We routinely give the advice that people should keep six to nine months’ worth of living expenses in cash or cash equivalents. This is usually money saved in checking, savings, money market or a short-term CD.
Conceptually, most people understand this and think it is a logical goal. Unfortunately, most don’t follow through. Recent reports by The Motley Fool have stated that 40% of U.S. adults don’t have enough savings to cover a $400 emergency and the median savings account balance across American households is $4,830. This might cover a few months expenses, but not much more.
The government shutdown highlights the importance of having this cash cushion. Most people working for the federal government never gave a thought as to whether their paycheck would arrive on time. However, with the longest government shutdown in history, real people are now faced with the dilemma of not having their paycheck and the necessary purchasing power that comes with it.
Obviously, this predicament is not limited to just government workers. A friend experienced the damaged inflicted by a busted water pipe in their house. Even with homeowner’s insurance, there was still the deductible to deal with. Adding insult to injury, the cost of repair ended up being higher than insurance company coverage. All of this had to come from somewhere.
Shortly after repairing the water damage, Hurricane Harvey tore the roof off the same house dumping buckets of water on the recently repaired flooring and sheetrock.
So many people in our area can relate to similar stories. Maybe the transmission falls out of your car, the air-conditioner dies in the middle of the summer or someone is hospitalized. The trauma of dealing with these issues is painful enough without the financial implications. However, stress levels skyrocket when you factor in the money burdens.
Without a sufficient emergency fund backstop, the options are bad and worse than bad. You can drain your retirement savings, run up your credit cards or go to a payday loan type company.
Once you go down this slippery slope, the interest charges start accruing at such a rapid pace it is seemingly impossible to escape. There is virtually no way you can borrow money at 26% interest and make it come out in your favor.
Furthermore, everyone you borrowed money from has little sympathy to your financial problems. They all want repayment. Absent the necessary cash cushion, all is takes is one or two dominoes to fall before the situation is out of control.
The advice of keeping six to nine months of expenses is not designed to maximize investment returns, but rather to emphasize the return of your principal. The money needs to be there when you really need it. As such, it allows you to deal with things that are completely unexpected.
If you shop around, you can find money market funds paying nearly 2%. At least you get a little return and maybe break-even after inflation.
That leaves investors with a dilemma—how best to balance short-term liquidity with long-term growth needs.
Emergency money is about flexibility and playing good defense. This allows you to absorb things that are unexpected—without knocking you out of the game.
Often, we see people with great long-term investments or other plans. Unfortunately, long-term investments take a long time (as in 10+ years) to mature and be realized. If you don’t have the necessary emergency cash and short-term flexibility to deal with unexpected expenses, you can be forced to liquidate long-term investments well before they produce the desired results.
Understanding this, use the government shut-down as motivation to get your plan in order. Know that when people lend you money, they control your finances. Figure out how to “right-size” your life such that you can save a significant cash buffer. Once you have laid a financially strong foundation, then you can worry about longer-term investing that entails more risk and volatility.