Sunday, January 7, 2018

Debunking The Rule of Thumb About Emergency Funds

It's been quite some time since the last time I talked about something that is related to personal finance so I think it's about appropriate to revisit them in the early days of the year.

The topic related is about emergency funds and it is right at the heart and foundation of personal finance.

Often, we hear about the internet or professional consultants who preach about how importance it is to keep at least 6 months of our living expenses as emergency funds before we can start investing and growing the rest of our funds.

In this post, I am going to challenge that rule of thumb that it's not always necessary and propose that we create more awareness instead about our whole situation.



What is Emergency Fund?

First, we need to comprehend the definition of an emergency fund.

An emergency fund, in my definition, is cash that we've stashed up for savings for the sole purpose of utilizing them when certain events that has a low likelihood of happening hits our lives in order to maintain the same lifestyle that we are currently experiencing.

The key to note here is events with a low likelihood and is not something that we are expecting to happen.

If it is something that has a probability of more than 50% chance of happening, then it doesn't fall under this category and we should be taking action to mitigate the whole situation before it happens instead of bumping it up through emergency funds.

Purpose of Emergency Fund

The purpose of keeping an emergency fund is pretty straightforward.

If I am a sole breadwinner of the household and have the responsibility to pay for my kid's school and other home utilities, then it'll make sense that I should keep a certain sum of money in case life takes a back hit.

What I am debating is if the general rule of thumb of at least 6 months worth of living expenses is sufficient or insufficient in cases like that.

The higher the amount, the more this can be deterring to many people especially:

i.) They do not know how much expenses they are incurring each month;
ii.) They do not know in crisis scenario how much they can scale down;
iii.) The total sum of money can be pretty intimidating to save.

How do we determine how much is enough?

You've heard so many versions of emergency funds that you are confused and do not know exactly how to start.

The first baby step (step 1) is always about increasing awareness and this is a foundation that I believe is more important than keeping an emergency cash.

By awareness, it means that we are fully aware of the surroundings and events within our boundary and control. For example, if I am someone with a background history of illness, then instead of waiting for the event to take place, I might want to proactively seek help by regularly going for medical check-up. I can even take a further step by purchasing the required insurance plan to guard myself against the expenses I might have to pay for the illness. Once this is done, I am able to reduce the amount made for my allocation of health in the emergency funds wallet.

The next step (step 2) is about understanding how much basic necessities vs discretionary are contributing to our expenses.

Many people can quickly compute how much expenses they incur in a month but failed to comprehend where the expense allocation goes to. In some cases, they are left bewildered where the money they spent are being allocated to.

In order to start understanding our own expenses, it is important that we start tracking down our own expenses for at least a month. It does not necessarily have to be to the dollars and cents and if you're someone who's lazy like me, you can aggregate them by the expense bucket lists. For instance, under my children's day and care, it would include things such as diapers, milk powder, clothing, napkins, baby food, vitamins and things like that. Then I have the education lists which include the school and the other curricular activities.

The importance and objective of doing that is we create more awareness on the overall spent on certain buckets and can eliminate discretionary expenses that aren't necessary.

The last step (step 3) is about determining where the optimal strength are in your household and surroundings.

Married couples always have the advantage on this because we have an extra partner to work with on the strength.

For instance, in my case, I am more comfortable with income creation while my wife is more focused towards savings. In this case, we agreed that we would roll the plan out by investing my income and kept my wife's savings as part of our emergency funds. 

In another case, if you are someone who is stronger in the savings, it also helps that you reduce or eliminate debts in good times so you have more room to mitigate in bad times.

If you are someone who is good in investing, then you can diversify the income so you are less dependent on one.

Summary

Often, many people keep so many months of emergency funds without understanding the underlying reasons behind it.

It is seen as an excuse that the plans are well in place when it could just be a lazy excuse to hide certain weaknesses away.

Perhaps proactively reviewing our own checks is a good way to start understanding about ourselves which might just allow us to discover some missing parts that need maintenance before it gets worse.


Thanks for reading.

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15 comments:

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