Call it what you want - emergency fund, safety net, cash cushion, bailout plan, family reserve, contingency fund, exigency fund, and so on. Just ensure that it is a critical aspect of your financial plan.
But do young investors really need one? Before I answer that question, here is some background.
All emergencies are not medical.
Don’t go with the assumption that emergencies are just medical. All emergencies are NOT medical. An Emergency is anything disruptive and out of the ordinary.
Your pet may need surgery. Terrible flooding or a cyclone may damage your house. Your air conditioner or refrigerator may break down during peak summer and you need a new one. Maybe the plumbing needs to be fixed in your house. There could be a death for which you have to suddenly travel. A pet falling sick and needing surgery will require substantial funds. Or, it could be job loss.
Crises have financial repercussions.
Disruptive events can cause a tremendous amount of stress. It is natural to get anxious and tense. The idea of an Emergency Fund is so that you will not have to deal with monetary stress, in addition to the emotional upheaval. Think of it as a financial shock absorber. Tragedy, to whatever degree, has a financial angle. To the extent that you can provide a buffer, you must.
There is a cost to sourcing funds in an emergency.
One reason that individuals do not give this much thought is because they can source funds from various avenues. But there is always a cost to it.
A personal loan from the bank or the use of your credit card is convenient, but carries a stiff interest rate. Taking a loan against your house is not cheap. Alternatively, borrowing from family or friends comes at zero interest, but has its own share of humiliation and obligation. Eventually, all these loans will have to be squared off. Getting into debt because of an emergency is very stressful. Tapping your own assets is invariably a better way to scrape up cash than borrowing.
You can dip into your provident fund or sell investments. But what if the stock market is abysmally low? You could be selling at a significant loss. Moreover, you would be drawing these funds from your retirement savings plan or child’s education plan. What will happen to those financial goals if you are going to deplete the money earmarked for them? The trick is to tide over the emergency without incurring debt, while simultaneously keeping your financial house stable.
Do young people need an Emergency Fund?
Mark LaMonica, head of individual research at Morningstar Australia, answers.
An Emergency Fund is a key component for investing success. It protects your long-term investments in growth assets like shares from unexpected expenses.
It is important to keep in mind that there is an opportunity cost from holding cash. Historically the return on cash has barely exceeded inflation. Over the long term the secret to building wealth is to earn a return that meaningfully exceeds inflation. Cash is not the answer.
The longer growth assets are held the greater the impact of compounding.
That means more total wealth. The opportunity costs from holding cash are highest when potential investment horizons are long.
Cash provides psychological safety which is something we all seek. Many people intuitively attain this security before investing as portfolio values can fluctuate significantly. Younger investors are faced with the greatest impact from high cash levels.
When I was younger, I tried to keep my Emergency Fund at a bare minimum and concentrated on saving and investing as much as possible. Looking at return projections helped to keep me focused. Over time I’ve grown my Emergency Fund as the opportunity cost of cash dropped.
An Emergency Fund is not a one-off endeavour. It can be built up overtime.
There is an argument that while you are younger there is less of need for a large Emergency Fund. As people age it takes longer to find a job. Highly skilled workers suffer from age discrimination and are often perceived as being overqualified for many jobs.
The likelihood and costs of unexpected expenses tend to grow as people age and more possessions are acquired. A car and house are two examples of possessions that can lead to high unexpected expenses which are disproportionately owned by older adults. Medical expenses tend to be lower when you are younger. And being childless can reduce the chances of unplanned cash outlays.
This is not an argument for not having an Emergency Fund. It is simply a statement of fact that a universal rule of thumb for the size of an Emergency Fund should be adjusted by circumstances.
More Back To Basics articles