How much of an emergency fund you should have & using planner to determine the amount
Hi,
I read Spend to the End. Watch and read alot of financial planners out there. So, my question is, how much of an emergency fund should you have? There is much disagreement on this out there. Maybe you touched on this in the book in some way & I don't remember it.
Suzie Orman says 8 months, Dave Ramsey says 3 to 6 months depending upon the security of your job/jobs.
I am wondering what Larry says, i.e., what is the economist's way of looking at this and can I use the planner to help me determine what the amount should be?
Any thoughts our suggestions are appreciated. Thanks,
Mary Kay Lofurno
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ESPlanner doesn't manage budgets within a single year--instead, it manages your annual budget across many years. Thus, the question about a emergency fund is not one that ESPlanner really can address. Like so many things you are probably best guided by common sense or your own sense of the security of your job.
You could, however, put in earnings for next year that are say half what you had this year and see what the program does to your consumption number.
Emergency (reserve) funds are dependent on the depth of the emergency and your specific situation. If you're optimistic and highly employable then you're likely to believe that you don't need much of an emergency fund. If you're pessimistic and not particularly employable they you're likely to believe that you need a pretty substantial emergency fund.
To the best of my knowledge there is no single number for a necessary emergency fund although I have frequently heard "6 months" from a variety of sources, none of whom has ever backed this number up with any sort of data or science.
Best,
Dick Munroe
The real sneaky question is - what's the purpose of an emergency fund?
This heavily depends on how rich you are. For example, if your car ran into major mechanical problems tomorrow do you have the cash on hand to fix it? If not then you'll have to hit your credit cards (assuming you have high enough limits) and then if you don't have a way to get the cash reasonably quickly you'll be stuck with incredibly high interest rate charges. There are variants on this question. If you get a major medical expense and you have medical insurance can you clear your deductible? If your roof turns out to have a major leak that causes widespread damage can you cover the cost? Let's say your car has a warranty, do you have enough cash to cover repairs until the warranty pays off? Etc.
The point being that if you hit a financial pothole do you have a big enough shock absorber to see you through without spiraling into an endless mountain of debt?
Having a pretty good financial base I primarily focus our emergency fund planning around employment. I calculate roughly how long I think it would take me to get a new job that I could live with (as opposed to want) and then create an emergency fund large enough to cover my family's expenses for that period of time.
This led, btw, to what I call our 'freedom fund'. It is a sum of money, added to the emergency fund, that equals our expenses for a period of time necessary for me to find a job I really want. Having this money on hand means I can always quit my job if I really hate it. Or, this being a major recession, if I get laid off this money means I don't have to grab the first job I find.
When both my wife and I worked I tended to calculate the emergency fund based on us both not working (the key scenario being that one of us gets hurt and the other has to provide care, we have both short term and long term disability insurance but short term isn't all the much and long term takes a while to kick in). But these days only I work so the math is simpler.
I'm sorry not to be able to give you a simple formula (save X months!) but that's because the formula doesn't exist. As "Spend 'til the end" explains in detail, most interesting financial problems don't have trivial answers.
Still, you could imagine a program like ESPlanner having a module to model various potentialities and to help give a running estimate of the amount of money needed to cover those possibilities. This would be a counter part to the insurance calculator. Think of it as a 'self insurance' calculator.
As you correctly pointed out, there is no simple formula for what amounts to an exercise in behavioral economics, which is what the whole issue of a reserve fund is all about. I'm fortunate in the I've had a good career, came into some money when my father died, and when I went unemployed in 2000, I was down for 5 years. I sent out 5000 resumes, networked like crazy, and got exactly 4 interviews in 5 years. At the time I had over 30 years in the software industry, had developed product for companies in over a dozen different disciplines, had run my own company, had managed projects, done architectural work, but really, really just wanted to grind code and develop product and I flat out couldn't get a job. No amount of prognostication on my part would have ever have led me to believe that I wouldn't be able to find a job anywhere in the US with my level of skills. If I hadn't had a good career and the "luck" of having an additional nest egg left me by my father I and my family would have been out on the streets long before I got connected with ESPlanner and started earning again.
This personal story is by way of illustrating that you actually cannot plan for everything and that even if you're careful and lucky basically you have to accept that there are always outlier conditions that flat out cannot be planned for. I suppose you can buy employment insurance out there but for how much and for how long? The answers to these questions are, at the moment, subjective and subject to the same sorts of targeting errors that traditional financial planning for retirement has, i.e., how much do you think you'll need to spend in retirement?
By comparison the process of consumption smoothing is trivial but if there is ever any science that lets us figure out emergency funding, rest assured that it will make it's way into ESPlanner. Most other things have thus far.
Best,
Dick Munroe