This is a follow up from our post last week when we couldn’t fit debunking all the arguments for emergency funds into one post. This is also good place the point out some of the great work other bloggers have done on this topic:
- The Green Swan: Emergency Fund Alternatives
- BeNetWorthy: HELOC as an Emergency Fund option
- Unchained55 thinks Emergency Funds are a scam
- (we must have forgotten some, please let me know if you see an obvious omission!)
Here are our reasons 6-10. Enjoy!
6: Not having an emergency fund is the same as not having insurance
“Why have life insurance at all? That’s opportunity cost going out the window.” From the comments section
“To me, not having homeowner’s insurance, although it’s probably mathematically better in the long run, if there’s an emergency and my house burns down, that doesn’t work for me. You could say the same thing of funding your unemployment with credit cards. Too risky.” From Scott Allan Turner
That is a very lame and inappropriate comparison. We never argued for foregoing homeowners insurance or other types of essential/mandatory insurance. The difference between an emergency fund and insurance is that an insurance company pools risk over many participants and charges a small premium to each customer to insure against a catastrophic damage occurring with a tiny probability. An emergency fund is a form of self-insurance against less-than-catastrophic events that occur with a low to moderate probability, such as car and home repair/maintenance. Due to adverse selection and moral hazard issues, some of these risks targeted with the emergency fund have to be self-insured because no insurance company would want to cover these risks or it would be prohibitively expensive to do so. In order to self-insure against these events with uncertain timing, you are better off saving in the highest return asset you can find, likely equities. Heck, even insurance companies invest their reserves in risky assets. They are very much discouraged by regulators from equity investments, but they do use longer duration bonds. No need to hold large sums of cash!
7: Some households are irresponsible and subject to behavioral biases
“Hey, if people were smart and math were the only issue, nobody would be in debt. This isn’t a math equation, it’s behavior. Most people have never had $1,000, $2,000, $2,500, saved up in their entire lives.” From Scott Alan Turner
Yes, agree. And? Just because some households are irresponsible (nobody in the FIRE community, of course) doesn’t mean we have to pile on even more bad advice to hinder the success of already financially challenged folks. Keeping an emergency fund while having credit card debt, for example, is one of the crazy irrational pieces of advice (see example here: “If you’re in debt, prior to getting out of debt it’s more important to create an emergency fund”), which encouraged us to write our original piece on emergency funds.
Besides, the behavioral bias argument can also work against keeping an emergency fund and rather investing in something more productive. Keeping your money out of sight in a brokerage account may avoid the temptation to raid the fund for an emergency LCD TV.
8: Having an emergency fund is better than having no money at all
Countless examples of sob stories about people who got into trouble not having any savings.
Yes, agree. And? Our recommendation was not to have $0.00 in an emergency fund and $0.00 in other savings. We propose accumulating a large net worth through a) savings rates north of 60% of net income and b) invest the savings in high-yielding productive investments, such as equities, (corporate) bonds, real estate, etc. Thus, our criticism is not so much if you should save, but where/how.
The argument of “better than not saving at all” is a prime example of the “false dilemma fallacy“: pose one (and only one!) crazy stupid alternative to your recommendation, incorrectly imply that these are the only two alternatives and, bingo, your recommendation seems optimal. We never proposed forgoing savings altogether. Quite the opposite, we save about 60% of our net income and have written about the power of frugality in achieving financial independence. Our savings target is about 35 times annual spending (=420 months, take that Suze Orman). Even the less risk-averse folks in the early retirement community strive to get to 25 times annual spending. We don’t have the problem of having $0.00 when the next disaster strikes. We are already about three steps ahead, thinking about the asset allocation decision.
9: Investing all your money in risky assets, you must be some risk-seeking, irresponsible, over-leveraged investment cowboy
For full disclosure, we do take on a lot of risks. We like risky assets because finance theory (and practice) teaches us that returns in excess of the risk-free rate are earned for taking on risk. That said, we don’t like excessive risk and try to avoid it when we can:
- We advocate a 3-3.50% safe withdrawal rule, rather than the often cited 4% rule, out of concern that future capital market returns may be lower than what we all got used to. We are quite conservative and cautious about our financial planning.
- We prefer index funds over individual stocks because we are turned off by the idiosyncratic risk of individual stocks.
- We recently warned that REITs seem to have a lot of risks, relative to what their stock and bond factor exposure would justify.
- Cash faces the risk of slow erosion of purchasing power because the current rates on money market funds are significantly lower than the rate of inflation
- Bonds face some unique risks of their own: potentially decade-long stretches of low or even zero real returns, as we pointed out here.
10: But emergencies happen to me all the time
Countless examples of the type “Our refrigerator/roof/transmission/etc. broke last year”
If people stumble from one financial emergency into the next they might be doing something wrong with their finances. Part of the problem could be incomplete budgeting. Homeownership and car ownership come with much greater costs and responsibilities than just the house and car payments. Both require regular maintenance, insurance, gasoline/utilities and both have expensive components that require replacement at more or less predictable intervals, e.g. new tires after 40,000 miles, new roof after 15 years, etc.
To be really serious about budgeting we should factor in the remaining useful life span of all the major components in the house/car and how expensive they are to replace or repair.
Something breaking down is not an emergency. Something breaking down earlier than expected is an emergency.
But some components will last longer than expected, so hopefully, over time, emergencies and windfalls will average out. Pamela at MyMoneyCounts recently had a good suggestion on “How to Implement Your Budget Like a Corporation” and here would be one good example of how households should apply business accounting and budgeting methods. If we have enough income to cover those average repair costs every month, why should we keep tens of thousands of dollars in a money market account at close to zero interest?