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
Quotes:
“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
Quote:
“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
Quote:
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
Quote:
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?
Great stuff as usual, ERN!
The “false dilemma fallacy” is a powerful rhetorical tool. Which is unfortunate, since its success and widespread use imply some very sad things about us simple humans. I feel like there should be a good “behavioral bias” name for falling prey to false dilemmas… I’ll have to think more about some appropriate names. This seems important. After all, thinking of a good name is my only alternative to absolutely wasting my time and energy doing nothing else. I practically have no choice! Damn these impossible dilemmas!!
Thanks for the comment, FL. As always very thoughtful.
Yes, absolutely, the false dilemma fallacies are pernicious. Politicians like to pose them a lot, too. And since I had only two choices: either point this out on my blog or punch myself in the face I knew what I had to do. 🙂
Cheers,
ERN
Thanks for the shout out, ERN. I think both part 1 and 2 are spot on and you know I stand with you on this issue. I think a responsible person with a reasonable grip on personal finance should have a better plan and better alternatives than to simply rely on an emergency fund. You’ve laid it all out well!
Thanks TGS! Glad you liked it and we’re on the same wavelength.
Cheers,
ERN
I suspect the last item your list is the real reason many people keep an emergency fund, and frankly the real problem with them. The reality is even an emergency fund kept inefficiently at 6 months of savings would have minimal impact on your overall portfolios opportunity cost. Honestly your talking about 10K -15K held constant which even at 4% is 400- 600 dollars a year in lost interest based on normal returns. The bigger problem is by having an emergency fund so many treat it as an excuse not to budget. It’s closer to a slush fund then an emergency account in definition, thus further encouraging poor financial management. I don’t favor them as cash in general, but the usage as an account to hit regularly concerns me much more.
Yup, good point. That’s why we saved this one item for last, haha. Good point that the emergency fund in absence of proper budgeting is a recipe for disaster.
Cheers,
ERN
Well done, ERN. Some of the lamer comments really don’t really deserve a response, but you are kind to address them all.
Best,
-PoF
Thanks PoF for stopping by. Thanks again for sharing that picture on Twitter today. That really made my day!
Cheers,
ERN
https://twitter.com/physicianonfire/status/776497023688118272
I have to admit that these two posts have made me rethink my strategy a bit. Curious, for anticipated items you need to replace (ex. a new roof), would you save that money in cash during your save up period or would you just continue to dump the money in your investments and then pull it out when you have to purchase it?
Thanks!
Everything goes into the investment account once we reach a $1,000 chunk. So far we were successful in paying for unforeseen expenses out of a HELOC and then pay the HELOC back ASAP with our regular savings. So we never even had to dig into savings and sell securities.
Thanks for stopping by!
Cheers,
ERN
I agree so much that not having an emergency fund is like not having insurance. I also think not striving to reach FI is not having insurance. If I had to bet, I’m pretty sure if I work 40+ years, I will be fired at least once in those 40+ years (can’t control when economic busts happen). I want to be hedged and have the optionality to not be stressed out when that happens. Do the things I can control now so that when uncontrollable things happen, I will sleep soundly!
“I agree so much that not having an emergency fund is like not having insurance. I also think not striving to reach FI is not having insurance.”
I would argue that not having SAVINGS is like not having insurance. I just don’t think that designated emergency funds in a money market account are a good way to save/invest.
Thanks for stopping by!
Cheers,
ERN
“Something breaking down is not an emergency. Something breaking down earlier than expected is an emergency.” I love this comment. Everyone knows that they will eventually need new tires, a new roof,a new car, get sick etc. It’s just a timing game. Save now so you have the money when the situation actually happens, or wait and have the situation happen and add more stress to it by not having the money. It’s personal preference/behavior/denial etc.
Yup completely agree. Glad you enjoyed our post!
Cheers!
Really enjoyed reading this post. You raised many good points. I agree, having an insurance isn’t the same as having an emergency fund.
Thanks Tawcan! Glad you enjoyed it!
Cheers,
ERN
I follow Betterment’s approach by putting my emergency fund in Wellesley Income Fund. It has been working out for me. Yes, it is for truly emergency events; and no, replacing tires in the car, fixing AC are not ’emergency’ enough for me to put that withdraw from my e-fund. Because of that, my e-fund money will work instead of sit idly. And I assume that this e-fund will grow over the year, keeping up and beyond the inflation rate.
Posting this on reddit would result in downvotes since “e-fund must be super liquid and non-volatile.”
Cool, thanks for sharing. I like the idea of roughly 36% stocks, 64% bonds. Lower risk, but without giving away growth potential.
Cheers!
ERN
You make a great argument for holding no emergency fund. We don’t hold any since our jobs are very secured and even if we were to lose our jobs our essential expenses are very low. We also have a 65% savings rate so we can do great even with one of us employed.
We did end up with a lot of cash in CDs because we were planning to buy a condo in the Dom. Rep. this year but decided to hold off on purchasing anything until a year after early retirement. We’re deploying the CD accounts into bonds and equities as they mature.
Why tight ourselves to a living place without experiencing the world? So we’re keeping our options open. Currently, we just leave enough money in our checking account to pay the bills comfortably.
I’m enjoying all of your posts. Great work!
Thanks a lot! That means the world to us! Yeah, we seem to be in the same boat: Not much need for an EF if we save so much. My situation is slightly different, though, because I work in a sector where jobs are not that safe. But if I were to get hit by a layoff, we’d still get by and just retire now instead of 2018.
Cheers!
ERN
ERN, I agree with most of your points but curious where does one store money to buy assets at a fire sale. Eg: if you want to buy Real estate during the next crash, do you still recommend plowing it in the stock markets or better keep that in cash or bonds? I agree with your point on inflation eating it away while waiting for a long/unknown period for the next crash. Any thoughts?
I like investing in real estate but prefer to let the pros take over the task of finding good deals. So, I invest in private equity funds.
I also like doing a short put strategy (https://earlyretirementnow.com/2016/10/05/passive-income-through-option-writing-part-2/) that will do well in a sideways moving equity market.
I prefer to not have too much cash floating around. I agree that the cost is that I won’t have the cash when the next big opportunity arises. But depending on how long it takes until the next opportunity arises it may not be worth the opportunity cost.
Cheers!
Would be interesting to read your thoughts on private equity real estate funds and how do you select. I looked at some deals on Realtyshares. At the valuations they are expecting the property to sell I would be surprised if they can recoup the investment on some deals I checked and also did a CMA.
I will write more about my adventures into the real estate world once I have some more concrete return data. That will probably take 6-12 more months. Stay tuned!
Cheers,
ERN
Very good article. I’m wondering though, how to approach this topic, if you’re not a home owner and thus can’t use a HELOC.
If you don’t have access to a HELOC and have only very rare emergencies (1/10th of the time), probably even a credit card is still better than having low-yielding asset sitting around all the time. See here.
Cheers!
There is also an opportunity cost to using cash itself, to pay for expenses directly. Ideally, one should use a credit card that has rewards points or cash-back, for any and all expenses. That way, every dollar spent earns back some of the cost drag of even a few thousand in cash sitting in a checking account following a paycheck. To optimally utilize this trick, paychecks should first be allocated to investments in Month 1, with all expenses possible being applied to rewards cards. Then in month 2, the bill comes due and it is paid directly from a pacheck (rather than going to an investment account). This strategy puts your cash into use in investments first, credit card bill second, and should leave you with only small remainders sitting in the checking account. The net result is more time in the market, maximum credit float, AND 2-3% earned back from every expense. A 2-3% return on SPENDING can then go towards further investments, or take the place of future cash flows.
Yup, good point! We are also trying to hack credit card points and credit card float to the max! Thanks for sharing!
Behavioral aspects are important even if they don’t make sense. The Ormans and Ramsays of the world make their living treating poor budgeting like an addiction. An E-Fund, however small, is supposedly the first step in breaking a bad credit card habit. I started out being bad at budgeting, but I was saving a little bit. Over two years of building good habits I went from half my net worth in cash to keeping just 30 days expenses in cash. I used to save up for those predictable maintenance issues until I realized keeping those funds invested until I actually needed them was essentially the same thing. My FI goal includes these expenses to ensure the money will exist in retirement even if it’s not in cash right now. My salaried job keeps my paycheck predictable so that with a 60% savings rate there is no such thing as an emergency that can’t be overcome in a month. I imagine people with more variable incomes, job stability, or large debts are less confident with their budgetary projections.
I find that behavioral biases can also be a reason to invest the EF in stocks. For folks with budgeting problems it might be a lot harder to liquidate a stock portfolio to waste money on discretionary spending than an EF in a money market account.
Thanks for stopping by!
I got one to chew on for you to debunk:
There is opportunity cost in not having the most efficient asset allocation, and there is a time cost associated with making sure you stay exactly on the optimal point all the time. 10k might be 3-6months of expenses for many people, which would maybe earn 600 a year. Also selling some stock could incur costs (broker, taxes,…) that could change the game. Yes, you should lean towards a smaller e-fund, 8 months are most likely too much. Also, I think you should calculate your living costs for the emergency period differently: e. G. you won’t need a new tv while recovering from an emergency, even if you are a person that regular hosts communal moviesession and get a lot of value from having the latest TV.
Note that I’m a German, so taxes and fees are Different here, also I haven’t seen any credit cards with relevant cashback. I do have an irregular income (freelance) and want to make sure all expenses get paid for even if I don’t rebalance every month. I don’t do budgets but just think hard before spending – and I make good money when I work, so I feel like reducing cash to 0 is isn’t worth the effort for me. Your posts still have compelled me to shout “get to work” to the money excess in my cash account!