As a responsible person you’ve no doubt set money aside “just in case”. It’s called “emergency money” and it’s a good solid move.
But did you know that your emergency funds might also pose a real danger to your financial security? You might find that hard to believe but there are 3 or 4 reasons why this is absolutely the case.
Let’s first look at the situation where you keep too much liquid as a cushion. Of course liquidity is good but there is a cost – low returns. Most liquid accounts pay nothing, literally nothing or close to it – to depositors. So one consideration is the forgone return you kiss goodbye if you keep too much on deposit for an emergency that isn’t highly likely to occur.
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Many people keep way too much for far too long in their emergency accounts. Let’s consider what that can cost. Assume you keep $50,000 too much in your backup fund and leave it there for 20 years. If you could invest that money and earn 7% on average by using balanced funds, you could have potentially earned $143,000 on that money. If you keep the money liquid, you’ll earn nothing. So in that case, it cost you $143,000 to keep that extra money liquid for no good reason. Unfortunately, that isn’t the end of the story.
People who are over overly conservative when it comes to their emergency money are often overly conservative when it comes to their retirement and other investments as well. If this same person has $400,000 in a retirement account, adds $10,000 to the account annually and invests unnecessarily conservatively it will be even more expensive.
At 3%, this account will grow to approximately $990,000 in 20 years. Not bad. But if this person invests more aggressively and puts a heavier emphasis on equity she might be able to earn 7% on average. If that is the case the account could grow to $1,950,000 instead. That’s a big tamale amigos.
Of course there are no guarantees that things will work out this way. Equity investments expose investors to more risk – especially over the short-run. But given that retirement accounts are long-term propositions it really makes sense to consider equity for long-term accounts. At the very least, you can see how expensive it is to completely ignore this option.
To be fair, some people make the opposite mistake. They are too aggressive and don’t keep enough money liquid. That can also be costly.
If investors don’t have enough available cash when an unexpected catastrophe hits they may be forced to invade their investments (probably at the worst time possible) or seek other financing options. Either way, it can be very expensive and uncomfortable to run around and try to get your hands on cash at the last minute.
Certainly, some people are forced to deal with extreme situations they had no way to prevent or prepare for. But others consciously decide not to set aside money. These folks are often dangerous optimists and that too can spill over to their investing career.
Sometimes these people invest far too aggressively because they believe nothing can go wrong. It’s the same kind of thinking that leads them to decide they don’t need an emergency fund.
This uber-aggressive investing style can have catastrophic consequences too.
Obviously, the solution is to have the right amount in your emergency fund. But don’t make the mistake of thinking that there is no harm in having too much liquid. As you have seen there is plenty wrong with it. At the same time, don’t use this as an excuse to ignore your need to have some emergency money. That can lead to catastrophic results as well.
Think about your situation. Are there any expensive activities or purchases coming up over the next 5 over the years? If so, set that money aside.
Next, think about the largest amount of money you’ve had to come up with suddenly and unexpectedly over the last 5 or 10 years. It’s no guarantee but it’s a pretty good indicator of the amount you might need going forward.
If you add these two numbers together you’ll have a reasonable idea as to what you need in your emergency fund. Of course the unexpected can always happen. People get ill and people lose their jobs. Make sure you have proper insurance and always be on guard at work. But don’t mindlessly pile too much or too little into your emergency accounts.
Do you have the right amount in your emergency account? How do you know?