Before saving for retirement, a vacation, or funding your investment account, it is important to build an emergency fund first.
What is an emergency fund?
An emergency fund is to be used to well, fund any unexpected expenses that may come in our lives i.e. unemployment, illness, car or home repairs, dental work, etc. As such, it should be liquid (in the form of assets that are easily convertible to cash when the need arises) and may take the form of certificates of deposit, cash or shares of stocks, bonds or t-bills (the latter are relatively liquid).
How much emergency fund do I need?
The amount varies according to each individual’s lifestyle and standard of living in one’s city. Personally, I prefer an emergency fund equivalent to at least 6 months’ worth of my net take home salary. Others deem at least 3 months’ worth of living expenses to suffice. You can choose an arbitrary amount that you feel comfortable living on in case an emergency ever arises.
Can there be too much of a good thing?
So, you built up your emergency fund, what now, do I keep going? Stop. There can be too much of a good thing. To recall, an emergency fund is kept in liquid assets usually in cash or certificates of deposit. Due to their liquidity and ease of withdrawal, these assets earn very minimal interest usually at less than 1% or up to 2% per annum (gasp!).
Don’t let inflation eat up your emergency fund.
Building too much of an emergency fund in these liquid assets may result to inflation eating up your emergency fund. Inflation or the Consumer Price Index is simply the change in the price of goods or services every year. Simply put, it is the real value of your cash in relation to how much services or goods such cash can buy. Average inflation right now is at 3-4% per annum.Thus, that is how much the cost of goods and services increase per year. The goal is for your savings and investments to keep up with inflation and therefore get the most bang for your buck.
For instance: If savings accounts earn an interest of only 1% p.a. with inflation rate at 3% p.a. Your savings account lose 2% of their real value to inflation (1-3=2%). In other words, your money a year later buys 2% less than what it could have bought before.
Now, back to my main point. If emergency funds are held in purely liquid form (savings accounts earning 1-2% p.a.), they will eventually be eaten up by inflation. It is therefore important not to hoard too much an amount as your emergency fund. Allocate the excess amounts in investments or at least in relatively liquid assets like stocks, bonds or treasury bills/bonds.
What form of assets constitute your emergency fund?
20 something lawyer