TodayForward

Why $1,000 to $1,500 Works for a Baby Emergency Fund

The idea of the baby emergency fund has been around for a long time, but it has hit the mainstream thanks to Dave Ramsey.  The reason $1,000 to $1,500 works so well as an emergency fund is (1) it can be saved quickly and (2) it covers most minor emergencies that come up.  Obviously we'd all like to have much larger cash balances sitting on the sidelines when an emergency strikes, but a baby emergency fund is good enough to get you through most of life's trouble spots.

Covering the Small Stuff

Most of us will have auto insurance deductibles under the $1,500 threshold, most appliances cost less than this amount, and all but a few auto repairs will fit in this range.  In short, most of the small stuff can be handled with a small emergency fund.  Larger emergencies like a loss of income, major health expenses, and the like will be outside of the scope of this small amount of reserves, but fortunately these types of emergencies happen less often than their smaller cousins.

Finding the Money

The quickest ways to come up with the money for a baby emergency fund is by (1) selling some stuff, (2) cutting savings, or (3) cutting expenses.  Sometimes the best thing to do is clean out your home, sell what you can, and donate the rest.  You'll make a few dollars on what you can get rid of, get a tax deduction for what doesn't sell, and have a less cluttered home.

If you're not into garage sales or ebay, cut your savings or one or more expenses to free up some cash to fund your baby emergency fund.  Sometimes it's as simple as reducing your savings or expenses for a short time until you have your $1,500.  If you're cutting expenses, take a good look at what you're spending and start cutting where it hurts the least.  Most of us will find a hundred dollars or more each month in pure wasted expenses so you probably won't need to look very far.

Stashing the Cash

Once you have your money, it's your call on how you'd like to stash your cash.  Some of the more creative ideas involve making origami out of 10 or 15 hundred dollar bills or framing the Benjamins with a 'break glass in case of emergency' sign, but you can also keep it under the mattress or in a savings account.  The key to stashing your emergency fund is to put it someplace where you won't be tempted to spend it on something that isn't of an 'urgent and important' nature.

*GASP* Emergencies Happen

Once you have your money set aside, an emergency will happen.  When it does, take it in stride and understand that since you have a small amount of money in reserve, you may have to drain and refill this fund several times until you can get in better shape financially.  You should not get discouraged just because you have to keep dipping into your emergency fund from time to time.  After all, this is the purpose of an emergency fund, right?

Wrapping Up

Though a large, healthy, maybe even fat, emergency fund is always preferred to a small, baby one, the bottom line is that having at least this $1,000 to $1,500 will keep you from being crippled by the smaller emergencies in life.  A baby emergency fund is a starting point in securing your financial life and is an absolute necessity.  The alternatives when this cash isn't available aren't pretty, so sell some stuff, reduce savings, or cut expenses until you have your baby e-fund.

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The Dow is Down More than 1,200 Points in Less than a Month - Are You Taking It in Stride?

The Dow Jones Industrial Average is down more than 1,200 points since its intraday peak on April 26th, and an appropriate question is whether you're taking it in stride or if the temptation to push the panic button is creeping into your mind.  When the market sinks more than 10%, Wall Street calls it a 'correction', and now we officially have one.  While the causes of this recent decline vary based on whom you ask, we find the entire discussion irrelevant.  Here's why:

Oracles, Seers, and Fortune Tellers

The fact remains that no one can accurately predict the movements of the market.  As we have explained previously, until you can explain the decisions of the billions of global market participants, you simply cannot know what will happen in the future.  Thus, oracles, seers, and fortune tellers that go by the titles of Chief Investment Strategist, Lead Economist, Hedge Fund Manager, and the like are no better able to assess what's coming next.

If the Future is Uncertain...

Accepting this fact, it is pretty simple to know what to do, and the answer isn't 'do nothing'.  Whenever the stock market takes a tumble, it is a good time to assess where you are with your portfolio, and what we mean by this is to consider not just how your assets are allocated, but where you are with your job, insurance coverages, emergency fund, and so on.  The reason for this is your investments - even long term investments for retirement - don't live inside of a vacuum.  They are an important part of your overall financial health.

Wide Lens Investment Management

To better weather a storm in the stock market, you need to review and ensure that you are covering all of your bases with particular attention paid to job security, insurance coverages, emergency reserves, and your ability to tolerate risk.  This is what we like to call 'Wide Lens Investment Management' because instead of taking the narrow view and only examining an investment portfolio, this method incorporates other important factors that can affect your investments.

T. Rowe Price has the slogan of 'Invest with Confidence'.  We like to think that confidence is a byproduct of knowing you have a secure job, appropriate insurance, and sufficient cash for an emergency because you can be as confident in your portfolio as you'd like, but that won't help if you're exposed in other areas of your finances.  It's nice to have a well put together portfolio, but many other issues must be addressed first.

How We Do It

On our site, we help you put together an asset allocation model, just like many other investment sites, but we do it with a wide lens.  We require you to complete an emergency fund plan first so we can better understand your cash position and ability to handle a job loss or short-term disability.  Once that is complete, you can then put together a retirement investment plan that will provide you with an asset allocation model.

Again, we use a wide lens because we don't just take into account your time horizon and risk tolerance, but we also assess your ability to withstand a major financial emergency and put that in view with the market's current valuation relative to long-term averages.  If you're light on your emergency fund, we'll suggest you hold cash in your retirement portfolio to cover the difference.  When the market looks expensive (as it has for some time now), we dial down exposure to stocks.  

The goal of our software is to deliver an asset allocation that is appropriate in light of your entire financial picture and to help smooth out some of the bumps along the way.  We don't worry about returns because returns are a function of your risk tolerance (never the other way around).  If you can 'Invest with Confidence', we're betting that your returns will be more than sufficient and you won't have quite the stomach ache when times are tough - like today.

If you would like to get a wide lens view of your portfolio, feel free to setup an account with us at TodayForward.  It's free for now, as we're still in our second round of testing.

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Types of Financial Emergencies

Financial emergencies can come in many shapes and sizes.  From the small, unexpected car repair to the life altering permanence of long-term disability.  In this post, we'll share with you the various types of emergencies to help you get a better idea of how much you should keep in cash reserves.

Minor, Everyday - Under $1,000

This type of emergency happens all the time.  In any given year, they could crop up several times with the most common manifestations being car repairs, replacement of appliances, minor illnesses, short periods of lost work hours, and unexpected cost overruns, among others.  Because these things happen so regularly, it's important to set aside at least $1,000 in your cash reserves and have what Dave Ramsey refers to as a 'Baby Emergency Fund'.

Mid-Sized, Relatively Common - $1,000 to $5,000

This next category inflicts a little more financial pain as a result of more serious issues.  This can include automobile accidents that require payment of a deductible, a more significant medical or health insurance bill, a simultaneous piling up of everyday emergencies, and others.  Generally, these will range from $1,000 to $5,000, and have the potential to cause some financial ripples.  Since these are relatively common (usually once every year or two), holding around $5,000 would provide a nice buffer, and if you have a high deductible health insurance plan, it's almost a necessity.

Major, Not Uncommon - $5,000 to $10,000

Next we get into major issues that traditionally take the form of major medical problems, a fire, flood, or other property loss requiring a large deductible payment, substantial loss in income, etc.  In these cases up to $10,000 may be required to set things right, and it takes a fair amount of time to recover from the emergency.  If you make $50,000 annually, this represents up to 20% of your pre-tax income or 25% of your after-tax income, and with the average savings rate around 5%, it could take a few years to get back to even.

Mega, Relatively Rare - $10,000 and Up

Extended periods of unemployment, major medical, disability, fire, flood, theft, or other un- or under-insured event, losing a lawsuit, and many other problems can wreak havoc on your finances.  Typically, when a mega-emergency comes up, it will be the result of lost income, inadequate insurance, or both.  While you can insure against many of the common causes of mega-emergencies, unemployment is a different story.  A sharp downturn in the economy (as we're experiencing now) can cause widespread, indiscriminate unemployment.  Regardless of the cause, this type of emergency invariably creates a great deal of financial pain and can lead to bankruptcy.

Wrapping Up

The majority of emergencies fall in the first two categories and won't kill your finances.  However, if you fail to adequately plan for these, you can fall into a constant cycle of digging out from relatively small emergencies - leaving you more vulnerable to bigger problems.  In addition, having suitable insurance policies in place is critical in averting mega-emergencies.  The right policies for you will be based on the annual premiums and the required deductible in the event of a loss.

While you can set aside a fair amount of cash and obtain the right insurance coverages, you'll always be vulnerable to unemployment (or for the self-employed, serious declines in income).  Keeping your skills sharp can help, but the risk isn't insurable.  As a result, the number one item to consider in how much to keep in your emergency fund is your risk of un- or under-employment.

To put this more simply, the amount you keep in your emergency fund should be the greater of mid-sized emergency costs or the amount of lost income from a stint of un- or under-employment.

Critical Thinking

• An emergency fund is the same as running your own insurance plan and is also known as self-insurance.  If selling, general, and administrative expenses are lower for an individual than an insurance company, why wouldn't more people self-insure?
• Insurance is available for many 'small emergencies' including extended warranties on appliances, automobiles, and other bigger ticket items.  Knowing that selling, general, and administrative expenses are lower for you than the company offering the warranty, is it smarter to self-insure or buy the warranty?
• If most mega-emergencies are caused by inadequate insurance and unemployment, does that mean that to truly be financially secure, you must carry both the right insurance and a healthy stash in cash reserves?  Could you get by with one and not the other?  Which would you rather have - insurance or cash?

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Why Murphy's Law Holds True - Emergency Fund Probability of Use Chart

Murphy's Law has many variations, but as Dave Ramsey likes to put it, "If you don't have an emergency fund, you're inviting Murphy to come in."  What he's referring to is Murphy's Law that simply states if something can go wrong, it will.  While we would all agree that we need an emergency fund, that doesn't necessarily mean that we all have one or that it is sufficient to cover life's emergencies - thus, Murphy and Dave are 100% right.

About the Chart

Since most of us are visual learners, we thought it a good idea to create a simple graph that shows what the probability of using an emergency fund would be.  In the graph above, we've illustrated this by showing the value of an individual's emergency fund expressed in the number of weeks worth of expenses and the percentage likelihood of having an emergency fund that would wipe it out.  It starts at 100% with no emergency fund and works down to about 3% at 52 weeks worth of expenses in reserve.

Interpreting the Chart

Another way, perhaps a better way, to think of this is that if you don't have an emergency fund, you are guaranteed to have an emergency come up.  However, if you have a full year's worth of expenses set aside, only once every 33 years would an emergency come up that would wipe out these reserves.  Thinking in this way is very helpful because understanding the probability of needing an emergency fund and of what size can be a big assist when it comes to ranking the need to set money aside for an emergency versus putting money towards other savings goals.

Finding the Sweet Spot

We all have limited resources and unlimited wants and because of this, the central question in personal finance is always applicable:  How should resources be allocated among competing needs and wants?  In looking at this chart, it's obvious that an emergency fund is necessary, but how much?  That depends on you, but here are some numbers to consider:

• 0 weeks = 100%, guaranteed to have problems
• 4 weeks or 1 month = 70% or every 17 months
• 8 weeks or 2 months = 49% or every 2 years
• 13 weeks or 3 months = 31% or every 3 years
• 26 weeks or 6 months = 10% or every 10 years
• 52 weeks or 1 year = 3% or every 33 years

Given these numbers, it becomes a little easier to determine how much you should set aside and where this need would rank against others.  In deciding where to put your money, there is a point that you reach where the probability of a cash killing emergency is low enough that you feel comfortable putting money into longer term goals like retirement.  This is different for everyone, as it's a question of peace of mind and individual circumstances, but for many, it will be between three and six months' worth of expenses.  For very conservative folks, it could be a year or more; for aggressive people, maybe as little as a month's worth of expenses will do.

Why Murphy's Law Holds True

Regardless of where your comfort zone is, the reason Murphy's Law hold true is because most of us live paycheck to paycheck with little money in cash reserves.  On the sample chart we've created, the majority of us would fall in the range of zero to eight weeks of emergency cash.  As a result, emergencies come up frequently, and this often leads to additional debt.  In short, without sufficient cash reserves, when things can go wrong, they will.

Critical Thinking

• How do you think comfort levels change over time?  How would your perception change from the time of being young and single to getting married and having young children to approaching retirement with an empty nest?  What steps should you take to prepare for these life stages?
• Unemployment rates typically rise as we age.  How does that impact the frequency and severity of emergencies?  What actions should you take to address this fact?
• If you have too little cash set aside and have to go into debt to finance an emergency, what are the long term costs associated with this?  Does it make emergencies more or less likely in the future?
• If you have too much cash set aside, what are the quiet costs that you must pay?  How much in the way of investment returns are you giving up by holding too much cash?  Is your added peace of mind worth the extra cost?

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Add to Emergency Fund or Contribute to a Roth IRA

Everyone has limited resources and unlimited wants, and one of the most common questions is whether to add to an emergency fund or contribute to a Roth IRA.  While the answer varies from person to person, for most people, contributing to a Roth IRA is usually the better move.  The reason for this has everything to do with the nature of the Roth IRA.

Contributions are Tax and Penalty Free

With a Roth IRA, your contributions can be withdrawn tax and penalty free.  When the Roth was created in 1998, legislators wanted to be sure greater flexibility was afforded to Americans in an effort to increase retirement readiness.  The result was a retirement account that included liquidity features that were far better than its predecessor, the Traditional IRA.

Cash is King

Though you might think of a Roth IRA as an investment, it's really just a type of account.  What you hold in this account is up to you.  If you are short on your emergency fund and retirement savings, the best bet is to contribute to a Roth IRA, but keep the money in cash.  The reason for this is when an emergency comes up, you won't have to take money out when the market is down (more emergencies come up when the market is down than when it is up).

Preserving Tax Benefits

Investing in cash isn't exciting and it likely won't take you much closer to your retirement goals.  However, it does preserve your tax break.  Roth IRA withdrawals are completely tax free during retirement, and even if you don't invest it in higher yielding assets like stocks or bonds, the tax break will be preserved.  As your financial situation improves and your emergency fund grows, you can start investing more aggressively.

Application:  Roth IRA in Cash

Let's say that Jane needs an emergency fund of $15,000, but currently has $3,000 set aside.  She can save up to $300 per month and decides to put this money into a Roth IRA.  After three years, an emergency comes up and she needs to pull out $5,000.  She can do so without penalty or taxes from the Roth IRA whose balance is just north of $10,800.  She takes $5,000 out, no penalty or taxes are paid, and the emergency is taken care of.

Application:  Roth IRA in Stocks

Wild Bill loves playing the stock market.  He, just like Jane, needs $15,000 set aside, has $3,000 in reserve, and can save $300 per month.  He too decides to contribute $300 per month to a Roth IRA over a three year period, but he will invest it in stock.  Over the three year period, Wild Bill contributed the same amount as Jane, $10,800, to his Roth IRA, but because the market declined, his balance was $5,800 when an emergency came up.  His $5,000 withdrawal to take care of the emergency left him with a balance of just $800 compared to Jane at $5,800.

Wrapping Up

In answering this question of putting money into an emergency fund or a Roth IRA, the Roth is the better option.  It offers tax and penalty free withdrawals of contributions, can be invested in cash, and preserves a major tax advantage to make retiring easier.  The big caveat, however, is that if you're short on an emergency fund and retirement savings, choose cash instead of the markets.  Only after your cash reserves balance has grown to a sufficient level should these funds be invested in more volatile assets.

Critical Thinking

• Investing in cash is certainly better for protecting against an emergency, but the market is usually up more often than not.  Why should cash be held over a stock portfolio in these examples?
• If Jane and Wild Bill had $10,000 instead of $3,000 in their emergency fund, should they take money from their reserves and put them into a Roth IRA or leave the money where it is?
• Once Jane and Wild Bill have reached their emergency fund goal of $15,000 through the Roth IRA, is it safe to invest the entire amount in a portfolio of stocks and bonds?  If not, how much should be put into the markets?

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