Monday, August 21, 2006

Emergency Funds Are Wasteful

A lot of financial plans include building up an emergency fund. My view is that, save in respect of one specific circumstance, an emergency fund is wasteful and money put aside in an emergency fund is better deployed elsewhere.

The logic behind emergency funds is that unexpected expenses could be incurred which you are unable to meet from current income or that your income stream could be disrupted so that you cannot be assured of meeting your expenses. The standard advice is to build up an emergency fund sufficient to meet living expenses for a short period (three months is common). The advice usually goes one step further and says that the emergency fund should be in the form of cash or on call bank deposits.

My view is that this is both too simplistic and wasteful.

A financial plan should address the question of how unexpected expenses or loss of income will be covered. But saying that the issue can be addressed by putting aside the equivalent of a fixed number of months salary is too simplistic. For people with a low savings rate it may be too little and for those with a high savings rate it may be too much. Consideration also needs to be given to the possible length of the disruption to income and the size of the unexpected expenses.

In my own case, I concluded that we did not not need any emergency fund at all. Relevant factors in this decision were: a two income household, a good savings rate (with room for improvement), several items of discretionary expenditure which could be cut, three months notice being required under my employment contract and the fact that at least some of our investments are in liquid form.

The second issue is the form of the emergency fund. Cash or call deposits are often recommended. While I appreciate the need to have an emergency fund kept in a form in which it can be readily accessed, cash and call deposits are lousy investments (most of the time). The after tax rate of return is usually less than the rate of inflation and, over the longer term, less than most other asset classes. Bonds, money market accounts, short term CDs and short term deposits all provide better rates of return than call deposits with relatively little additional risk. Many listed shares and many mutual funds are also highly liquid - price may be an issue but the liquidity is there.

Given that, by definition, an emergency fund is for the unexpected, I take the view that the additional return which can be achieved by investing the emergency fund in better performing asset classes more than justifies the additional risk involved. The only situation where I might take a different view is where my monthly income is expected to be both highly variable and uncertain.


makingourway said...

it's a very interesting question.
I often wonder if I'm putting to much into emergency cash - I keep it in high yield money markets at countrywide earning 5.25%. I keep about 10 months of cash in the money market accounts.
Would it be better off in equities etc?
I might get some interesting advice from an investment advisor I'm thinking of hiring, but then again, it's more of a financial planning idea.
My networth update shows my cash and asset allocations (for August).
Let me know your thoughts.

traineeinvestor said...

Having thought about it a bit more, I suppose it really depends on your confidence in your ability to deal with unexpected expenses or unexpected loss of income. In our case we have two incomes from our jobs. One job is very secure. The other is relatively insecure but has a lengthy notice period (at least three months).

I would certainly put paying down non-deductable debt ahead of most other investment decisions if I lived in a high tax jurisdiction.

After that, it really depends on your investment outlook and tax situation.


Sofia Britts said...

I think it depends on the person. If you're the type who's not so much of a detailed planner when it comes to expenses, an emergency fund would be really useful. But if you're very much aware of what you're going to need for the next few months or so, then it's better to invest the extra money on something that appreciates in value.

traineeinvestor said...

So maybe I should confess to spending too much time on financial planning? :-)

You're right though. As wasteful as emergency funds are, if you don't have a good understanding of your cash flows, then having an emergency fund may be a better alternative than running out of cash and paying fees, interest etc to banks and credit card lenders.