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How much should we have in our emergency fund?

Friday, May 29, 2015

Having an emergency fund is important. No rational person would ever say an emergency fund is unimportant. Rationally, we know that bad things happen sometimes and we might need to have more liquidity at hand for such situations.

Whatever our persuasion might be in our journey as an investor, we cannot deny that cashflow is important. There could be times when cashflow is negatively affected and slows to a trickle or it could even dry up. That is when an emergency fund is drawn upon.





If our cashflow is a like a stream of water, an emergency fund is like a water tank that will dispense life giving water in the event of a drought.


The question of how big an emergency fund is enough is more difficult to answer because there isn't any one size fits all amount, obviously. Then, is there any guideline which AK could offer? Well, I could talk to myself, I suppose. Remember, however, AK is just sharing what he has done in his life. He is not a trained financial adviser.


Whether an individual's emergency fund is sufficient depends very much on his lifestyle, the number of dependents he has and how old he is.








Lifestyle

We could have a simple lifestyle or a lavish lifestyle or somewhere in between. Of course, what is considered simple or lavish would differ from person to person. No matter what our definition, we will have certain expenses which are fixed or routine and some which are discretionary.


Fixed expenses are mortgages, Telco bills, loan repayments, insurance premiums etc.


Discretionary expenses are holidays, birthday parties, visits to restaurants etc.


Of course, there is some room for debate as to what is fixed and what is discretionary. However, I will say that fixed or routine expenses are those that cannot be eliminated as easily as discretionary expenses.


Number of dependents


For those of us who are still single, some of us might have to take care of elderly parents or young siblings. For those of us who are married, some might have children who still need to be cared for. Our dependents will have routine expenses (and discretionary expenses) too.


Age


As we grow older, it is harder to find employment if we should be retrenched. If we manage to find re-employment, we might have to take a pay cut. Well, I am just taking my own advice to be pragmatic and not be overly optimistic or pessimistic. So, I think a bigger emergency fund as we grow older, all else remaining equal, is sensible.









So, bearing the above points in mind, is there a formula we can use to arrive at an amount that we should have in our emergency fund? Forgive me that I do not know how to express this in a neat equation. I offer you a neat paragraph:


If we take all our monthly routine expenses (our own + our dependents') into account, we will know what is the minimum amount of money we must have each month in order to maintain our current lifestyle. If we are in our 20s, multiply this amount by 6 to determine the size of the emergency fund required. If we are in our 30s, multiply by 12x. If we are in our 40s or older, multiply by 24x.


Someone once denounced me for being fake when I said I maintained an emergency fund enough to cover 24 months' of routine expenses. He didn't believe that I still needed an emergency fund because my passive income stream was strong enough to replace my earned income. Do you feel the same way?





If we remember my earlier analogy that our cashflow is like a stream and that our emergency fund is like a water tank, we will understand why I think an emergency fund is a must even if we should have a passive income stream.


So, how much should you have in your emergency fund? I hope this blog post has given you an idea.


Related posts:

1. Why a meaningful emergency fund is important?
2. Emergency fund: How much is enough?

11 comments:

The Sun said...

Hi AK,

It will be good for us to know that one's passive stream of income may not be constant, especially if one is invested in properties, stocks, or perhaps even in REITS and business trusts. In the event that this stream of income is reduced, at least one can still fall back on his emergency funds.

victorlsl1 said...

I think all the emergency fund can be put into Singapore Savings bonds. better right?

AK71 said...

Hi Sun,

Emergencies could take many forms and I will not be so confident as to say that I will never ever need an emergency fund because I have a strong passive income stream from my investments in the stock market. -.-"

AK71 said...

Hi victor,

I blogged about my thoughts on the SSB before and who I think will find it attractive: Singapore Savings Bond: Good or not?

I believe that it will be a good place for some to park their emergency funds. ;)

pf said...

Did I mention before?

I attended a course for wealth management recently. The instructor said he does not have any emergency fund. His emergency fund is by way of personal credit.

He also do not maintain any deposit account. Amazing.

His approach is too extreme to me. But I also do not think we should overdo the emergency funds. Because the most critical of all emergencies is life threatening illness. Which should be covered by insurance policies, Medishield, etc.

Next, it would be the loss of job. Which I agree there should be some funds to cover. However, I believe we should all try to keep ourselves as marketable as possible. To avoid issue of can't get any job. :)

pf said...

Oh...and to add on. I think SRS can be a good emergency fund to tap on for loss of job. Although there is a penalty, but for loss of job, we have no income to pay tax upon. So it's ok for me to draw out SRS for such purpose.

Other than that nothing much to be defined as emergency to me.

AK71 said...

Hi pf,

Oh, I agree that the example of not having even a savings account is extreme. Rely on an overdraft account for emergencies? It seems like a really bad idea to me. Seriously, it boggles my mind and I am concerned that this person is actually a wealth management trainer... -.-"

pf said...

Actually he is not too bad. ...shared a good point about life insurance. He said that he buys whole life insurance because in the event he didn't manage to pay premiums, it would go into policy loan. Won't lapse. If it is term insurance, policy will just lapse.

I mean, there should be a balance lah. We need to rationalise and define what are emergencies to us lor.

If it is illness, then medical insurance. If it is loss of job, then Savings and SRS and rent out rooms of my flat to ppl.

If it is parents illness, then now shld try to find the source of funding already. No need to wait till emergency.

If it is anything else, relative being chased by loan shark....sudden feeling to go overseas for further education....suddenly being sued by other ppl...??? Suddenly family got kidnapped and need ransom? ????

All those no go for me lah...no money try not to get into trouble or for things that are out of reach lor.

Not sure what else can be defined as emergency?

AK71 said...

Hi pf,

Is this trainer an insurance agent by any chance? ;p
Buys whole life insurance. Hmmm...

If he cannot pay for the whole life insurance, it will only be "self paying" if he has been paying for it for many years (e.g. 13 to 20 years). If he cannot pay for it in the early years, it will lapse anyway. Policy loan? There has to be cash value in the policy to be used as collateral.

Buying term life is much cheaper. How much cheaper? For the same insured value, 90% cheaper possibly, off the top of my head. What he pays in a year for his whole life policy, he could use the money to pay an equivalent term life policy for 10 years! I think it is easy to simply put aside the money to pay for 30 years of term life if he can afford 3 years of whole life.

Of course, this is difficult for him since he does not believe in having a savings account to lock away some money. ;p

This person just sound quite bogus to me... -.-"

pf said...

I think he is just an aggressive in his wealth mgt. He believes in saving and not spend excessively as well. Some examples he shared...he needed a car when he had 3 young kids but not an expensive first hand car. Modest 2nd hand car will do. Borrowing less than 50% to pay for the car.

However, he doesn't let his cash sit idle. He mentioned it was too high opportunity cost to him.

Anyway, on the whole life insurance, I believe it is what fits his circumstances. If he didn't have the liquidity short term, and in the event he pass away, his family would still be taken care of.

I believe that one's risk appetite and purpose would dictate the instruments to achieve financial objectives.

So for emergency funds, i don't think there is a standard guideline for how much to set aside. As a risk manager, I would first assess what are the risks and formulate a control to address the risk. So, my point is that people should think what sort of emergencies they think they would face. What is the likelihood of such risk event? Are there any controls already in place to address this risk? If having cash as emergency fund is the only way, then thats fine.

Once people are able to identify and articulate the risk event, then would be able to think if risk control/mitigation, risk transfer (insurance), or risk acceptance....always bear in mind the cost benefit of all the options.

AK71 said...

Hi pf,

I can't and won't comment on his personal circumstances. I respect the decisions he make for himself but to conduct a session in wealth management and to propagate his more adventurous ideas is, I feel, rather irresponsible. If he weren't a trainer, I think I would not have any issue.

Most people are not sophisticated enough to do what he does and most people are not sophisticated enough to realise this. For most people, to err on the side of caution is a good thing. We want to remember that "money not made does not equal to money lost". Some opportunity cost is not a bad thing. To sit on some cash is not a bad thing. There are worse things to do than sitting on cash.

Well, I can only caution anyone attending his class to question the ideas offered and not simply accept them. Like you said, the choice of instruments is very personal and depends on a person's objectives as well as his ability to stomach risks.

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