe but the amount you keep in your emergency fund may do you a lot more harm than good. At the very least, how you approach emergency funds speaks volumes about your financial process and is a good predictor of what may lie ahead on your financial path.
The Problem With Having Too Much
It’s important to have sufficient liquidity. Even if you have a little too much laying around in your emergency account, it’s not the end of the world. But if you stuff too much cash in there, you could be looking for trouble. I say that for a couple of reasons.
First, emergency funds by definition have to be liquid and secure. And the only accounts that fit that criteria pay just about no interest whatsoever. It follows then that the more you sock away, the slower your overall financial picture improves. Let’s use an extreme example to illustrate this point.
Say you scrounge around, work hard and build up your emergency account because you hate surprises. Assume you put $100,000 more into your emergency account than you really need. Don’t scoff – plenty of people keep even more than that liquid. Further, assume you could invest that money in the market and earn, on average 6%. (Obviously, that doesn’t imply a guarantee and when you invest in the market, you take on greater risks).
Had you invested that money rather than allow it sit in the bank like a bump on a log, you would have $220,000 more when it comes time to retire. Did it feel good to have that extra $100,000 cushion? Probably. Was that feeling worth $220,000? Doubtful.
And it gets worse and more expensive.
People who tend to overly inflate their liquid accounts are often excessively conservative. That conservative nature influences their long-term investment approach as well.
Let’s continue our example with the person who has $100,000 too much in their emergency fund and assume they happen to have $100,000 in their 401k as well. And let’s make believe they add $10,000 to the account each year. Bueno? OK.
If this person invests very conservatively and buys money markets and short-term bonds, they might earn 3% on average. If so, they’ll have about $450,000 at the end of 20 years. On the other hand, if they invest in a balanced fund and are able to earn 6% on average they’ll have $690,000 over the same time period – a cool $240,000 more.
And if you take this $240,000 plus the extra $220,000 they could have by not overdoing it on the emergency account, they could have a sweet $460,000 more when they retire. At 4%, that $460,000 would generate an additional $17,000 in retirement income for as long as they live. That’s a spicy meatball Pilgrim. Why miss that opportunity? You shouldn’t.
The Danger of Having Too Little Set Aside
Other problems await those who don’t leave enough on the side “just in case”. Obviously, if you don’t have the Benjamins when you get hit with a nasty surprise, it’s going to hurt. Who are you going to call when you need a new roof and don’t have the scratch? Hint – it ain’t the Ghost Busters.
You’ll either have to invade your long-term investments, tap your retirement accounts, run up your credit card or look for other people to loan you the dough. Each of these alternatives are expensive. Obviously even if you put enough aside, emergencies happen. But my experience tells me that emergencies happen much more often to people who aren’t prepared at all. I hope that isn’t hurtful. It’s just my experience.
And the mindset of not considering the downside spills over to investing too. Often, people who expect only sunshine and strawberries invest too aggressively. Since they think that everything always works out at the end, they ignore the risk/reward tradeoff and often get caught by nasty “surprises” they should have expected all along.
We just saw that having too much or too little tucked away for emergencies can lead to painful consequences. The question then becomes, how much is enough?
The best approach in my experience is to consider the following:
- Do you know that you’re going to spend a large sum over the next 3 to 5 years?
- How stable is your job situation?
- Do you have adequate health insurance? Do you have enough disability coverage?
- What has the largest financial emergency you’ve had to face over the last 5 to 10 years? Did you have enough cash on hand to take care of it?
- How did you pay for that event?
Finding the right balance between long-term growth and short-term emergency accounts is an art, not a science, and it’s dynamic. The numbers change as your circumstances shift. It’s OK to err on the side of being a little too conservative or a little too aggressive.
Of course, life happens and you can’t predict the future. Unforeseeable problems have a way of popping up. But ask yourself the questions above and re-evaluate your situation from time to time. Nobody is asking you to be perfect. But do your best to find the right balance.
Do you have enough cash set aside for emergencies? How do you know?