Can You Be Too Conservative with Your Emergency Fund?

April 24, 2007

MoneyquestionSeveral personal finance sites are teaming up this week to take on the topic of the emergency fund. We’re answering a reader’s question as to whether you can save too much money in an emergency fund; along with a follow up question of what’s the best place to keep the money in your emergency fund?

Yesterday, Binary Dollar discussed how most people don’t have to worry about saving too much because they don’t save enough and Lazy Man made a suggestion about how those more comfortable with risk could use a home equity line of credit for their emergency fund.

Can you be too conservative with your emergency fund? Trent from The Simple Dollar stopped by yesterday’s emergency fund answers and commented that his goal is to have 18 months worth of cash built up. As you’ll read below the Silicon Valley Blogger thinks 6 – 9 months reserve is enough, while Golbguru is a fellow believer in stashing away more cash.

Golbguru @ Money, Matter, and More Musings
Let me start with the basic idea of an “emergency fund”. According to my definition of the concept, it’s a pool of money to account for *unexpected* circumstances and *must* adhere to the following three requirements:

1. It should easily available in an emergency (must be liquid and easily accessible through common instruments like cash or checks).
2. There should be a sufficient margin of safety built into it (a part of my answer to the question lies here)
3. It should be held as risk free as possible (you don’t want a devalued pool of investments right at the time of an emergency)

So is there such a thing as too much emergency fund?
I look at emergency funds as a sort of foolproof “hedge” against unforeseen circumstances. For example, it is like a cushion to break your fall and allow your survival if you loose a job (unexpectedly), or if the stock market crashes and you lost a major chunk of your net worth, your house catches fire and your insurance company messes with you and delays payments….things like that. Agreed that these things don’t happen on a regular basis…but they need to happen only once in your lifetime to make you realize the importance of a cushion.

So ideally, your emergency fund should be able to cushion the worst possible scenario (specific to your personal situation) that you can imagine. Add a 20% margin of error to that estimate (roughly) and aim for that emergency amount. The right amount will be something that makes you feel “safe” after considering the worst case scenario. More than that is probably “too much”. Of course, the measure of “too much” will vary greatly depending on your lifestyle.

Where to park the money for maximum returns?
Since I view emergency funds as ‘hedge’ ..returns on these funds are not a major concern. I would first satisfy the above three requirements and then maximize my returns from the available choices. Online savings accounts with ATM and/or check facilities are one of the potential places to park such funds.

If you park your funds in such a place where the funds are not easily accessible, make sure you have an instrument of equivalent value available for use (for example, you could use a credit card at the time of an emergency…and then repay it as soon as you get your funds at a later time).

I understand that I have a more conservative (almost a bit paranoid) approach towards this issue. However, due to the “unforeseen” nature of emergencies, it does merit some consideration.

Silicon Valley Blogger @ The Digerati Life
By conventional wisdom, your emergency fund is parked in a conservative spot. Given that, I would search far and wide for the best returning conservative financial vehicle for this money that should also be fairly liquid so that it is ready to use if needed. Hence, a money market fund that has a good return after tax and fees can be selected. You can do some comparisons among various fund families to find such a MMF.

Yes, there is such a thing as saving too much in the fund. There is also conventional wisdom in this regard that tells you to save 6 months worth of living expenses in your emergency fund. My particular recommendation is to save within 3 to 9 months’ worth depending on your comfort level and ability to save. The more conservative you are, the higher you hike this amount (perhaps even higher than what has been suggested). But consider that you may be sacrificing investment opportunities by keeping too much in your emergency fund. Once this is used, however, you will need to build this back as soon as you are able as you don’t want to get caught without a fund to cover you.

One day, I’ll go into specifics as to how I have built my emergency fund. I have done it as part of an overall investment strategy involving recognizing my particular risk profile so it may be a bit more involved to discuss here.

Emergency Fund Options
Stop by tomorrow to read several different options from the Sun on how you can keep your emergency fund liquid but still earn some interest income on your wad of cash.

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Ben

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Ben
Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn't like the other kids... His addiction to personal finance has paid off for his family and now he's helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.

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5 Responses to Can You Be Too Conservative with Your Emergency Fund?

  • The Trader

    Another consideration when deteminining your goal balance for an emergency fund should be how much your passive income can help cover your expenses. If your investments can kick in $1,000- a month, that’s another $6,000 you don’t actually need saved in advance, assuming you are going for the 6 months worth of living expenses rule.
    Also worth considering is if you’ll be able to lower your expenses when unemployed, such as less dry cleaning or only part-time day care if you have kids, less money spent on commuting, etc.

Trackbacks/Pingbacks

  • Friday Finance Findings for April 27th : Generation X Finance
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  • Where I Put Our Emergency Money | The Sun’s Financial Diary | A Personal Finance Blog on Saving and Investing
  • Money Smart Life » Emergency Fund Investment Options

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