Recently, Ben @ Money Smart Life ran a series of posts on “Can You Save Too Much In An Emergency Fund“. The purpose of the series was to answer this question posed by a reader:
â€œIs there such thing as saving too much money in an emergency fund? Whatâ€™s the best place to keep the money you do save so it still earns you something while just sitting there?â€
I contributed a quick response to the question and it looked like this:
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:
- It should easily available in an emergency (must be liquid and easily accessible through common instruments like cash or checks).
- There should be a sufficient margin of safety built into it (a part of my answer to the question lies here).
- 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 lose a job (unexpectedly), or if the stock market crashes and you lose 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 (update: “end of the world” is not a valid scenario). 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 such park 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.
Do you think it’s an overly conservative approach towards emergency funds? What would have been your response to the question? I encourage you to visit this post @ Money Smart Life to leave a comment on the issue.
I thought a bit more on this issue after leaving my response and came up with some additional stuff.
Technically, with increasing emergency funds, you are opting for greater security and lesser returns - sometimes this makes me think that there really isn’t any “too much” when saving for emergency funds; what you lose in returns you will gain in stability/assurance/security. I sketched a quick schematic to illustrate my point:
Note that the term “Increasing Returns” in the above graph is only valid under the following assumptions:
- Emergency fund is assumed to be highly liquid with low returns.
- If you choose to keep a small emergency fund, you are diverting a large portion of your money into high yield investments.
- If you choose to keep a large emergency fund, you are diverting a smaller portion of your money towards high yield investments.
Hope that makes sense.
Another thought is that I don’t consider insurance as an *emergency* fund..however, some people tend to think that way. Insurance is very situation specific (it’s not economically feasible to insure every aspect of your life) and there can be incredible procedural delays in getting your money through a claim. In fact - like I said before - your emergency fund should fill in that gap caused due to a procedural delay (and/or eventual dismissal) of your insurance claims.
I have some more observations on this issue, but I don’t want to clutter the post with too many lines of thoughts, so everything else will have to wait.