Three to six months' expenses in your emergency fund. It's probably what you've heard you need since you first tried to learn something about money. Three to six months' expenses.
But where did that number come from? And is it right? Do you really have to have 6 months' expenses in cash to have a stable financial foundation? Or is it more? Or less?!
My answer to this question is that many of us overestimate how much we need in pure cash to cover an emergency. And while the final decision is up to you, you can definitely have too much sitting in cash.
Here are a couple reasons I think the cash experts say we need to cover an emergency is often inflated.
1. Overestimating the TIMING of emergencies
When you hear financial emergency, you might think about needing a new set of tires unexpectedly, or having to take a trip home for a wedding or a funeral. For longer periods of time, a job loss or a disability might come to mind.
All of these things ARE emergencies, and they do require access to money. What many of them do NOT require, however, is accessing the money IMMEDIATELY (within 24 hours). Even financial emergencies that might occur, such as a burst water pipe that leads to a homeowners insurance claim, or that set of unexpected new tires, may only require $1,000 or less in a day's notice. Why? Either the expense itself is less than that amount, like the new tires, or all that's needed to start the repairs on your end is to pay your deductible, like your homeowners' insurance deductible.
In fact, you'd be hard-pressed finding more than 3 to 4 emergencies that require more than a couple thousand dollars within a day's notice, that don't also carry a deductible that limit your exposure.
Health insurance? Sure, it might take you paying $2,500-$5,000 toward your care before your insurance provider steps in. But rarely do medical bills carry a due date within 30 days of receipt, meaning the timing itself doesn't fit the category of an emergency.
Fender bender on the interstate? It may require money quickly, but $1,000 is as high as your typical deductible reaches.
Last-minute plane ticket? Even if you need a hotel and rental car, I can't imagine an emergency trip requiring more than a couple thousand dollars on no notice.
Does this mean all you need is a few thousand dollars in emergency savings? Absolutely not. There are events that might require you to access cash of larger amounts for an extended period, like a short term disability or an unexpected job loss. And don't worry, by the end of this article I'll share how much I think is appropriate in multiple scenarios.
Regarding the timing of financial emergencies, those most likely to occur still give a week or so of notice before large amounts of money are needed.
To me, the true benefit of having money in emergency savings is the ability to access it within 24 hours. If you don't need it that soon, there are other resources that offer access in plenty time to cover the typical emergency, while offering the potential for significantly higher returns.
And now, the second reason people overestimate how much they need in cash savings.
2. Fear of what it means to invest
- As much as you read about the stock market online, and as many news stories were written about meme stocks like AMC and GameStop, the percentage of Americans who own stock is only slightly higher than 50%. Unsurprisingly, the more you earn, the more likely you are to own stock. As of the fall of 2021, only 24% of households earning less than $40,000 were invested in the market.
Ironically, these are the households likely struggling to establish an emergency fund. But they are also the ones who could benefit the most from a good year in the market ... if only they were invested.
Let's be clear, the economic forces keeping these people from saving are far greater than they should be. Ridiculous student loan balances, s%#tty pay at their jobs, the high cost of housing; it's not as simple as just creating an emergency fund and then investing some money and stocks.
We shouldn't, however, discount the role fear of the market plays in our resistance to investing. Surveys of young professionals have found that over 60% don't invest because they find the market scary or intimidating. Diving deeper into their specific fears, we find the following:
- 50% are afraid of making a bad investment and losing money
- 35% are intimidated by the amount of money they feel they need to invest
- 31% don't know who to trust for investment help
- 24% don't know how to get started
In my experience working with new investors, their fears are typically centered on fear of being too aggressive and losing money, and the belief that investing means they lose ACCESS to their money. Both concerns can be addressed:
Fear of being too aggressive
When you've never invested, it's easy to believe putting money in the market is as aggressive as a 10 on a scale of 1-10. In reality, investments such as mutual funds often pick their investments so they fall within a certain category of risk: conservative, moderately conservative, moderate, moderately aggressive, or aggressive.
By researching some of the best-reviewed conservative or moderately conservative funds, you'll find that not only are their returns in up markets far greater than you'd earn from a savings account, but their losses in down years are not as severe as you'd expect.
Does this mean there's no risk in investing? No, and in fact, our first rule of compliance as investment managers is to remind you that past returns are not indicative of future performance. But understanding an investment's strategy and making sure it fits your risk tolerance can help ease your fears, and let you know that dipping your toe in investing waters doesn't mean you have to dive into the deep end.
For those who are looking to start investing after they've funded their emergency accounts, I often recommend starting with something that isn't too aggressive. The initial funds you're investing are only one step removed from traditional savings, so you don't want their returns to be too volatile. Investments ranging from moderately conservative to moderate risk tolerance likely have plenty opportunity for the novice investor, with some downside protection in case the market drops.
Fear of losing access to your money
If 10 people come to my office hoping to talk finances, probably 7 of them have their only investment inside their company retirement plan. They have a checking account, a savings account, and a company retirement plan. That's it.
Because I work with mostly younger professionals (50 and under), they can't access their retirement funds without paying a penalty and taxes in most cases. Since these accounts are the only stock market investments they have, they assume there would be similar restrictions if they were to open another retirement account.
Not the case. Work retirement accounts are often in qualified plans, which can charge a 10% penalty and income taxes on any distribution you make that isn't a 'qualified distribution'. The most commonly known qualified distribution is withdrawing your money after age 59 1/2.
Certain nonqualified investment accounts, however, carry no age restrictions on accessing the money. Nonqualified brokerage accounts not only allow access at any time or age, they can cash in investments and have money back in your account within a business week.
Remember what I said about the timing of a true financial emergency. It is, in my opinion, one where money is needed within 24 hours. Excluding major holidays, nonqualified accounts could deliver money to your account on a Friday that you requested on a Monday; plenty of time to cover most emergencies.
So ... How Much Do I Think You Should Have In An Emergency Fund?
It depends on a number of factors. I do think three months' expenses is a fine number to be safe, especially for a two-income household.
Three months' expenses are likely enough to cover any deductibles for which you're responsible, such as health insurance or car insurance.
Should you experience a long-term disability and be eligible to file a claim, standard policies require you to be disabled for 90 days before they start paying a percentage of your lost income.
The average period of unemployment? Right at four months.
But HERE'S WHAT'S IMPORTANT TO REMEMBER: I think you should have access to far MORE than 3 months' expenses when it comes to your investments outside of your retirement account. When factoring in investment accounts like nonqualified brokerage accounts, I would love for you to have access to up to a year's worth of expenses or MORE. Why not, when there's no limit to how much you can contribute?
The three month number is all about what you keep in PURE CASH SAVINGS.
And the goal is not to stop saving. The goal is to reach your emergency savings goal and then INVEST any additional funds, rather than putting more in cash accounts that don't keep pace with inflation.
Are There Any Exceptions To The Rule?
There are always exceptions to the rule. In the case of emergency funds, here are few examples of times keeping more than three months' expenses in cash is a good idea:
Your Income Fluctuates
As a financial advisor, it's taken years to build my income as I gained clients and formed relationships. And while I've thankfully reached a point where I have a higher baseline of income I can expect to earn, my pay still fluctuates from month to month. Realtors, corporate salesmen and women, even construction managers know that there may be months where the amount they bring in is lower than their fixed expenses. These professionals may need to keep a much higher amount in their checking or savings account to cover themselves in periods of lower pay
You Have A Large Upcoming Expense
We've talked about investing the money you plan to save after meeting your emergency fund goals. Investing is great, and the stock market sees positive returns in more years than not. Those positive returns, however, are not guaranteed. As boring as savings accounts are, as insignificant an amount of interest they pay, you are guaranteed not to lose money in a savings account.
When a large purchase is ahead of you, such as a home purchase or buying into a business, you need the guarantee of having, at a minimum, the exact amount you saved available at the date of purchase.
Within 3-6 months of large financial acquisitions, it's advisable to keep the money you need in cash to protect it from potential downturns close to the date of purchase.
For those currently experiencing health challenges, or who have an extensive medical history, having larger amounts in cash can prove more dependable if funds are needed to pay for the cost of care.
How To Get Started
Even if you decide you'd like more in your savings account, you can still get started and create a plan to (eventually) invest your extra funds.
Let's look at an example of a family who wants to keep 6 months' expenses in cash, and devotes $500/month to their goal. We can help them reach it with a tiered savings system
They save $500/month directly to cash until they reach 3 months' expenses. After 3 months are reached, they can open a nonqualified brokerage account and invest as aggressively or conservatively as makes them comfortable. They can then save half of their contributions in cash, and invest the remaining half until reaching the 6 month goal.
After 6 months' expenses are saved, there is no need to park more money in cash. The family is now free to contribute all additional savings to their investments. If an emergency occurs and they have to dip in to their emergency fund, they can star the system again until the account is replenished.
At the end of the day, determining how much to keep in emergency savings is a personal decision. My opinion, while it is informed by experience, is still an opinion and not a fact.
I encourage you to look at the factors affecting your finances and determine what's appropriate. The one request I would make is if and when you meet that emergency fund goal, do whatever research is needed to feel comfortable investing the additional funds. Building your way to wealth in nothing but cash accounts in next to impossible; you have to find ways to invest money in vehicles that give you the opportunity to earn a rate of return. So keep saving, find what investments suit your tolerance for risk, and commit to pursuing them when the time is right!