Emergency Fund: Do I Really Need One?

An emergency fund isn’t just a repository of cash you can dip into when the tires wear out or the dishwasher breaks down. Those emergency dollars may actually be critical to your overall investing strategy.

For example, let’s look at two different investors.

Polly Prepared: Spent a few years building an emergency fund, tucking the money away in a savings account and some short-term fixed-income securities.

Ivan Impromptu: Has pretty much all his available assets and money tied up in bonds with long-dated maturities and in the stock market.

When a fierce autumn storm blows through town, both investors suffer major damage to their vehicles from falling branches. The bill for each, even after insurance, is around $1,000.

Polly uses this as an occasion to dip into her emergency money, which is now literally a “rainy day” fund, to pay the repair bill. Her investments remain untouched. They can keep working to meet her eventual goals, which may now include buying a new car without a damage history.

Because Ivan lacks an emergency fund, he faces the choice of selling some stock shares at a loss—it was a tough month for the market—or using his credit card to pay for the damage to his car. Neither choice is particularly palatable. Although credit cards can provide a short-term fix, they can’t sustain an investor in the long term without potential financial damage. And, of course, selling stocks at a loss could hurt Ivan’s chances of reaching his long-term financial goals.

“The last thing you want is to invest in the markets and have to dip into your investment portfolio at a loss,” said Robert Siuty, senior financial consultant at TD Ameritrade. “If your investment portfolio drops and you don’t have an emergency fund, you might panic, capitulate, and sell at the worst possible time.”

The lesson? Keeping emergency funds grouped with your long-term investments in the market can throw a wrench into your investment goals.

Budgeting for an Emergency Fund Can Be Key

Now that it’s clear why setting up a separate emergency fund can be critical from an investment standpoint, what are the dos and don’ts of getting started, how much is needed, and how can someone with debt and long-term expenses even find the money for an emergency fund in the first place?

It all starts with budgeting. Figure out your monthly expenses, every one of them, and determine which expenses can’t be avoided. An emergency fund generally covers the following types of outlays:

• Food and shelter
• Transportation
• Insurance and health
• Taxes
• Cost of finding a new job

“Balance out committed expenses versus stuff that’s more discretionary, like going out for dinners and lunches and taking vacations,” Siuty said. “That’s stuff you can cut down on if you need to. When I meet with clients, one of the first things I always ask is if they have an emergency fund. It’s what you want to tackle first.”

Where should emergency money be stowed? It can be cash and savings that are easily accessed—think CDs, money market funds, or short-term fixed-income investments at a brokerage. A savings account won’t earn much interest, but it can be one of the safer places to put money. On the other hand, a short-term bond fund, while somewhat less predictable and safe than savings, might offer a better chance of making some compound interest on the original investment. Compound power can grow with time because the money earned in interest begins earning interest as well.

Some investors set up a separate bank account specifically for emergency funds. Others keep emergency cash as part of their brokerage accounts but sliced to the side, so to speak, so it doesn’t get mixed up with funds slated for longer-term goals like retirement.

How Much Emergency Money Do You Need?

So once investors find ways to save, how much should they devote to that emergency stash?

“The general rule for emergency savings is three to six months’ worth of expenses, but that’s not set in stone,” Siuty said. “It depends on personal lifestyle, career, and income. If income is a little more stable, maybe they can stick to something shorter. But if the situation is unstable or if they’re in a profession where maybe there’s risk of attrition, then they may want to have a longer type of fund set up.”

What about other important priorities, like paying off college debt, saving for a down payment on a house, and building education and retirement savings? Again, all that is important, but having emergency cash is the key short-term priority, because without it, longer-term goals could get dinged. And remember, there’s good debt and bad debt. Mortgages are considered good debt because they can help build long-term wealth. Bad debt would be credit card and other high-interest revolving debt, which young investors should try to avoid by limiting expenses.

Siuty advises clients to put their goals into short-term, intermediate-term, and long-term buckets. The short-term budget includes emergency savings. Intermediate goals may include buying a house and paying for college. A critical long-term goal is retirement. But the longer-term buckets can spring a leak if emergencies aren’t covered by short-term funds.

“You want to set up an emergency fund and have it in place sooner rather than later, because things happen that can throw a wrench into your long-term plans,” Siuty warned.