The Emergency Fund Balancing Act

By Gary Silverman, CFP®

Last week we took the concept of savings and divided it up into saving for emergencies (our current topic) and saving for knowns (a later topic). In our quest to prepare you for the next financial crisis, today we look the balancing act you must perform with your finances in order get that emergency savings “just right.”

The definition of an emergency has, as a fundamental part, the potential immediacy of the event. In other words, it might happen today, next week, next year, or never. We will look at the two extremes: Today and Never.

Since your emergency might happen any day, you can’t wait to save up for it…you might not have time. You also can’t take risk with it since you might not have time to wait for your investment to recover from a loss. Because of this, your emergency savings needs to be a high priority in your financial life, and you need to invest it in something really safe.

Since your emergency might never happen, you don’t want to put too much into your emergency savings as the lost earnings (the difference in what you’d earn from a “risk-free” investment and a balanced investment portfolio) across your lifetime can be significant.

There is a tension here: Needing to save safely for emergencies vs. needing not to save too much. Let’s look at two examples of how this can mess you up. In both cases a person comes into my office with a $1 million portfolio. They withdraw $40,000 per year for living expenses.

In my first scenario, $500,000 of the $1 million is kept in CDs to be safe in case of emergencies. This might appear reasonable if you add up everything that might go wrong and in the worst way. But is it really reasonable to think that all potential emergencies will happen at the same time? Not to mention this represents over a dozen years of spending needs. If you assume that the emergency savings earns 1% and the rest is kept in a balanced portfolio earning 6%, that $500,000 being kept safe is costing this person over $1 million in earnings over the next 20 years.

On the other hand, let’s say that instead of putting half of their $1 million into safe investments in case of emergencies, the person in question just invests the whole portfolio. In this scenario, I will assume that around March of 2009 they needed $50,000 due to an emergency of some sort. Unfortunately, since this happened at the height of the Financial Crisis, they would have been selling off securities that used to be worth $75,000 to raise the $50,000 needed. That $25,000 difference is not the only cost to them for not having a nice safe emergency fund set up. That’s because, assuming the same balanced portfolio from the first example, that $25,000 would have earned close to $83,000 over the subsequent 20 year. So, the emergency cost them well over $100,000 extra since it wasn’t prepared for.

These examples are extreme, but should make it obvious that there is a real cost for saving too much or too little for potential emergencies. It’s all about balance. More on this coming soon.

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.