Are You Prepared for a Financial Emergency?
One of the core principals of personal finance is to establish and maintain an emergency fund. This week I want to discuss this in more detail.
According to the most recent data from the Federal Reserve, the median bank account balance for American households is $5,300. Bank account balances in this analysis include checking, savings, and money market accounts.
As a brief digression, the median value is different from the average, because the average can be skewed by extreme values. For example, the average net worth of you, me, and Bill Gates is over a billion dollars. But I am not a billionaire, and probably neither are you. In this case, median is a more representative measure, because it means the middle value.
What that means is that half of American households have bank account balances under $5,300. According to the U.S. Bureau of Labor Statistics, the average household budget is $63,036 per year. That means half of all American household have only about a month of cushion in case of emergency. (I couldn’t find a median number for this category.)
The COVID-19 pandemic that resulted in widespread lockdowns last year showed just how quickly a situation can change. The U.S. government stepped in because it financially affected so many people, but you can’t count on that. If you lose your job, you have to be able to count on yourself.
The good news is that financially speaking, you probably aren’t an average American. You are reading this article to gain financial insights that will put you ahead of the average American.
I will add a caveat that I advise people to pay off high-interest debt early on in their financial plan. The emergency fund is really the top priority, but if you are paying 15% interest on a credit card balance, it can be really hard to find the extra money to establish that emergency fund. So, as a compromise maybe you can establish a short-term emergency fund, and as you eliminate the high-interest debt, you can add to it.
How much should you set aside? This partially depends on the nature of your job. If you work in a field where there are numerous jobs to be found at or above your current salary, you can probably get away with a 3-month emergency fund. That means a fund that will cover three months of your household expenses in case of emergency.
If you have an average household budget, that means you need to have about $15,000 set aside.
A more conservative approach — and one that is much safer if you have a job that may be more difficult to replace — is to have six months of expenses set aside. That means about $30,000 for the average American household budget.
Liquidity Is the Key
As you establish this fund, it needs to be readily accessible. That means it needs to be in a cash account. I know it can be extremely difficult to watch this money earn nearly zero interest in the current economic climate, but under no circumstances should you invest this emergency fund into stocks.
There have been plenty of times that the stock market has corrected by 30% or more, and that usually happens during economic crisis. As the lockdowns spread last year and people started losing their jobs, the S&P 500 fell by 32%. Thus, if you had your emergency fund in stocks, you could have found that your 3-month fund was suddenly just a 2-month fund just as you lost your job.
Keep the money in a cash account so it’s there when you need it. It’s for emergencies. It’s an insurance policy. Don’t dip into it for vacations or for non-emergencies. If you have the ability to grow an emergency fund, you have the ability to grow additional savings for investing or non-essential spending.
Where to Park Your Money
The most popular place to park your money is probably in a high-yield bank account. Presently “high-yield” is still only about 0.5% at best, but some banks do offer bonuses for new accounts.
The second recommendation is to place it in a money market account. A money market is similar to a normal savings account, and can be opened at a local bank or brokerage. A money market invests in securities like U.S. Treasury Bills, but there is typically a management fee for the fund that at present reduces the yields down to a paltry 0.01% or so. Thus, you are probably better off with the high-yield bank account.
Certificates of deposit, or CDs, offer a fixed rate of return for tying your money up for a specific time period. But, it’s not as liquid as the previous options because you may have to pay a penalty to close your CD account early to access your funds. Still, it may be worth the risk in this case if you can get a substantially higher interest rate.
For example, interest rates above 1% are available for 5-year CDs. If you don’t have an emergency during that time, you are going to earn more money than in the previous examples. But understand the penalty for early withdrawal. Even if it’s 100% of the interest, the risk is probably worth opting for CDs over money market accounts.
One strategy is to split the emergency fund into CDs of varying maturity dates. This is called “laddering”, and it can help insure that a certain amount of money is always available on short notice.
Once you have mastered the discipline to establish your emergency fund, you will be well-positioned to use that same discipline to start deploying funds into the stock market.
Editor’s Note: You also need to shield your wealth from the economic damage of COVID, especially its Delta variant. The rule of thumb is for a portfolio allocation of 5%-10% in hard assets. Our investment team especially recommends gold, in the form of gold mining stocks, exchange-traded funds (ETFs), or the physical bullion itself, depending on your risk tolerance and profile as an investor. To learn more about hard asset investing, visit this link.