Yeah, wouldn’t it be great if there’s an equation out there that tells us how much emergency funds we should keep?
Like f(x) = x^2 +3x – 2
So let’s say I am a Type 2 person and x = 2, so I should be keeping 8 months of my normal expenses as emergency funds, just like what Suze Orman recommended? Sounds silly right, but at the very least, it’s not a one-size-fits-all approach like what she preaches, isn’t it?
But first of all, I am going to argue that an emergency fund isn’t necessary for everyone. Afterall, there’s gotta be a x type which gives us a value of 0 from the equation, right? Before you start throwing insults at me, (like what happened the last time round), let me explain further and hopefully, clearer.
Accumulating an emergency fund might actually be harmful if you have access to credit and is already utilising some of it with your credit cards. Let’s say the bank has granted you a credit of $20,000 and you owe the bank $5,000. You then pick up a mainstream personal finance book which tells you that having an emergency fund is absolutely essential! Should you then start building one?
Absolutely not! The main priority is clear the high interest debt, which is an emergency happening by itself. After all, what’s the worst that could happen? If another emergency happens (probablility isn’t that high, right?) during the period when you are clearing the debt, simply go further into the same debt at the same interest rate. You are no worse off. However, if life carries on as normal (more likely), you would have saved yourself a mountain of interest payments!
With credit card companies paying us up to $80 just to sign up, you will be surprised just how many out there are subsidising the rest and really shouldn’t start accumulating an emergency fund until high interest debt is fully paid off. And that’s not even including those who can live off the land like Thoreau (Walden) or billionaires with too much assets and money to worry about financial emergencies (just sell off a property right?)
Even then, those situations still represent a small proportion of the population, right? For most of us ordinary folks, it would be prudent to keep an emergency fund. But how much is exactly optimal? That depends on a few factors:
Factor 1: Age
I still believe that for most, the main utility of an emergency fund is to protect against the risk of unemployment as compared to “unknown unknowns”. And since the trend is that one is most vulnerable to retrenchment in the late 40s and early 50s, the amount to set aside should be proportional to the number of white hair (or worse, the inverse of the amount of hair).
Factor 2: Risk Aversion
Ties in with expectations too. It’s like sitting for a test. For some, covering 90% of the base is already a wonderful achievement. But for others, 99% is simply not good enough. It needs to be at least 99.9% if 100% isn’t possible. Enough said.
Factor 3: Experience
For some, they have been battle-hardened and may even have scars to show after the 99% they had prepared for was not enough. It could be the Asian Financial Crisis, SARS or the recent Great Recession that meant only a minimum of 99.99% was enough for future templates. Admittedly, most of my generation hasn’t been through these shit so we probably won’t appreciate an emergency fund of the magnitude of 12 months of incomes or more. (Especially so if you’re intent on early semi-retirement like I do.)
Factor 4: Situation & Family Background
If you’re welcoming new dependents into your family, having more cash set aside seems like a good move. Especially so if the spouse is going to become a stay-at-home mum and the diversity-of-income trump card can no longer be depended upon.
Even though the government doesn’t provide much of a social safety net, being born with a silver spoon means that there is always something you could fall back on even if the start-up (when even the last cent is poured in) fails?
Factor 5: How little you can thrive with
This has more to do with the quantum that one sets aside. For some, even a number not reaching 5 figures would suffice. These people understand that it doesn’t cost much to live a good life (provided one is in good health) and can easily thrive on <$1,000/month per pax. A small roof over your head and simple but nutritious meals generally do not cost a bomb.
And the list goes on. These are just a few factors I feel one should consider when deciding the optimal amount to set aside as emergency funds. Whether the amount is just $2k or a massive $200k, it should be an enlightened choice that takes into consideration your unique personality, outlook, mentality, circumsatances and capabilities. And hopefully, life would be good enough to you so that you will never have to use all of it at one go.
P.S. If you’re new to this blog (i.e a couple of weeks old), let me reassure you that this isn’t a blog that only talks about emergency funds. This will be the last post on this subject for a long long time and I admit thinking about it further will be akin to flogging a dead horse. Had a wonderful time “sparring” with many in the comments section though. =p