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Why a meaningful emergency fund is important?

Saturday, October 19, 2013

This seems like a rhetorical question since the answer seems obvious enough. It is so obvious that I do not recall having a blog post dedicated to the topic.

So, when I came across a blogger who thinks that an emergency fund is not important to him, it got my attention. This is a contrarian and I always like to find out why contrarians think the way they do.


In summary, the reasons why he does not keep an emergency fund are:

1. His family has adequate insurance coverage.
2. His family's expenses are relatively low.
3. His family's investment portfolio is sizable.*

*Current value is about $150,000, generating about $10,000 of passive income annually. This is taken from the regular updates provided in his blog.

Anyway, have a read as I don't want to poison the well:
Why we don't keep an emergency fund?

An esteemed blogger, CW, had this to say:

No emergency fund? Never mind. But still have to maintain adequate level of liquidity to meet unforeseen multiple life events happening.

It is never one hole that sinks a ship. It is several holes happening one after another that sinks that ship.

The blogger, My 15 HWW, replied:

I admit my life experience is lacking compared to many qianbeis like you but I do hope that life would not be so harsh as to sink my small boat. Because it’s small, it could also be nimble and flexible enough to steer clear of impending danger (unlike Titanic)?

If several holes happen, think the emergency fund might not be enough too and one might have to liquidate other assets.

To which, AK says:

I get where you are coming from.

However, I would really encourage some kind of demarcation and even a blurry one is useful. Why?

Let us say that Mr. Market gives us that correction some of us have been waiting for, how much of your cash on hand would you put to work? Doing what you do, if we put in 100%, then, we would have no money left for emergencies.

A small craft might be nimble but try watching “The Perfect Storm” instead of “Titanic” to see the other side of the coin.



"We never want to count on the kindness of strangers in order to meet tomorrow’s obligations." Warren Buffett

A perfect storm could sink us if we did not have a meaningful emergency fund.

Update (29 May 2015):
How much should we have in our emergency fund?


Related post:
Don't think and grow rich.

22 comments:

PSTan said...

While the blogger you mentioned do not keep a specific designated emergency fund, he did set aside a certain percentage of his / her asset in liquid asset:

"we are holding 30% of our assets in liquid instruments like cash deposits and foreign currencies, which already adds up to around $60,000"

AK71 said...

Hi PSTan,

And I ask how much of that is he putting to work when opportunities knock? If he says he does not need an emergency fund which seems to be the drift, then, he could put 100% of his "liquid instruments" to work leaving him with no money for emergencies.

Of course, if he says that he would never invest all of his cash on hand, then, how much is he going to keep holding as cash? There must be some inkling. Naturally, if this should be the case, he is already buying into the idea of an emergency fund.

A rose by any other name would smell as sweet. ;)

EY said...

Hi AK,

The size of emergency fund would correlate with the life stage we are in and family circumstances. I used to stay nearly 100% invested during my younger days and my bank account (including Save-as-you-earn with POSB) would not exceed $5000. Everything was poured into the stock market and a few life insurance/endowment policies, unit trusts. The rationale? I have a capable brother whom I could count on during emergency! :P

What did I do when an opportunity knocked? I divested my investment holdings and smashed all my piggy banks (life/endowment policies, unit trusts, savings) which I deemed would generate lower returns. Had I suffered a loss? Obviously, yes. But the returns on the new opportunity would have outweighed the losses if I decided to go for it. That's my interpretation of 'money goes where it is best treated'. Is it the best strategy? Absolutely not. But when resources were limited and when I was young, I decided that I could afford to start all over again if my financial experiments failed.

Would I do the same thing now? I can no longer afford to as I have become quite high maintenance and financial obligations are a lot more than before.

Would I be 100% invested? Yes, when the time is right. But not in the long term. Even so, is this prudent? Well, it depends on whether somebody else is able to offer the safety net. No, certainly don't count on the kindness of strangers. Not even friends, pls. :)

AK71 said...

Hi Endrene,

Thanks for sharing your thoughts. :)

You mentioned before that you are quite the risk taker. I can appreciate that more fully now. LOL. I don't think I can live life like this. I am a worrier by nature. -.-"

Well, during my much younger and financially less savvy days, when I was more a punter and gambler than an investor, maybe. Any vestiges? Perhaps. ;p

You are right that we have heftier responsibilities now that we are older. I need to be able to provide a safety net for more than just myself now. -.-"

The Sun said...

Hi Ak,

Thanks for sharing your insights.

Btw, you may also want to read up the latest article entitled 'Saving for that 3 to 6 months paycheck worth of emergency fund' posted by Drizzit on his Investment Moats website at www.investmentmoats.com which explores why having such a fund is useful.

Cheers,
Alwyn

Singapore Man of Leisure said...

AK,

LOL!

Our opinions and beliefs will change through different life stages.

Some of your younger readers in a previous post have confused emergency funds with opportunity funds too.

In our 20s, there's little money to invest after setting aside an emergency fund AND an opportunity fund...

It's like selling a young and healthy us in our 20s on the prudence of a hospital and surgical insurance plans ;)

If we survive till our 60s, we will either look back and say:

"Shit! I should have taken more risks!"

Or

"Shit! I should have taken less risks!"


Enjoy our middle age! We can only have mid-life crisis once (I hope!)

They say guys also have some kind of menopause too?

Testosterone shots anyone?

EY said...

Hi AK,

o.Oh? My little revelation helped you realise how much of a risk-taker I was(am)? Hmmm...better not say more and get myself incriminated. I have many more cans of worms all sealed up nicely. :P

My bro thinks that I'm a risk seeker. He still does. Well, my life is a learning journey and an adventure. That's how I prefer to live it. Losing is part of the game and so is dealing with it.

My current obsession? Thinking about quitting my job to do something crazy. Most probably in 2-3 years time when my financial plans pan out the way I anticipated them to. :D

Well, I can't quite live life as responsibly as you do. That's why I do think that you are a good role model. Maybe you are just grown-up and I have yet to! LOL~

AK71 said...

Hi Alwyn,

I think this is the first time I am addressing you by this name. :)

Drizzt was the first person to respond to the blog post mentioned here. Drizzt produces beautiful infographics. I have always admired them. Makes a difference whether we are good at IT stuff or not. Very apparent. ;)

AK71 said...

Hi SMOL,

Guys' menopause? Andropause, I think it is called. LOL.

Anyway, you are probably right about life stages although for people who stay single their entire life, it is a bit harder to see. We will always be boys. ;p

Well, with hindsight always perfect, it is almost impossible not to have a few regrets in life. I can only hope to be right more than half the time in my life. :)

AK71 said...

Hi Endrene,

I am sure pickled worms are a delicacy in a certain somewhere in the world. ;p

Anyway, some people also think of me as a big risk taker, even now. I would invest a lot more in a stock which I am fully confident of. 30% to 40% of my entire portfolio? I've done it before.

"If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety." Warren Buffett

Hubris? Perhaps so. However, to be fair to myself, there were not many such instances in my life as an investor.

Like you and everyone else, I have lost money before. The important thing is to learn from experience although I think it is easier said than done. I know because I make the same mistakes sometimes. Yes, shame on me. :(

I have turned more philosophical as I age. I want to take things easy. Well, one day, it will happen (I hope).

I am not a good role model at all. There is so much more to life than what I know and what I do. I am a frog in a well. ;)

EY said...

Hi AK and SMOL,

Your exchanges almost never fails to provide me with new insights on the 'male things'. Sometimes I think I get internal injuries trying to suppress my laughter. =.="

Agree with SMOL that there is a distinction between emergency fund and opportunity fund.

Emergency fund tides us over the rough patches. If we don't have a big sum set aside, is it going to be suicidal? My take is no, if we have sufficient liquidity - using the quick ratio concept might be an useful alternative to consider.

About opportunity fund - should it be in cash or its close equivalents? Selling one kind of asset to raise money for another more lucrative one isn't 'opportunity' fund? I think it is all about portfolio management. We have different preference of how we would stash away our money. Using that one size fits all approach is problematic.

What is important is knowing what we are doing and why. There are limitations in every approach. Quoting SMOL's cheeky expression 'you not me, I not you' - we know our circumstances and temperament best. For those who are absolutely clueless then, following the guru's advice might be a good start.

And sure, by all means set aside as much money for whatever funds we want to call it. The sense of security/peace of mind is worth as much as we value it. :)

EC said...

Thanks for initiating this discussion. It is indeed helpful to hear a view that seem to fly against conventional wisdom.

My take is that everyone is unique with his own circumstances that would necessitate a customized financial management for his own. Of course this requires knowledge and probably advice from others but ultimately it's one call. This reminds me of an old blog post in 2007 by a "Mr Wang" - http://mrwangsaysso.blogspot.sg/2007/05/managing-your-own-money.html

知己知彼 - the key to a battle (if we assume that to be a successful personal financial management) hinges upon knowing yourself and the enemy. I would say knowing oneself might be the biggest hurdle for many people.

To each his own. Some choices are certainly better than others but I guess that's what life is all about haha.

Best wishes,
Eugene

AK71 said...

Hi Endrene and Eugene,

Everyone has different circumstances and everyone has different beliefs. So, we should have different approaches. It is quite simple.

However, I believe that there are some values in life which are universal. There are also things which only time could teach.

So, we should not interfere and time will do its work. ;p

Singapore Man of Leisure said...

Endrene,

What new male insights?

Just roll-over and ogle at your significant other tonight. And stop giggling while checking him out!

Gee thanks! It's nice to know I can still make 1 girl laugh ;)

My power sword still not old!

Ben said...

Hi all

It is important to have emergency fund of at least one years of the annual income. The reason why the annual income rather than annual expense is chosen, is due to margin of safety. The annual expense will fluctuate and depend on the expenditure, unexpected cost etc. If one ensures that the annual expense does not exceed the annual income, he/she will be alright for the entire year.

Ben

AK71 said...

Hi Ben,

Having more money is always good. No arguments there. :)

However, there is an opportunity cost to holding money. So, the question is how do we reduce this cost?

It is a necessary cost but we don't want it to be too hefty either. Hmmm...

Ben said...

Hi AK 71

Agree with you that the opportunity cost of keeping the money for the emergency fund can be hefty if the amount is quite significant. It depends on each individual's views.

I feel that there is a need to add this buffer for the emergency fund. We cannot ultilise the fund from other areas (such as existing investment) to cater to the emergency usage. This will be worse if losses has to be incurred in the process.

Ben

AK71 said...

Hi Ben,

You have hit the nail on the head. Whenever I read that people would liquidate their investments during bad times in order to meet financial obligations, I cringe.

There could also be a chance that the investments would have to be liquidated at depressed prices like you have pointed out.

Although slightly off tangent, a recent blog post comes to mind:
$15,000 passive income.

We should have 2 funds on standby. An emergency fund and an opportunity fund. In an emergency, we would utilise funds from the former and, in extreme cases, the latter as well. However, the emergency funds ideally should not be used to fund investment opportunities.

Ray said...

Having no emergency fund and rationalizing it to being able to liquidate investments quick enough is assuming the "emergency" did not severely impact the investments i.e. emergency is more personal than global. When a global emergency strikes, I guess only cash is safe(r). (not that sure about gold either)

AK71 said...

Hi Ray,

During good times, it is easy to be lulled into a sense of safety. I think many people lack a sense of crisis.

Some people are not prepared for a crisis because they lack the ability to be so. If we have the ability to be prepared, we would be doing ourselves and our family a disservice not to be so.

I think the blogger in question with his $200,000 portfolio (cash included) is financially prepared for a crisis but his mentality might not be.

In a global crisis, the portfolio of equities could drop by 50% or more in value. Dividends could slow to a trickle. Cash on hand might not last very long if unemployment strikes. If it should happen together with some other unexpected expenses, then, it would be hell.

Daryl said...

Hi AK,

A young friend here seeking some advice. Considering a young chap serving his national service for at least the next year, the risks of unemployment would be zero. Thus, highest emergency would be for medical issues. In that sense, have bought term insurance liao.

Capital at my age would be limited so will like to seek the 老鸟 here on whether a how the remaining cash should be used. Currently 80% of cash invested in stocks. Remaining will be for war chest.

Any advice?
Thanks! :)
Deryl

AK71 said...

Hi Daryl,

An emergency fund is to cover all our regular expenses in case our income source dries up. How big this fund should be depends on the individual's circumstances, of course, but generally it should be big enough to cover 12 to 24 months of regular expenses, in my opinion.

Anything in excess of the emergency fund could be put to work. Not investing all excess funds but to keep some aside in a war chest is a prudent thing to do, I believe.

I think you have ticked all the boxes. Well done. :)

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