If you are an investor, you need an emergency fund or a rainy day fund. Most adults probably need an emergency fund. There are just too many unexpected events that occur in life. An emergency fund can help you deal with these events, whether higher expenses or lower income.
As an investor, you need to take care of the basics. My emphasis has been on dividend growth stocks. However, I was not always a dividend growth investor. Before I had enough money to buy my first stock, I had to take care of the basics. One can probably recall from college Maslow’s hierarchy of needs. At the very bottom, two levels of the pyramid, one needs to satisfy two basic needs that are physiological needs and safety needs. These include food, water, warmth and rest, and security and safety. I put an emergency fund in these two categories. It is a basic need.
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Why You Need An Emergency Savings Fund?
Hence, first and foremost, I needed to take care of my investing basics, which in my opinion, was creating an emergency fund. This fact may not seem relevant, but it allows one to handle financial surprises that are a regular part of life. This fact is essential. Unexpected financial shocks can be expensive, stressful, and limit your ability to build wealth. So, what are these random events? They can broadly be categorized into unexpected expenses or unexpected loss of income.
Unexpected expenses can include medical or dental emergencies, unplanned home repairs, unplanned car troubles, recession, and others. The more problematic of the two categories is an unexpected loss of income due to a job loss. One only needs to look at the news to realize that unanticipated financial surprises are beyond one’s control. Ultimately, an emergency fund can help deal with these surprises and help cushion the blow.
Americans Don’t Save Enough
As a rule, Americans generally do not have enough money set aside to deal with unexpected events. According to FINRA, roughly 19% of people in the U.S. spent more than their income in 2018. This fact has led to a situation where many people do not have enough money to cover emergencies.
For instance, 23% of all Americans have overdue medical bills. Medical bills are usually expensed beyond monthly expenses and make it harder to make ends meet each month. But having an emergency fund in place could help one deal with medical or dental emergencies. The other options are undesirable, in my opinion. For example, one could take a loan or hardship withdrawal from a retirement account, limiting your ability to build wealth. Retirement funds should be allowed to compound over long periods to build wealth. Alternatively, you could borrow money, but this adds to debt that must be paid back.
Not having an emergency fund is a relatively large problem for most people in the U.S. In 2018, 49% of Americans had a rainy day fund, but 46% did not have one. These numbers have improved over the past decade. In 2009 only 35% of Americans had a rainy day fund. So, the data in 2018 shows a significant improvement over the past decade. I attribute this improvement to painful lessons learned during the Great Recession combined with the recently robust economy.
Low-Risk and Liquid Is Key
Saving for a decent size emergency fund can be challenging, but it is not impossible. One needs to plan for it and put aside money each month in a separate account to build the fund over time. A different bank savings or money market account keeps temptation low for using the fund on a non-emergency. Note that a money market can lose value since they are not federally insured. The best place, according to FINRA, is a low-risk and liquid account that is easily accessible. An emergency fund can help handle those unexpected financial surprises.
How Much Do You Need In An Emergency Fund?
How much is enough for an emergency fund? I think that three months’ worth of expenses is a minimum and six months is better. But for some, that may not be enough; if you work in an industry where layoffs or work stoppages are familiar, then one needs to factor that into your calculations. If your income is non-steady, such as for actors, artists, or real estate agents, then one may need to consider an even more robust emergency fund of 12 months. Retirees who rely upon stocks and mutual funds as part of their income may also need a larger emergency fund. One never knows when dividends will be cut or suspended due to poor market performance or a ‘Black Swan’ type event, e.g., coronavirus pandemic. Families that have a single income may also need a larger emergency fund. In any case, having some emergency fund is better than nothing at all.
How Do You Save for An Emergency Fund?
How do you determine the amount you need for the emergency fund? One possible method is to total up your essential monthly expenses such as mortgage or rent, food, health insurance, car expenses, personal expenses, student loan payment, etc., and multiply by three, six, or 12. Next, you can take out non-essential expenses that one can do without for the duration of the emergency, like eating out, vacations, movies, etc. These seem like necessities to some, but they are primarily consumer discretionary. Finally, one needs to set a realistic goal. Having a plan can help you stay motivated in creating and building your emergency fund.
Even a tiny amount of savings per week or month can add up quickly. For instance, if you save $50 per paycheck, you are saving about $1,300 per year, assuming a bi-weekly paycheck and 26 paychecks per year ($50 x 26 = $1,300). This amount does not seem like much, but if you double it to $100 per paycheck, the savings are $2,600 per year. So, arguably in one year, you could have about 1 – 2 months of expenses in an emergency fund depends on your actual costs. Of course, if you can save even more per paycheck, the dollar value goes up even more quickly.
Another strategy is to direct a raise toward the emergency fund. If you are earning $50,000 per year. A 3% raise will give you an additional $1,500 before deductions and taxes. Assuming that taxes and deductions equal 33%, you still have $1,000 leftover to save for an emergency fund.
A third possible strategy is to use tax refunds to jump-start or rapidly build an emergency fund. In 2019, reportedly, 72% of all Americans received a tax refund from the federal government. The average refund was $2,860 in 2019. So, this would go a long way to building an emergency fund. Hypothetically, if one receives the average refund combined with saving $50 per paycheck, the emergency fund is a reasonably decent size at $4,160. Save for two years, and then the emergency fund is double that, which is pretty good.
There are other ideas on how to earn money for an emergency fund.
You get the idea. One pretty much needs a system that you can stick to religiously for an extended duration. Then, once the emergency fund is sufficiently large enough for your situation, the monthly savings can be used for other purposes such as investing to build wealth.
Recent history has reinforced the need for an emergency fund. Events like COVID-19 are unexpected and can cause financial hardship for people who are unprepared. The three steps for saving would be to (1) set a goal, (2) create a system, and then (3) save. It would be best if you took financial responsibility for yourself. Planning for a rainy day and unexpected events is a giant step in that direction.
Thanks for reading Reasons You Need an Emergency Fund.
You can also read about What You Need To Know About a Sinking Fund.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.