This “golden rule” of emergency funds could be costing you a fortune. Is it the right thing to do? Or is it obsolete with today’s zero percent interest rates? Read on to find out how to create a great safety net emergency fund while still maximizing your returns.
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Beware: the traditional advice about emergency funds is a double-edged sword.
Do you have an emergency plan for your finances?
Quick . . . What did you do with your $1,200 windfall from Uncle Sam in the spring of 2020? Those who stashed this mailbox money in the bank as an emergency fund are still sitting on their $1,200. That’s a good thing. At least they didn’t spend it. But those who put it in the stock market instead of an emergency fund bank account are most likely sitting on some big increases.
For years the “golden rule” has been to keep a stash of money in the bank in case of emergency, preferably three to six months or more of living expenses.
Young adults may hear that and cry. For them, this “golden rule” of personal finance is all but impossible. Their expense to income ratio absolutely stinks. Their salaries are low. And thanks to our obscenely expensive college system, they likely have a boatload of debt—student loans, a car payment, rent or a mortgage. Basically, while earning likely the lowest wages of their life, it’s “good luck” pulling together four or six months of living expenses.
Meanwhile, you have older folks with significant nest-eggs and reliable Social Security income sitting on cash. Question: Does it make sense for them to keep a stockpile of cash just to follow this rule? Answer: There’s no one-size-fits-all emergency plan that works for everyone.
So, perhaps it might be time to debunk this across-the-board myth . . .
Emergency Fund: Rules Meant to Be Broken?
Having an emergency fund sounds great on paper. It sounds like a super smart move, but in the real world it can be quite something else. For one thing, savings accounts now pay zero interest, unlike when these emergency fund rules were written. So the $1,200 you dropped in that account in May will never amount to much more than $1,200. Not even in 20 years.
Meanwhile the stock market is booming… at least for the moment. Still, you have to reckon with the fact that life’s emergencies don’t come with a timeline. So, are you damned if you do and damned if you don’t? Not necessarily.
What is necessary is the need for you to understand the heart behind the rule and know how to apply it for yourself.
Knowing why, when, and how to break the rules is critical to doing so in a healthy and smart way.
Textbook wisdom tells you to keep your emergency fund out of the stock market in case the market falls. If you have $20,000 in the market and the market tanks 50% right before your emergency, you’d lose $10,000. True. In theory. At least.
But it’s not as bad as the $143,000 loss you might incur. Let’s fast forward a bit…
Is It Opportunity Cost or Opportunity Lost?
Let’s say fortune really does favor the prepared, as it often does.
That means that today you plunked $20,000 in a savings account and you never need it. Ten years from now you still have that $20,000 in the bank. When you retire, you’ll still have that $20,000.
But…
What if at the age of 25 you put that money in the stock market – one of the greatest wealth machines in history – and never added to it… and you earned the long-term market average of 6%?
By the age of 55 you’d have an astounding $143,000 – quite the emergency fund indeed.
A Contrarian View on Emergency Funds
Here’s another take on the situation. Focus on liquidity instead.
That means having multiple streams of income… Like a side hustle. A second job (or the ability to find one quickly). It means living with financial margins in place, so you can access credit if necessary – and not be maxed out to the last penny with student debt, mortgage debt, or car loans. Shed the debt that robs your margins, stops you from investing, and keeps you awake at night.
Liquidity for you might mean being willing to cut expenses to the bone for a time, when necessary. Take in a renter. Dine in instead of out. If you’re a dual income couple, live off one income and invest the rest. That’s your liquidity. If one of you loses their job, you’ll still be solvent, because you’re already used to living on one income.
It’s not bad to have some cash reserves. We do. But you have to realize you’re sacrificing your upside potential by keeping six or 12 months of living expenses in a low-interest or no-interest bank account.
The (Extreme) Jeff Bezos Example
Let’s take Jeff Bezos as an extreme example. He doesn’t need a savings account with $50K just in case his roof goes bad. He could obviously just sell a few shares of his Amazon stock to pay for it. Who cares if he sells it at a low? He’s got enough liquidity to weather the storm.
Furthermore, his upside potential in the market is far greater than anything he could get sitting on money in the bank. (Want the best when it comes to investing? Check out TD Ameritrade or Schwab.)
People like Bezos are much better off keeping their money in shares of Amazon than keeping it in a cash account. Sure, the shares could be down 30% from their highs when he needs to sell. But they might also be up 200% from their lows.
Don’t be the guy or gal who misses out on the stock market’s big gains because you’re too scared to buy a stock. Keep some cash reserves. Absolutely have a “safety net plan” for bad days or years. They hit all of us. But bear in mind that the stock market is one of the biggest wealth generators in history. And you definitely want to be a part of that.
We want to see you thrive and prosper. And that means it may be time to bust the myth of the six-month emergency fund just to check that box. We’d love to hear your take on this. What are you doing to create a safety net while still gaining the maximum upside?
