Turbocharging your emergency fund
When circumstances change, we must change with them.
A traditional emergency fund is enough cash to survive for three to six months. Being very risk-averse, in The Poor Man’s Guide to Financial Freedom I recommend holding enough cash to get you by for six to twelve months.
However, I’ve noticed that some in the ‘sphere are concerned about cancellation, rolling lockdowns, vaccine mandates and whatever may hit us next. They are saving for an emergency much greater than being downsized and spending a year or so out of work.
They want a fund sufficient to last several years – enough to get them established somewhere else, perhaps overseas, with a new career and a new life.
This is fair enough. I had the same idea and ended up having sufficient resources to survive two years (and counting) out of work during the Great Coof.
Missteps and tradeoffs
We need to think through the best way to set it up. I’ve seen some errors:
- Putting it all in cash. At today’s interest rates, you’ll get murdered by inflation.
- Putting it in some sort of retirement account that is expensive or impossible to access before you reach retirement age.
- Putting it in cryptocurrencies that may crater in fiat value right when you need it.
- Putting it all in an index fund. Not as risky as crypto – you won’t lose it all – but there’s a possibility that the market will crash right when you need to withdraw, thus realizing a nasty loss. Keep in mind that recessions and job losses are highly correlated.
- Putting all one’s savings (not just the emergency fund) in a safe habour like bonds, thus missing out on long-term stock market growth and spending much longer in a state of dependence upon your present income.
There are probably more missteps that I haven’t heard of.
To some extent, financial independence and an Apocalyptic Emergency Fund must conflict. The more you set aside for a rainy day, the less long-term investments you’ll have for reaching independence.
I’ve given some thought as to how to manage these competing priorities and this is what I’ve come up with. Note: everything I’ve written thus far about finance is bog-standard stuff that you can figure out for yourself by reading widely from the best sources. In this post, however, I’m coming up with an original strategy. As I’m not a financial advisor you should do your own research, get personalized advice etc.
The bucket retirement strategy
When considering an Apocalyptic Emergency Fund (AEF), we should take our ideas from retirement strategies that aim to limit risk. After all, being cancelled will be like a mini-retirement until you get back on your feet.
Unlike wealth-building strategies, which are all about the same (avoid debt, save, invest in index funds etc.), there are various retirement strategies that can work equally well if done properly.
I know much less about these than I do about the basics of wealth creation. However, I personally like the Bucket Strategy: keep your money in three buckets, cash, bonds and shares. Cash is for everyday expenses, bonds are for the next few years and shares are for the more distant future.
There are different ways of managing this approach, but I like the idea of drawing from the cash and bond buckets during market downturns and using shares to live off and refill the other buckets during the good times. Thus the retiree should always have enough money for daily expenses while also enjoying the benefits of long-term growth, which is important as you may be retired for decades.
Adapting the strategy
I reckon a younger investor worried about cancellation or whatever can adapt the Bucket Strategy to form an Apocalyptic Emergency Fund. How to do so will depend on where he is in life. The further along you are, the more generous your AEF can be without compromising long-term objectives.
In my book I suggest keeping the whole emergency fund in cash. However, (a) interest rates are extremely low right now and (b) the Apocalyptic Emergency Fund will be too large to keep entirely in cash at any time. Therefore I suggest that emergency funds be kept in a combination of cash and bonds, like so:
|100,000||6 months||3-6 months|
|300,000||6 months||1-2 years|
|500,000||6 months||3-4 years|
|700,000+||6 months||5-8 years|
Things to note about this table:
- If your savings are below 100,000 then you need to be focusing on building long-term wealth through index funds or equivalent. The turbocharged emergency fund will have to wait.
- By the time savings are over 500K, your emergency fund is basically the same as the Bucket Strategy for retirement.
- Don’t put these bonds in a retirement fund as getting it out can incur a penalty or may be impossible, depending on where you are and what kind of fund you have. Emergency funds must be accessible. I suggest a Vanguard diversified bond index fund.
- Don’t put these bonds in a ‘balanced’ or ‘diversified’ index fund where they are combined with shares as you can’t withdraw just the bonds while leaving the shares intact. You’ll need a dedicated bond index fund.
- The suggested amounts to hold here in cash and bonds are far lower than are normally suggested for retirees. This is because (a) you are assuming that you can eventually establish a new income some time after the shit hits the fan, and (b) even in retirement I think this approach is mathematically sound given current returns, but that’s a complex issue I may address in a future post. For now, just be aware that this table might give reputable advisors a heart attack.
- Everybody’s ‘1 year’ living expenses will be different. Mine is USD $15,000 because I can live comfortably on that in the back blocks of Asia.
- There’s no magic pudding. If you want more security, it can only come by lowering (likely) overall growth in the long term. If you want more growth, put up with less security. Modify these buckets as you please but whatever you do, there will be a cost.
Variation of the strategy
Instead of aiming for these amounts, a simpler way of achieving the same purpose might be: Hold 10% bonds from ages 20 – 40.
Previously I would have only recommended bonds for young people if they were complete bedwetters who couldn’t psychologically deal with full-on exposure to stock market volatility.
However, I now see a good reason to hold some bonds at any age: as an extended emergency fund.
Ten percent in bonds won’t hurt your returns very much over the long run so don’t get your knickers in a knot about it. Twenty percent will start to have an impact. Five percent probably won’t be enough to act as a buffer.
I suppose every man must consider his own circumstances and risk tolerance. A bloke in a highly cancellable or lockdownable line of work might opt for 15% in bonds just in case. Another fellow unconcerned with these risks might opt to stick with 6 months living expenses in cash and not worry about holding bonds until he’s older.
If you’re out of work and stock market returns are good, resist the temptation to withdraw emergency living expenses from stocks. Take it from cash, then bonds. You need to leave shares untouched over the long run for compounding to do its work. Chopping off the top after periods of growth messes it up.
If you were retired it would be different, but you’re not. It’s an emergency so use the emergency fund.
If you exhaust your cash and bonds, I suppose you’ll have to move on to cannibalising your shares. Bloke’s gotta eat.
Instead of having a flat, minimal emergency fund throughout your life, you could expand it into bonds over your lifetime so that an Apocalyptic Emergency Fund will eventually evolve into the Bucket Strategy for retirement, or leave you with enough to segue into another retirement strategy.
This may help to even out the risk of cancellation, lockdown or whatever other craziness may occur over your lifetime.
This is a new idea and I welcome feedback. I’m thinking aloud.